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Courtney Martin joined MV Financial in 2010. As an investment analyst, her responsibilities include developing allocation models, evaluating assets selected for client portfolios, performing ongoing monitoring, and providing operational support.
In this role, Courtney conducts... Full Bio
Interest rates are once again the trending topic as anticipation for the Fed’s June policy meeting next week grows. Last week we considered the potential impact of a Fed rate hike on equities and the possibility of a pullback. This week we shift the focus to what the Fed action might mean for your fixed income portfolio. Back at the beginning of the year, most economists predicted that the Fed would decide to raise rates in June – meaning next week. But after a string of weak economic data the consensus was pushed back, possibly even to next year. That being said, recent data including nonfarm payrolls and this week’s retail sales have been strong. A September rate move looms large, meaning that it is important to make sure that the fixed income portion of your portfolio is positioned accordingly.
Investors say Junk Bonds are indeed “Junk”
An article in the Financial Times this week focused on outflows in high yield bond ETFs since the beginning of June, citing rising rates as a driver. This does not necessarily mean that you should get rid of your high yield exposure in anticipation of rising rates. High yield (or junk) bonds have been found in the past to be less interest rate sensitive than other investments. Rising rates can indicate an improving economy, which in turn means a better environment for companies with poor credit ratings (those companies are the ones issuing high yield bonds). For these and other reasons, junk bonds tend to trade more like equities than bonds – the Barclays US Corporate High Yield Bond Index is 74% correlated to the S&P 500 versus only a 16% correlation to the Barclays US Aggregate Bond Index over the past five years.
In fact, for much of the past year high yield prices have actually moved in the same direction as benchmark interest rates. As rates fell through the second half of last year, junk prices fell as well. When rates rose on the back of good economic news in February of this year, high yield prices performed well. Where this pattern broke decisively was just a couple weeks ago, when the 10-year yield spiked and junk bonds tanked. In other words, if recent outflows are being driven by rate perceptions, that would seem to be more of an anomaly than the “junk bonds fall when rates rise” rule suggested by the Financial Times’ article.
There are two sides to every coin, and more risks to take into account than the directions of interest rates. Call risk affects any bond with call features, and this includes the vast majority of high yield bonds. Most high yield bonds have a maturity of 10 years but are callable at 5 years. In a falling rate environment these bonds tend to get called because the borrowers can then reissue the same bond with a lower interest rate, meaning their borrowing costs fall. In a rising rate environment the opposite will happen – the bond won’t get called because it would have to be reissued at a higher duration. Investors holding callable bonds can get the worst of both worlds – lower duration when rates fall and higher (i.e. more negative price sensitivity) when rates rise. When positioning portfolios for a rising rate environment it is important not to ignore the implications of call risk.
Ever heard the disclosure “past performance is not indicative of future results”? The above chart illustrates why that regulatory disclosure is always worth keeping in mind. Even though junk bonds have historically performed more in line with equity markets than with fixed income, over the past eight months the correlation has been spottier than usual. Junk bonds mirrored equities until October, when stocks experienced a deep pullback. High yield followed stocks down, but then kept falling while the S&P 500 pulled a stunning V-shaped recovery.
Why the divergence? A considerable number of junk bond issuers are energy exploration and production companies, and the energy sector led the broader market down as oil prices were plunging. So even though the S&P 500 enjoyed a sharp recovery, investors dumped high yield bonds fearing a rise in energy-related default risk. A similar story happened back in 1999 and 2000: during the period of high volatility leading up to the implosion of the tech sector in 2000 (which also happened to be when a rate hike program was in place) junk bonds had a negative return and underperformed other asset classes.
When in Doubt, Diversify
Because it has been awhile since the last Fed policy decision to raise rates (eleven years to be exact), it is difficult to predict how the scenario will play out this time. The more recent data we have on rate hikes happened in the context of a 30 year macro bull market for bonds. If we are about to enter a secular rising rate environment (and we don’t know for sure if this is the case), the most recent comparable data we have to work of off is from 1951 – 1981 – it is safe to say that the world is vastly different now than it was back then. Quite possibly, we are entering into a whole new world of rising rates.
