Fixed Income Investment Outlook
Last quarter we wrote about the confusion that can be created by the Federal Reserve’s (Fed’s) two official mandates: keeping inflation in check and ensuring full employment. We also pointed out that given the rather fragile economic backdrop, talk of letting the economy stand on its own two feet by reducing their bond buying might be premature. During the third quarter, it appeared most economists felt comfortable that the Fed would indeed begin “tapering” its purchase of Treasuries and mortgage securities after the September Federal Open Market Committee (FOMC) meeting. While a very small minority remained skeptical, the consensus forecast gravitated to a $10-15 billion monthly reduction in asset purchases and an end to those purchases altogether by mid-2014. It appeared to be a done deal. The reaction to this “fait accompli” was most acutely felt in emerging markets, with a rapid decline in their currencies versus the U.S. dollar caused by the fear that rising rates in the U.S. would lead to a rise in capital outflows from their markets. As everybody now knows, the Fed surprised the markets on September 18th by reversing course and announcing that their bond buying would continue unabated. Treasury and equity markets initially posted healthy gains, but after the euphoria wore off, equity markets sold off from their highs, while Treasuries marked time. We would posit that the recent Fed action has created more, not less uncertainty in the markets and that good news (no tapering) may actually be bad news (the economy is weaker than many recently thought). However, in our minds the overall economic situation is relatively unchanged from last quarter.
For us, it is unclear why there was such consensus that the Fed would taper in September. In their initial announcement they noted that any action would be data dependent. Based on economic data since May, we see weakness in some drivers of growth. New home sales, durable goods orders, capital goods orders, personal consumption, core price deflation, and consumer sentiment all weakened a bit during the summer months. The Fed governors also lowered their economic growth projections following the September FOMC meeting (see our last outlook for our thoughts on FOMC forecasting). Oil prices increased over the summer, initially due to seasonal factors and later because of increasing tensions in the Middle East. Remember that rising energy prices typically act as a headwind on the consumer. The Fed was surely taking all of this into account during the summer.
Another possible factor in their decision is what happened in emerging markets. While emerging market currencies were actually declining prior to the “taper” talk, it seems plausible that the Fed’s intended actions may have hastened those capital outflows looking for shelter in more established markets. In India, for example, the rupee/dollar exchange rate moved from about 55 in mid-May to a high of almost 69 by the end of August, a 25% devaluation. The Brazilian real also depreciated approximately 20% versus the dollar in the same period, reaching a 4 ½ year low, as did a number of other currencies. While not unprecedented in magnitude, these rapid changes are extremely disruptive to less developed economies. Typically, expectations for spikes in inflation cause central banks to raise interest rates, which can choke off economic growth if not quickly reversed. Brazil’s central bank raised its target interest rate to 9% and India’s central bank rate was raised to 10.25%. Unfortunately, central banks in the affected countries must also use valuable U.S. dollar reserves to support their currencies, which they did in August and September. So, was the Fed correct in changing their intentions due to weak data? Only time will tell.
After the June weakness in the equity market caused by the premature talk of tapering, major indexes managed to rally throughout the summer to new highs in September. One can make the case that markets do adjust to unexpected news as new realities are priced in. Removing the market easing crutch was initially viewed negatively, but the underpinnings of such a change by the Fed must be positive, no? The belief that the Fed would not end one of their major market supports if the economy were not healthy enough led to increased confidence and rising equity markets, despite higher interest rates, throughout the summer. Bad news morphed into good news once again. (We discussed this schizophrenic perception of good news/bad news last quarter.) It seems the markets are still non-plussed.
Now, with the Fed seemingly reversing course in September, we seem to have experienced a mirror-like reaction in the markets. Initially the news of no “tapering” was greeted with a strong rally in both equities and Treasuries, but quickly reversed to selling in equities due to the realization that perhaps the underlying weakness in the economy was the factor that led to the Fed’s U-turn. Again, good news turned to bad. Asian markets rallied on the news, and emerging market currencies continued their rally which began after their central banks intervened in late August.
Given all of the confusion created by the Fed, we have to ask: Has the Fed lost its way? The Fed stressed in May that any future actions would be data dependent. The markets interpreted that as meaning that they must have had the data they needed to pull away from their asset purchases. However, the Fed remained true to their word and as economic data stumbled a bit over the summer, they concluded that now is not the appropriate time to tighten policy. Sometimes people hear what they want to hear and not what is actually being said.
This begs the question: What is an appropriate course of action for fixed income investors going forward? Given our risk-averse nature, we have always felt it is best to control what we reasonably can and to avoid jumping from one strategy to another in an attempt to get ahead of anticipated actions, over which we have no special insights or control. We all look at the same data and draw our own conclusions. If there is no clear directional change in the data, then how does one justify changing course? For some time now we have held the belief that the U.S. economy has been and will likely continue to be in a low-growth, low-inflation environment. As the Fed continues to increase its balance sheet, this will likely continue to act as a headwind to growth. If we are correct that governmental actions continue to inhibit growth, then the next question is: when will growth be strong enough to justify an exit by the Fed? We will leave that topic for future outlooks as the global markets continue to heal. While Europe seems to have stabilized, it is at a level of growth straddling zero. They have not yet recapitalized their banks, so future growth likely remains tepid. Asian and emerging markets have been buffeted this summer and hopefully we will see signs of stabilization there soon.
At the risk of sounding like a broken record, in light of the returns offered in the market weighed against the risks, we still favor the path we have been on for some time. That is, to emphasize shorter-dated maturities in well-managed companies within the high yield universe. We are also looking for opportunities in convertible securities. As companies continue to take advantage of record low interest rates by refinancing their debt, default rates should remain relatively low as maturities are pushed out and interest burdens are lowered. Unfortunately there is no free lunch and this is reflected in the relatively low absolute rates offered in the high yield universe driven by strong demand from investors. As you know, we will not stretch for extra yield by extending maturities until the returns justify it. Hence our focus is on shorter maturities, where duration risk is lower. While Treasury yields have risen somewhat in the past few months, they still don’t represent compelling value to us. As we approach the budget and debt showdowns in Washington D.C., the possibility of more market turbulence exists. Therefore, we are keeping some cash on hand in order to buy on weakness should the opportunity arise.
Let’s hope that calmer markets prevail and once again thank you for your confidence in us.
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