Fixed Income Investment Outlook
The question we keep asking is “Will the real Fed mandate, please stand up?” The Federal Reserve (the Fed) traditionally is charged with keeping inflation in check, but it also has a second mandate to ensure full employment. This dual mandate can occasionally create general confusion as to what is the best policy at a given time and which policy goal the Fed is trying to achieve. Today, we are at a juncture where the Fed’s mandates may not clearly align with stated future monetary actions. Recent Fed comments about possible tapering of monetary stimulus roiled global markets. Yields on Treasuries spiked, equity markets sold off and yield spreads between “safer” government bonds and the credit sensitive corporate bonds widened as investors became more wary of risk. Additionally, growth in China recently hit a wall, Europe remains mired in recession, and commodity prices and wage growth are both weak. In light of this not so rosy picture, a few more questions come to mind. Does it make sense for the Fed to talk about tapering now? Is the market weakness due to real economic softness or simply fear that the Fed will prematurely become less dovish? In other words, does the good news in the Fed saying the economy is healing, become bad news in terms of the Fed potentially taking away the market’s security blanket? We think it makes sense to take a step back to look at the big picture in order to better understand how best to navigate these choppy waters and separate the good news from the bad.
Inflation appears to be low. The year-on-year change in the Urban CPI currently stands at 1.4%, compared with a peak in 2011 of 3.9%. This is now well below the Fed’s inflation target of 2.0%. Industrial commodity prices, such as steel, copper, aluminum and coal have been weak, which is typically associated with periods of soft economic demand. Prices for food commodities, such as wheat, corn, coffee and sugar have also been soft, but can be attributed to weather patterns and crop yields. Gold has been weak as well, which may reflect more bearish sentiment in China and India. Oil prices have been fairly stable, but at high price levels. While real estate prices are rising, this seems to be offset in the CPI measure of inflation by negative industrial and food inflation. If the pattern of economic growth remains subdued, barring a meaningful recovery in China, we would expect commodity inflation to remain low. Typically, when inflation is low, it is a tailwind for consumers (read: good news for the economy).
The unemployment rate has improved versus the worst readings at the start of the recession, but is still stubbornly above the Fed’s target of 6.5%. Some have argued (and we agree) that much of this improvement is due to changes in the size of the workforce, which is the denominator in calculating the unemployment rate. However, when one looks at other measures, the improvements begin to pale. The most notable measure is the U.S. Labor Force Participation Rate. Since mid-2008, this has steadily dropped from around 66.0% to the current 63.4%. We need to go back to the early 1980’s to find readings this low. Wage growth also remains subdued. For the past three years it has been at or below 2%, barely matching inflation. These data also do not support meaningfully higher interest rates nor presage wage-push inflation (also somewhat good economic news).
Low inflation, weak employment and low wage growth should imply that some easing from the Fed is still needed to avoid deflation and further encourage economic demand. This would in turn hopefully lead to more job creation. According to the Fed Governors most recent projections, the unemployment rate is anticipated to be around 6% by 2015, thereby allowing them to taper monetary stimulus sometime in 2014 as the economy becomes self-sustaining. But, how accurate has the Fed been in its past projections and can we rely on their forecasts of future economic growth? Bianco Research recently highlighted an article in the Washington Post that tracked the Fed Board of Governors’ economic predictions since 2009. According to predictions made in 2009, 2010 and 2011, GDP growth should be nearing 4% by now. In fact, it appears that the Fed Governors, along with the Congressional Budget Office, have been consistently overly optimistic in their economic projections. Assuming they are correct this time, in their forecast of better economic times, this should eventually translate into good news for the economy. However, if past is prologue and they’re once again overly optimistic, meaning economic growth will be below expectations, then shouldn’t we expect continued stimulus? If that is the case, this recent market weakness may be a head fake. A contrarian would argue that we should wait for the Fed to get more bearish in their outlook before worrying about a robust economy, sustainably higher interest rates and rising inflation.
Looking at Treasuries, the 5-year Treasury yield has more than doubled from 0.6% on May 2nd of this year to 1.4% at quarter end. 10- and 30-year yields also bottomed this year on May 2nd at 1.7% and 2.8% respectively. They ended the quarter at 2.5% and 3.5%, respectively. This essentially brings rates back to where they were in August of 2011. A skeptic would say that the expansion in the Fed’s balance sheet over the past two years may not have borne much fruit. An optimist might observe that if, in fact, the economy has become self-sustaining, albeit with a subdued growth rate, then the trillions were well spent and interest rates should return to their natural levels, after being held artificially low. We think the answer likely lies somewhere between these two views. Although economic growth is subdued, and may remain so for some time, interest rates are still very low by historical standards and the Fed should probably keep some dry powder by easing up on the stimulus.
In the end, future Fed actions will be data dependent. The Fed stressed this repeatedly in its recent communications. Given that their forecast is for improved economic performance, it follows that a tapering of Quantitative Easing is appropriate. The markets seemed surprised by this and traded down violently. This begs the question: Is this “new” forecast by the Fed materially different from what Wall Street analysts were expecting? Not really. Most economists have been fairly optimistic about continued, albeit subdued growth in the U.S. and a slowly improving labor picture. Perhaps they were surprised that the Fed would agree with them? We think that the prospect of withdrawal of Fed stimulus has unnerved the markets more than the pleasant thoughts of a sustainable expansion and slowly rising interest rates. Only time will tell.
In sum, we think most signs point to continuing below average economic growth, low commodity price inflation and stagnant wage growth. This would argue for below-trend yields and no major short-term shifts in Fed policy. In this type of environment, well managed companies should do reasonably well as reduced costs offset less-than-robust demand. We have been in a low growth, low interest rate environment for some time and small changes in expectations can sometimes generate large changes in market sentiment. For example, Japan, which has been fighting deflation for the past twenty years, and has been mired in low interest rates, has had a number of large market moves, both bull and bear, but the net long term result is that since 1995, the return on the Nikkei Index has been minimal. Returns in their bond market have also been low. If, in fact, we are entering such an extended period of slow growth here in the U.S., we feel that the low rates in the investment grade sector of our bond market are not attractive. We continue to find values in higher yielding securities with short to intermediate duration of companies we feel are well managed. In periods of market weakness, we plan to continue to opportunistically add positions in companies we like at higher yields and also in convertible securities where we may get bond-like yields with potential upside from future stock price appreciation.
Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
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The CPI (Consumer Price Index) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
The Nikkei Index is an index of 225 leading stocks traded on the Tokyo stock exchange. It is not possible to invest directly in an index.
Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. 
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