There are some logical assumptions we can make, though. Investments that are less interest rate sensitive (as indicated by shorter effective durations) are more likely to perform better in a rising rate environment. High yield bonds fall into this category, but as we saw above there really are no guarantees. It is more prudent to adjust your allocation accordingly in different market environments rather than to either eliminate an asset class altogether or double down on the one you think (based on past performance) likely to do best.
Floating rate debt, short-term fixed rate issues, agency & non-agency mortgage backs and asset backed securities can potentially help immunize your exposure to interest rate risk. As noted above, don’t forget about call risk. The bottom line is that when the terrain is uncharted, a well-diversified portfolio is likely to be the best way to avoid missteps.
This week we found out that US labor productivity – the output of goods and services per hour worked – of nonfarm workers fell by 1.9% for the second consecutive quarter, bringing the 5 year average to a measly growth rate of only 0.65%. This information comes on the tail of last week’s disappointing news that the economy grew at a mere 0.2% during the first quarter (just an initial estimate – but still). “Fret not!” says Positive Polly – we had another rough winter this year which is probably why the GDP numbers are less than stellar. Labor productivity will increase in time. And unemployment is the lowest it’s been since May 2008!
Indeed, the fundamentals don’t look terrible – the recent jobs numbers have been mostly promising, and (with the exception of Q1) GDP was positive in 2014. But what will it take to return to growth comparable to – or even half as robust as – we saw during the 1990s?
Working 9 to 5
The workforce would seem to be steadily increasing. New jobs have been added every month since September 2010 and, while not at levels pre-financial crisis, the unemployment rate is at a respectable 5.4%. However, there is a dark underlying truth: we have an aging workforce, slowing population growth and (as per the trend described above) slowing productivity. By 2020 approximately 25% of the workforce will be at least 55, and most baby boomers cite their optimum retirement age at 66. This means that by 2030 the majority of baby boomers will no longer be working, and the population hasn’t been increasing enough to support a one for one replacement for this large portion of the workforce. Many women are waiting longer to have children – in 1970 the average age of first time moms was 21 and by 2008 it had increased to 25.1. The birth rate has declined every year since 2007.
Gen Z Bails on After-School Jobs
Another trend working against labor participation growth is at the young end of the labor pool. After-school jobs have become less en vogue with high schoolers, who in other times took on a variety of jobs by way of introducing themselves to the work force. Employment among 16-17 year olds is lower today by 7.8% from its level in 2005. More teenagers are pursuing higher education (census data estimates that only 28.8% of baby boomers earned a bachelor’s degree or higher) and after school work is taking a backburner to SAT prep courses and other pursuits deemed more likely to impress college admissions offices. So not only is the younger generation dropping its after-school jobs, it is also delaying its entrance into the workforce. That also skews the average workforce age higher.
A declining rate of workforce and population growth leave productivity as the only viable path to a faster-growing economy. So we need to pay close attention to what has caused our labor productivity to slow down for the past 5 years. The easy answer would be that the financial crisis is the root of all our productivity problems. But let’s not forget that the recession ended in July of 2009, and even with the combination of a growing workforce and below-trend wages, productivity is still suffering. One reason for this could be due to the fact that companies have prioritized giving money back to shareholders (mostly in the form of dividends and share buybacks) over investing into their businesses. This trend has intensified since 2009. As the old saying goes, you have to spend money to make money. Unless businesses find new ways to invest in and improve the efficiency and effectiveness of their process flows, it may be tough to move that productivity dial much.
Other economists argue that productivity slowed when the technology boom of the 1990s ended, which would signify a much more concerning growth problem in the US. Innovation in the 1980s and 90s saw workplace productivity improve immensely, fueled by adaption of successive Information Age technologies like the PC, client-server networks and Internet 1.0. Now, innovation is not dead – cloud computing, social media and 3D printing are just a few of the technologies which have disrupted traditional industry structures since the dawn of the millennium. So where are the productivity benefits? Perhaps the dynamics of modern consumer markets have contributed to a discord between innovation and efficiencies. Or perhaps we have all grown too impatient, and the productivity gains from recent innovations will show up eventually.
