Animal Spirits – Real or Ephemeral?
Investors would have done well in 2016 to heed the words of Heraclitus, paraphrased: “Expect the unexpected.” Brexit and the U.S. election results were two glaring examples of the unexpected becoming reality. We imagine if investors were polled at the end of 2015, not many would have correctly predicted the events of 2016. After getting off to a rough start, high yield was a standout performer. Equities were quite subdued until after the election and investment grade bonds were looking to notch up a pretty good year until animal spirits released the ghost of inflation and rising interest rates. Looking at 2017, the real question for investors is: Is the rally we have seen in equities and high yield sustainable, or is it a head fake?
The Bank of America Merrill Lynch U.S. High Yield Index (BofA ML U.S. HY) returned 17.5% in 2016 following a -4.6% return in 2015. Excluding energy, metals and mining, the return was 12.8% vs. -0.4% in 2015. This means that sectors representing about 14% of the total index at year end 2015 were responsible for more than a quarter of the performance in 2016. In 2015 those same sectors represented about 90% of the negative return in the high yield market; quite a snap back! To help answer the question of what 2017 may bring for high yield, a look at history may help. It is interesting to note that as far back as the calendar year data goes (since 1987), every time the high yield market returned over 10% following a negative return year, the subsequent year’s return was also greater than 10%. This has happened four times. In fact, in two of those instances, the third year was also up more than 10% and in all cases the third year had a positive return. What would need to happen for a repeat in 2017 and how does this market today compare to those at recent peaks? At year-end 2016, the high yield market yields 6.2%, comprised of a 6.5% average coupon, an average price of $99.6 and an average spread of 439 basis points (bps). This compares to the 2014 peak, where the average yield was 5.2%, the coupon was 7.1%, the average price was 105.96 and the spread was 353 bps. The 2007 peak, while not fully comparable, given that the Federal Funds (Fed Funds) rate was 5.25%, had a yield of 7.4% and average price of 101.04 but only had a 252 bps spread. As you can see, it would not be a stretch, assuming the recovery continues, that slightly rising bond prices, coupled with a moderate tightening of spreads added to the current coupon, could give us another good year. We will have to wait and see how things develop.
Equities were late to capture the spirit of recovery in 2016. Through Election Day, the S&P 500 Index (S&P 500) had returned about 6.2%, although by year end the return had jumped to 12.0%. As you can see, about half of the return for the year occurred following the election. We believe that in order for equities to continue their upward trajectory, evidence of durable improved economic data will be needed. Higher Treasury yields alone are not proof of improving economic growth, and could be merely discounting higher inflation expectations.
Investment grade bond returns peaked for the year on July 10th, at over 7.4%, and it was looking like 2016 would be another solid year as the Federal Reserve (the “Fed”) was on hold and the economy was continuing its sub-par recovery. Fed chatter about the possibility of a rate hike in September caused a bit of a wobble, but when it did not materialize (like in 2015), the disappointment was muted. Up until the election, returns were similar to equities, around 5.4%. However, following the surprise victory by the pro-business, pro-growth candidate, investment grade bonds and equities parted ways. The full year return for investment grade was 2.9% for 2016, with most of the weakness occurring post-election. The question for 2017 is whether the Fed actually raises rates according to the latest dot plot, which indicates that three increases to the Fed Funds target rate are possible, or will they return to the dove nest and slow the pace of normalization? This will, of course, depend entirely on how robust the economy grows and how persistent the increases in inflation are.