The Sub Par Recovery Continues: Fixed Income Investment Outlook
There is a well-known trading adage, “Sell in May and go away,” which espouses selling your stocks to avoid a seasonal pre-summer decline in prices. Selling in May (or April or June) did not work this year as the markets continued their rise to new highs. Perhaps the reason for this is that the weather-induced economic weakness of the first quarter has been followed by increased optimism for growth in the second quarter and beyond. We have seen inflation, even in the core (ex- food and energy) rise, although this may be transitory. Recent events have elevated geo-political risks, but the markets do not seem to be paying much heed at this time. The questions we are continuing to ask are: What has really changed economically and how should investors think about the future?
Initial first quarter Gross Domestic Product (GDP) was reported at a negative 1%. Consensus estimates for the revision to Q1 GDP were a negative 1.8%; while the actual revision came in much worse at a negative 2.9%. This means that in order for the full year GDP to reach most economists’ earlier projections of approximately 3%, we would need a nearly 5% average growth rate for the next three quarters. This may explain why 2014 GDP estimates have been coming down. We believe that although the rebound in economic growth in the second quarter may be a mirror image of the first quarter, that growth for the remainder of the year will likely resume the sub-par trajectory we have seen for most of the past five years.
Headline inflation recently increased from 0.3% in April to 0.4% in May. The Core Consumer Price Index (CPI) (ex- food and energy) also surprised to the upside, moving from 0.2% to 0.3%. In both cases, economists had expected 0.2%. This puts the annualized readings for both measures above the Federal Reserve’s (the Fed’s) 2% target. These are, however, rounded numbers. When we look at the raw core CPI numbers, we find that the past two months were actually 0.24% (which rounds to 0.2%) and 0.26% (which rounds to 0.3%), a much smaller annualized increase. The amount of press this has received is in keeping with our thesis that in low-return, low-volatility environments, small surprises can generate a lot of hand wringing but little actual impact. Fed Chairwoman Janet Yellen, in her post Federal Open Market Committee (FOMC) press conference, dismissed the increase in inflation as being “noisy” and has stated that the Fed can tolerate readings above their target. Although one data point isn’t a trend, it will be interesting to see if the upward tick in inflation is temporary or if it has staying power.
The conflict between Russia and Ukraine continues, but markets seem confident that whatever the outcome, it will likely have little lasting impact on the U.S. economy or financial markets. Recent sectarian violence in Iraq may be a different story, however, as any disruption of oil flows there may cause a further spike in energy prices. Both Brent and West Texas Intermediate (WTI) crude oil rose as high as 5% after the latest hostilities began, but have since pulled back. Although the overall market seems to be largely ignoring the situation in Iraq, it bears watching because sustained increases in energy prices act like a tax on consumers, which could be an economic headwind by causing consumer spending to slow. The main conclusion from the recent Fed meeting was that their full year economic outlook was tempered a bit as a result of slower than expected first quarter growth. As expected, they also continued to taper their purchases of securities by another $10 billion per month. However, their terminal interest rate forecasts (the “dots”) moved up a bit. Technically, this could be interpreted as marginally more hawkish. We believe that the Fed is worried about market distortions and diminishing returns on their liquidity “investments.” The Fed recently announced that they will conclude their bond buying stimulus by October. The next phase of stimulus will likely consist of more forward guidance and some re-investing of interest income and maturing security proceeds from their portfolio. They can fully re-invest those or they can taper those as well and accelerate the shrinkage of Fed holdings. Such decisions will presumably depend on future economic data.
In the meantime, we think that forward guidance will remain generally dovish, which helps the markets adjust to less actual stimulus. At some point interest rates will likely rise, but we believe they will do so gingerly. The Bank of England will likely be the first central bank to raise rates and all eyes will be watching to see how markets respond. Their central bankers have been talking about it for some time, so it should not be a surprise to anyone when it happens, but as in the past, we can never be certain. We continue to expect sub-par growth with below-trend, but slowly improving, employment statistics. We think wage growth will remain subdued and that although reported inflation may rise, it should not spike to dangerous levels. Treasury bonds have had a good run so far this year, but have recently pulled back a bit. If the economy does continue its rebound from the dismal first quarter, we may see a further sell-off. In any case, we feel that current Treasury yields do not adequately compensate us in a benign interest rate environment, nor do they offer enough protection against rising interest rates. We continue to believe that the best risk/reward opportunities lie in the U.S. shorter duration high yield market and also in select convertible bond issues; and we continue to position ourselves accordingly. Cash is also a valuable commodity, especially in periods of rising volatility (read: corrections) which have been notably absent so far this year. In markets like these where valuations are elevated, but reasonable relative to major markets elsewhere in the world, we continue to believe that accepting somewhat lower returns and being well-positioned to preserve capital is preferable to reaching for extra returns and hoping that the day of reckoning is still far off.
As always, we thank you for the trust you place in us and welcome any questions or comments.
Sincerely,
Carl Kaufman
Simon Lee
Bradley Kane
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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Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.
Duration measures the potential volatility of the price of a debt security, or the aggregate market value of a portfolio of debt securities, prior to maturity. Securities with longer durations generally have more volatile prices than securities of comparable quality with shorter durations.
One cannot invest directly in an index. [9774]
© Osterweis Capital Management
© Osterweis Capital Management