Since the end of the financial crisis, most investment assets have grown at a robust clip. Wages, consumer prices and other economic growth measures have lagged. This is not a recipe for sustainable economic success. We should be mindful of how the productivity trend develops – for therein lies the most plausible key to real growth.
2014 was a year of both higher job growth and consumer confidence, which in turn helped boost retail sales for most of the year. A post-recession high for December consumer confidence, in conjunction with lower gasoline prices, should be a winning combination for more discretionary spending amongst consumers. However, the retail sales data that came out on Wednesday showed a -0.9% decline as well as a downwards revision to the previous release of the strong November numbers from a 0.7% advance to 0.4%.
This brings about the biggest drop in retail sales since last January. Not surprisingly, gasoline stations had the largest decline among the retail sectors with a -6.5% drop (falling oil prices mean gas stations are making less money). We would expect a gas windfall to produce a big bump in middle class spending, but consumers’ savings at the pump don’t seem to be translating into spending elsewhere yet.
The retail sectors that grew in the month of December are arguably the more “staple-like” sectors: food and beverage, furniture and home furnishing, and health and personal care. In contrast, some of the hardest hit retail sectors were clothing stores, motor vehicles, and electronic stores.
Let’s step back from the December figure and consider the larger context. Over the past five years retail sales have grown steadily, while the household savings rate has declined slightly. In 2014 savings fell somewhat more notably, but at the same time the rate of retail sales growth tapered off and in fact was lower than at any time since the end of the recession. This could be a sign that households are doing things with their savings other than going to the mall – paying down debt, perhaps. That may be the signal we are seeing from the December retail number. It also may tie into the stagnation in wage growth we highlighted in last week’s market flash.
Another factor to consider is that maybe the American consumer’s behavior is beginning to change. As noted above, retail sales growth for the year is the lowest that we have seen since we were in the midst of a recession in 2009, which is especially interesting considering that 2014 has been the best recovery year since the recession ended. And although we saw one of the most successful Black Fridays of all time this past November, consumers – and even retailers – showed a noted (if perhaps only anecdotal) reversal in attitude towards the overt commercialism of the day. More and more shoppers are forgoing the mall for their computers to shop, and the holiday season cash cow – where retailers have traditionally made the majority of their yearly earnings – is changing. How this change will impact the broader economy is still a work in progress.
Monthly leading indicators can provide a good spot check on the economy, but are oftentimes misleading as they are subsequently revised and provide a data snapshot of just one month. All in all, we don’t feel that December’s disappointing retail sales numbers are anything to fret over, but we shouldn’t ignore them completely. Traditionally consumer spending drives the US economy as the highest component of GDP. If consumer habits are indeed changing, the very basis of the economy and the way it operates will likely be changing along with it.
The S&P 500 recovered ground this week, climbing from last week’s low of 1909.57 to high of 1953.45 at the time of writing this piece. It seems the market has continued to move onward and upwards, repeatedly shrugging off geopolitical worries as it has for the greater part of this year. While this is seemingly good news for investors, it is important to keep abreast of some of the troubles which are brewing abroad and may bring further volatility in days to come – namely a region which has continually kept investors’ anxiety on edge since the Great Recession, the Eurozone.
Rise up and hear the Bells: Troubling Numbers from Abroad
This week, economic reports from Europe showed that trouble still lingers for many of the countries within the region. Surprisingly, even the stronger economic powerhouses of the continent, such as Germany and France, are beginning to show signs of trouble. Germany’s economy has failed to show positive growth; in recent economic releases German GDP shrank by 0.2% - the first time that the country has shown a negative outlook in over a year – and France’s economy hasn’t shown any growth for the second consecutive quarter year to date. Other countries such as Italy and Spain, who are no strangers to negative economic data, continue in the same fashion with the prospect of steady growth still far off in the horizon.
Draghi: For You They Call
The European Central Bank (ECB) has had their work cut out for them since Draghi’s proclamation of “whatever it takes.” While the Fed continues to tighten the quantitative easing pedal here domestically, abroad it seems the ECB cannot do the same. The ECB, like the Fed, has taken measures to keep low interest rates, encouraging cheap bank loans and purchasing securities to beef up Europe’s respective economies; but it seems the ECB, unlike the Fed, may have to ramp up their efforts in the near future.
