Keeping a Close Eye on Corporate Bonds

As we’ve stated in recent market notes and quarterly conference calls, we have grown somewhat cautious on corporate credit. It is best to anticipate a turn in the market and position ahead of widening spreads, but as we all know, the signs are not always obvious when it comes to calling an inflection point.

One caution sign we see this year is corporate spreads modestly widening from historically very tight levels. Some of this widening we attribute to technical factors. There is less buying support from foreign buyers as hedging costs rise in tandem with LIBOR spreads. There is also some selling pressure while corporate treasurers unload short-term bank bonds as part of their cash repatriation program. 

But some of this widening, we believe, its attributable to investors acknowledging that corporate earnings are peaking, balance sheets are cyclically fully leveraged, and current tight spreads may not fully compensate for risks at this point in the cycle. Recently we have seen BBB’s start to widen vs A’s, and we believe this could be one of the early signs that all spreads may continue to drift wider as this long-lasting credit cycle starts to fade.

Spread Premium of BBB-rated corporates vs. A-rated corporates –  Ten Year Maturity

5.21.18 photo.jpg

What makes calling the inflation point an art rather than a science is that not all signs are pointing in the same direction. For example, high yield spreads are, in some cases, holding in better than investment grade spreads. Perhaps in this yield starved environment greed still overcomes fear, or perhaps high yield default rates are still very low.

Heeding the above caution signs, we have peeled back some corporate risk in portfolios. At this point in the cycle there is more downside than upside, so it makes sense to act on these early signs and anticipate the turn.

Source: Barclays

Will Higher Oil Prices Grease the Path to Recession?

Oil prices are up 17% so far this year, and the news is filled with stories of higher oil prices greasing the path to the next economic downturn. Quite frankly, we don’t see this happening, as the facts tell a different story.

First, oil prices are not historically high. It may be hard to remember, but the average price of oil over the last ten years has been just about $75/barrel. So even if oil goes to $90 or more in the short term, it would not be out of line with other strong economic periods. Remember, oil was over $140/barrel during the boom times before 2008, and high oil prices were not the cause of the great recession.

Second, today’s relatively higher oil prices are due to recent supply constraints from Saudi Arabia and Russia, who desperately needed higher oil prices to balance their budgets. When oil was below $40 in 2016 these countries were in dire financial straits. The green bars in the chart below show how recent supply constraints have led to oil inventory reductions during the past few quarters. Now that inventories are reduced to more normal levels and oil prices are higher, the Saudis, the Russians and others will likely produce more. And as we know, more production will eventually lead to lower prices. The oil price cycle does not rest!

5.14.18 Weekly Bullet.png

Finally, today’s higher oil prices do not take the same bite out of the economy as those of the past. The U.S. is now one of the largest oil producers in the world and we are far less dependent on imported oil. Furthermore, the economy is far more energy efficient, and few of us are driving the 12 mpg gas-guzzlers we did in the 1970s. My new Subaru gets 33 mpg, but I still miss my 1974 Thunderbird with the Rocket 4 barrel V-8 engine!

Sources:  U.S. Energy Information Administration, Bloomberg, the Financial Times

Federal Reserve Word of the Day: Symmetric

What is so special about “symmetric”? Last week the Federal Reserve added this one little word to its post meeting statement, which created quite a stir. As we know, the latest economic numbers show the Fed’s inflation target (as measured by core PCE) is just shy of its 2% target, and everyone wants to know how reaching this target will impact the speed of rate increases. The Fed said:

“The Committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace in the medium term and labor market conditions will remain strong. Inflation on a 12-month basis is expected to run near the Committee's symmetric 2 percent objective over the medium term. Risks to the economic outlook appear roughly balanced.”

What does this mean for the speed of rate increases? Some say it is hawkish, some say dovish and others think it is balanced. We could speculate, but we think the data will have the final word. If we look at core PCE over the last twenty years, it was only over 2% consistently during the four years prior to the financial crisis. In fact, the average over the last 20 years is only 1.6%.

5.7.18 photo.jpg

What the data says to us is that a small rise above 2% is not uncommon in a robust economy, and that the Fed can just continue slowly raising rates. It can indeed be balanced and symmetric in raising rates. From our perspective, this is fine. As we have been saying for a while, getting more income in high quality bond portfolios is a good thing!

Sources:  The Federal Reserve, Bloomberg, The Financial Times, The Wall Street Journal

MuniLand – State General Obligation Credits Present Opportunities as Late Cycle Haven

A flattening yield curve, tight credit spreads and positive but slowing employment growth are key indicators that the extended U.S. economic cycle may be reaching an end. In this investment environment state General Obligation and Appropriation bonds may present more reward than risk. States have sovereign powers to tax, promulgate legislation and reduce expenses, which better protects their bonds from economic forces compared to other sectors of the municipal market. For example, a toll road is dependent on vehicular traffic and toll fares. Vehicular traffic typically increases during periods of economic expansion, as a growing economy encourages more miles driven to work and a greater willingness to pay tolls. When an economy slows, jobs are lost, fewer people drive to work and freeways and surface streets become a substitute for tollways. States are also sensitive to economic conditions, but have the ability (and in many cases the “rainy day funds”) to manage through downturns better than highly economic sectors of the municipal market. Super high-grade states that structurally balance their budget, manage future obligations well and have management teams and political leadership with a demonstrated willingness to adjust to economic realities continue to be a stable source of risk-off exposure. On the other end of the spectrum are BBB rated states. BBBs exhibit dysfunctional budget and legislative processes, backlogs of unpaid bills and the potential of falling into the non-investment grade universe. While cheap to extremely cheap, these credits do not have the fiscal cushion to muddle their way through an economic downturn. There are also mid-range state credits that that have stabilizing credit pictures, demonstrate the political ability and willingness to tap new revenue sources and have economic fundamentals that are less volatile than the national averages. These states and associated tax-backed bonds offer value and are better positioned to handle a potential downturn in the economy.

Source: SNW Asset Management Research Team

The Sun Also Rises…….

Last week the ten-year treasury touched 3.0%, as the economy continues to improve and this quarter’s earning’s season has been quite strong. However, the performance of risk assets did not correspond to this rosy picture. Look what happened to Caterpillar’s stock price when it announced a very strong quarter, but stated that Q1 likely represents the high point of their year (the company’s stock closed down 6.2% on Tuesday).

The ten-year is higher now than it has been since 2011 and S&P 500 earnings are up a whopping 26% so far this quarter compared to the same time last year. Lower taxes, a growing economy and a weaker dollar all have contributed to higher earnings. Still, this torrid pace of growth will end; trees don’t grow to the sky and we don’t expect earnings growth will either.

5.1.18 photo.jpg

While the sun may be setting in the eyes of some risk assets, for fixed income investors, the sun is actually rising. High grade fixed income investing is all about income and safety. When you can get a good return over inflation on government bonds, protect principal and avoid significant volatility, it is a bright new day.

The two-year treasury topped out at close to 2.5% last week, the first time it has been this high in ten years! With core inflation (as measured by PCE) of 1.9%, this is a great combination of risk-free income and safety. Add some yield on top of this risk-free rate with high quality tax-free municipals or corporate bonds and it is an even brighter sunny day as a fixed coupon and principal returned at par is a marvelous thing.  

Income and safety. The sun is rising, so enjoy the new day!

Sources: Bloomberg, The Financial Times, The Wall Street Journal