Fixed Income Investment Outlook
January 2013
Our leaders in Washington have resolved one part of the fiscal cliff issue, raising individual taxes, but have not passed a budget or raised the debt ceiling. We are a bit disappointed that there was no grand deal; what we got was the proverbial curate’s egg. Now we are faced with the uncertainty of dealing with the debt ceiling and spending cuts. These issues will hopefully be resolved within the next two months before the debt ceiling is breached, but given the down-to-the-deadline histrionics we just witnessed, we do not expect a proactive approach to addressing these issues. The question now at hand is: How long can business decisions regarding capital spending, hiring and long range planning remain on hold while waiting for more certainty from Washington? Although no one knows the collective answer, we suspect that corporate leaders will eventually return to aggressively and competitively building profitable enterprises. In spite of short-term uncertainty and expected subdued near-term economic growth, all is not bleak. Despite the recent disappointment from our nation’s leaders, there are signs that the U.S. economy could rebound longer term.
Sadly, the current incomplete legislative package keeps investors in a bit of a bind as they try to plot a near-term course of action. In one possible scenario, we get a package of limited spending cuts and could avoid a meaningful economic contraction. One would expect a back-up in interest rates, as the “risk-on” trade takes hold. Equity, convertible bond and high yield bond markets could rally while Treasury bonds and investment grade corporate bonds should weaken. On the other hand, without sounding too much like a nonplussed economist, if our leaders cannot come to an agreement and we do enter sequestration (read: deeper cuts), we could see rates move even lower on Treasuries and investment grade bonds and “risk” assets plunge. If the market’s message is strong enough to bring the parties back to the table to take legislative action on the debt ceiling and the budget, then such a pullback should be used as a welcome buying opportunity. Given this backdrop, we think it is productive to look in more detail at the U.S. and global economies.
Without considering the potential impact of sequestration, U.S. economic growth expectations for the first half of 2013 already seem to be ebbing. According to Bloomberg, the median estimate for real Gross Domestic Product (“GDP”) growth in the first two quarters of 2013 has dropped from 2.4% and 2.8% a year ago to 1.6% and 2.1% today. We assume that estimates would be even lower if we enter sequestration and stay there. According to Bianco Research, the impact of sequestration on GDP is about -3.5%, which would qualify as an economic recession. In turn, we would expect that earnings growth expectations would be muted until meaningful reforms are enacted. In the unlikely event that we enter sequestration, “muddle through” investment strategies that assume we avoid a major economic contraction and continue on a trajectory of slow growth may also need rethinking.
International economic growth is subdued but not dead. Germany is on the verge of falling into recession following most of Europe. Japan’s newly elected premier is strongly urging the central bank for more easing in order to finally inflate the economy and weaken the yen. Hopefully, the recent rally in Japanese stocks is correctly anticipating that the deflationary stranglehold may at last lessen its grip. Meanwhile, China’s economic engine has slowed, but recent stimulative actions by its central government may help reverse that. Additionally, oil prices have fallen a bit, hurting oil exporting countries like Russia, but helping consumers in nations dependent on oil imports. We also continue to see massive monetary stimulus in Europe and Japan. Although subdued economic activity is depressing global trade, it helps alleviate growing imbalances between major trading partners, such as China and the U.S.
Coming back to the U.S., while the consumer does not yet appear to be spending heavily, much less borrowing to do so, there are a number of longer-term tailwinds that could help revive our economy and create job growth. First, the falling price of energy, especially gas, may offset some of the negative impact from the newly enacted tax increases. Additionally, our meaningfully lower natural gas price, combined with a skilled workforce, is a competitive advantage for either re-shoring manufacturing by U.S. companies or for foreign companies building de-novo plants here in the U.S. This is already happening in the petrochemical industry, where energy is a major cost component. By locating refineries here, operators benefit from a meaningful cost advantage globally. U.S. manufacturers are also now discovering that the hidden costs of outsourcing were initially masked by exceptionally low overseas labor costs when the trend began years ago. The December 2012 cover of The Atlantic blares: “Comeback-Why the Future of Industry is in America.” An article titled “The Insourcing Boom” in that issue discusses why General Electric has begun relocating manufacturing and product development for appliances back to Ohio from China. In one example it was able to lower the retail sticker price by 20% for a U.S. made water heater versus the same model made in China. Third, we are still a leading innovator, but have been willing to give up seemingly mundane manufacturing profits to other countries. As we learn more about the advantages of integrating product design, testing and manufacturing here at home, we may capture a larger share of product revenue and profit streams, while actually lowering overall costs. The effects of U.S. innovation and potential renaissance for manufacturing could be positive for GDP growth, employment and tax receipts over time and also help ameliorate our trade imbalance when economic activity picks up.
In spite of the continued short-term uncertainty that has been created by Washington’s inability to deal comprehensively with all of the key issues facing this country, our view of the fixed income markets remains the same as in last quarter’s Investment Outlook. We continue to feel that the mismatch between yield and interest rate exposure means that investment grade bonds are less attractive compared with the non-investment grade universe, especially in shorter maturities. Treasury, investment grade corporate and high yield bonds have yields and effective durations that are virtually unchanged compared to levels three months ago. Yields on short-dated high yield paper have actually risen a bit and are still, in our opinion, the most attractive sector we look at in terms of interest rate risk. We are continuing to keep durations short and look for opportunities to invest when prices are weak. Additionally, given our generally positive long-term outlook for equities, we are also open to adding convertible bonds to the mix as buying opportunities present themselves.
We thank you for your continued support and welcome any comments and questions you may have. Here’s to a healthy and prosperous 2013.
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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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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.
© Osterweis Capital Management
© Osterweis Capital Management