Draghi seems to be resistant to this idea however, voicing scrutiny directed towards the leadership of different nations, highlighting that reforms and policies must be enacted within the different Eurozone nations to become more competitive.
The Ship is Anchor’d – Safe and Sound?
So, all this data begs the question: what does this mean for capital markets around the world? The answer is yet to be determined. The US domestic picture continues to be strong; it remains the biggest engine of growth in today’s capital markets. How asset prices begin to reflect the lagging of the Eurozone depends on whether investors will continue to focus on positive US data or if the economies of countries abroad will become too heavy of an anchor for positive overall momentum.
Our outlook remains generally positive; however we will keep a watchful eye on markets abroad from Europe to China and everywhere in between. This year’s markets have been a story without much volatility, but for investors to fall asleep at the wheel now could prove dangerous.
The markets seem to like what new Federal Reserve Chairwoman Janet Yellen has to say, which may be surprising since Ms. Yellen herself has expressed some confusion about the current economic data in front of the Fed. After one of the now seemingly routine DC snowstorms derailed the February 13th meeting, Ms. Yellen testified in front of the Senate Banking Committee on February 27th to discuss the recent soft economic data, weather woes, and the Fed’s outlook for its bond buying program. Nonetheless, U.S. equities have continued on their merry way to successive record highs.
Ms. Yellen did not deviate much from the views of the Fed at the last meeting in January and the monthly tapering program remains in place. However, members’ uncertainty over the current state of the economy has become increasingly apparent.
Economic Data: A Mixed Bag
Some less than stellar economic data have trickled in over the past couple of weeks. U.S. retail sales fell 0.4% (the most since June 2012), industrial production was down 0.3%, and housing data has been mixed. Questions remain about recent employment numbers: Thursday’s jobless claims were 323,000 versus the projected 336,000, but the absolute level would seem to be a bright spot of sunshine. February’s nonfarm payrolls were 175,000, an improvement over January, but the unemployment rate ticked up to 6.7%. The average monthly payroll gain for the December-February period is 129,000 versus 230,000 for the same period one year ago.
A question that has been on everyone’s mind is how much these numbers can be attributed to the unusually harsh winter weather. The soft economic data “may reflect in part adverse weather conditions, but at this point it is difficult to discern exactly how much” stated Yellen, and any effects could be felt months down the road. Investors will be taking an especially hard look at the forthcoming spring numbers to see if there is a resumption of the more robust growth numbers we were starting to see last fall.
Despite the Fed’s uncertainty on this issue, it is expected that March’s FOMC meeting will see continued tapering, which would trim bond purchases another $10 Billion to a total of $55 Billion. Ms. Yellen did not think that the recent soft data was enough to constitute a continued bond buying program, but “if there’s a significant change in the outlook, certainly [the Fed] would be open to reconsidering.”
QE: The Debate Continues
While the consensus remains that QE is in its sunset phase, not all members of the Fed are gung-ho to be done with the program. Philadelphia Fed president, Charles Plosser, is “very worried about the potential unintended consequences” from the unwinding of the program and warned that it may be “many, many years” before the economy returns to growth rates seen before the recession. On Wednesday, U.S. GDP was revised downwards to 2.4% for Q4 2013, a disappointing revision from the initial report of 3.2%.
Elsewhere in the world, the Bank of England and Bank of Japan have followed the Fed’s lead, both embarking on asset buying programs of their own and bringing interest rates to or maintaining them at historic lows. Plosser noted that pressure on central banks to provide stimulus to their struggling national economies is at “unhealthy highs”, giving voice to doubts that the programs may be sustainable for much longer.
The Fed’s effect on the fortunes of emerging markets currencies continues, exacerbated by various geopolitical flashpoints including the turmoil in Ukraine (and, by extension, Russia) and uncertainly in advance of India’s forthcoming national elections. While none of these events by themselves may pose an extreme risk, the heightened baseline volatility in world asset markets is likely to be on the Fed’s radar screen as they ponder the data ahead of this month’s meeting.
Again, our baseline view is little changed: we expect to see the Fed continue with its QE taper and for macroeconomic data to show renewed strength as spring finally arrives. The next set of readings may tell us a great deal about where asset prices are headed in the coming months.