Today’s Economy: It’s Not Like it Used to be
Recent economic and asset trends have perplexed more than investment advisors and investors. Even some very talented fixed income professionals are surprised by recent trends in the U.S. economy.
Last Thursday, while a guest on CNBC, Guggenheim Partners CIO, Scott Minerd, said a few things which caught our attention. He stated that he still likes junk bonds and loans because credit spreads in this area of the market have “historically” narrowed when the Fed tightens policy. As our previous charts prove, Mr. Minerd is correct. However, as we have stated many times prior, Fed policy and the economic construct of the U.S. (and the world for that matter) have never been here before. Thus, history might not repeat, or as we have argued, history has already repeated. With high yield credit spreads as narrow, or narrower than any time in the past, other than during the housing bubble, it might be unrealistic to expect high yield bond and loan credits spreads to narrow further. As we are six years into an expansion, it is not unreasonable to conclude that all the spread narrowing which we have already seen is all we are likely to see.
Another statement by Mr. Minerd which caught our attention was with regard to investors continuing to plow money into bonds instead of stocks. Mr. Minerd stated: “I just think the demographics in this country, where people are so income oriented, every time we get this kind of backup in rates people see it as an opportunity to put money to work.” Bingo! The failure of the great rotation to materialize, the inability for long-term interest rates to rise and the relatively low participation in the equity rally by individual investors appears to be due to demographics and a need for income. This thirst for income is a new paradigm. Portfolios among Boomers could be more fixed income weighted than in the past. Thus, when interest rates rise, capital could be attracted by the ability to earn higher levels of income rather than repelled by the possibility of price declines. After all, if one is primarily concerned with income generation and one has the ability to hold until maturity, or until a fixed income security is called, price volatility is little more than noise.
Demographics could be a game-changer for the high yield market. In years past, the high yield bond and loan markets were populated by aggressive and speculative investors seeking high total returns. Today, the number of not-quite-so aggressive investors seeking to generate income is greater than in the past. Bond Squad believes that, if higher yields can be found further up the credit scale, there could be a tide of capital out of junk debt into the higher-quality areas of the fixed income market. This could also put a damper on the junk bond spread narrowing story.
Our view is that successful fixed income investing is based on three basic principles:
Know what has happened in the past.
Understand what is different today.
Do not stray beyond your true suitability requirements.
By staying true to these principles, Bond Squad believes intelligent and suitable fixed income portfolios can be constructed. Fixed income investing needn’t involve financial alchemy.
We advise readers to pay close attention to volatility in the interest rate markets (UST, German Bunds, etc.). There is much repositioning going on. EMU sovereign debt were apparently overbought. There was an unwinding of interest rate and currency arbitrage trades. There might have also been some selling of UST to meet margin calls in other assets. Although liquidity in the UST market is less than what it was in the past, it is still the most liquid bond market on the planet.
Mr. Minerd voiced his opinion that the result of Fed tightening should be a flatter yield curve, with short-term rates moderately higher and long-term rates not much higher than today’s levels. Bond Squad concurs and have been of this opinion for quite some time.
In the March 11, 2015 edition of Making Sense, we wrote: Some investors might wish to go long the dollar, but we are probably in the seventh inning of that game.
Checkout the trading pattern of the DXY USD index since that date:
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.