Advises Bonds Close to Fair Value, Caution Warranted
KOHLER, Wis., October 21, 2010
Looking back at our forecast for 2010, we got a lot right. Last year at this time, we predicted that the economic recovery was going to be historically weak and that inflation and interest rates would stay lower longer than people expected. Many believed we would see a sharp recovery following the severe recession we experienced in 2008 and the first half of 2009 because that is what occurred in past post WWII recession/recovery cycles. A strong recovery, along with massive liquidity supplied by the Federal Reserve, would have quickly pushed inflation and interest rates higher in 2010. Our forecast for a weak recovery and low inflation, which has in fact prevailed in 2010, was based on the belief that an impaired consumer would not lead this recovery and that the additional economic “headwinds” of increased regulation, higher taxes, huge federal deficits and rising foreclosures would further restrain growth. Interest rates have actually fallen in 2010 with resulting strong bond returns.
But it’s been a bumpy ride. Going forward, we see many of the same constraints for the consumer – high unemployment, tight credit and impaired net worth.. Policy uncertainty due to health care and regulatory reform, along with expected higher taxes, is weighing heavily on the business mindset. With many of the temporary federal stimulus programs behind us such as the first-time homebuyer tax credit, economic growth is likely to remain subpar.
Though post WWII historical economic data would suggest 9% growth in the first year of this recovery given the severity of the recession, actual growth has been only 3%. We are sometimes asked how this contraction compares to the Great Depression. This one was mild in comparison in both depth and duration mainly due to the massive government response. Federal Reserve Chairman Ben Bernanke, a former academic who studied the Great Depression, erred on the side of avoiding a 1930’s style deflationary collapse of the economy.
But the positive effects of $800 billion in stimulus are now behind us and the absence of government spending will act as a drag in coming quarters. While the stimulus helped, it did not produce a lasting jobs recovery. To understand the weakness in jobs, one needs to look beyond the stated unemployment rate at underemployment caused by furloughs, part-time jobs and those who stopped actively looking. The underemployment rate is 17% -- roughly 1 in 5 adults who would like full time work isn’t working full time. At a 4% real GDP growth rate, it would still take over 5 years to reduce the unemployment rate from almost 10% down to 5%, where it was prior to the start of the recession in December of 2007. U.S. GDP is currently growing at 2%. Clearly the jobs recovery will take a long time.
While we struggle to grow, Europe faces continued challenges. The United States and Europe are headed in different direction as Europe is more focused on austerity measures to fix their debt crisis.
Here the Fed has been extraordinarily accommodative. The most impactful thing they did was to bring short rates down to near zero. The only other time we’ve seen this was during the Great Depression. Despite this “pedal to the metal” zero-rate policy, deflation, not inflation, is the near-term concern given the historically weak, below-trend growth we are experiencing
While many watch commodities, we watch wages closely for signs of inflation. Once you embed rising inflation into wages you have a problem. But wage pressures are nonexistent now. Unemployment and underemployment will keep inflation lower longer. As of June 30, core CPI was .9%, below the Fed’s preferred range of 1.5% - 2.0%
Falling prices in the housing market have been another headwind to economic growth. The mortgage equity withdrawal that fueled consumer spending prior to 2007 is having a huge reverse effect now. An unsustainable debt burden was built, and debt is still too high. Total private sector debt at the end of the first quarter was over $24 trillion with household home mortgage debt 45% of the total. Nominal GDP is $14.6 trillion for comparison. The 2008 financial crisis was the tipping point that forced the deleveraging process to begin. We underestimated how destructive that deleveraging process would be as individuals sold assets to pay debt which put more downward pressure on asset prices. Household net worth is down with home values and stock portfolios well below ’07 peaks. Year over year to June 30, the savings rate is +4% and consumer credit is -4%. In the long run, less debt and more savings for the consumer will lead to a healthier economy. In the short run, it limits economic activity.
Home prices have stabilized at lower levels. They are actually up 4.2% on a year over year basis. With the expiration of the tax credit, home sales activity has temporarily fallen sharply, and the pipeline of foreclosures continues to put downward pressure on prices. Despite these concerns, we believe most of the housing price declines are behind us.
While the consumer has pulled back, the government has used its balance sheet to fill the void and spent unprecedented amounts of money. To put this in context, the government’s response to the crisis is greater in current dollars than the price tag of WWII. But this massive outlay means we are now in the second year of annual federal deficits approaching $1.5 trillion
Can we support these deficits? Today it isn’t a problem because demand for Treasury debt remains strong given the current global flight to safety and liquidity. If anything, we think Treasury prices are too high and overvalued though we don’t believe they represent another full-blown bubble. As a result, we maintain some holding in Treasuries for liquidity, but are underweight the sector.
But we continue to become more of a debtor to China. China leads the group of foreigners who continue to buy more than 40% of U.S. Treasury debt. China is now the number two economy in the world, surpassing Japan, and their global influence continues to grow.
The seeds of the current financial crisis were planted a long time ago. And the fix will take longer because of added debt over the subsequent years. How much pain will we see as we address serious structural issues? Harrisburg, PA recently avoided a default. And there continues to be pressure in both the public and private sectors of our economy.
However, a bright spot in this recovery has been strong corporate profits. Business spending has led the recovery. We see some hesitation about investing these profits; uncertainty makes it difficult to make long term decisions. Many businesses are on hold due to the uncertainty surrounding policy changes – new financial regulations, healthcare reform and impending tax hikes. A huge amount of cash is building up on corporate balance sheets which are quite healthy now.
A lot of this corporate cash found its way into the bond market. Rates have fallen. Weren’t rates supposed to rise in 2010? We always say, “Beware the consensus.” Ninety percent of experts thought interest rates would be higher this year. Only 6% expected them to be lower. The 10-year yield fell more than 100 basis points—that’s almost 12% of total return for 2010! We remain committed to our duration neutral strategy as the consensus is frequently wrong.
Demand for bonds continues to be strong. Corporate spreads have generally returned to fair value, but selected opportunities still exist. But what about supply? The supply of U.S. Treasuries ballooned in 2009 while there was a net pay down in asset backed securities (ABS) and commercial mortgage backed securities (CMBS). In fact, when you take into account the reinvestment of coupon income, net new supply of all non-Treasury sectors is actually expected to be negative for 2010, and we expect these favorable net supply trends to continue. Borrowers paying down mortgage balances, weak refinancing and weak purchase activity contributes to the negative net supply for agency mortgage backed securities. Given low mortgage rates, refinancing is surprisingly low. But a lack of home equity has reduced many people’s ability to refinance.
With the exception of agency MBS, most sectors are close to fair value. Agency mortgage pass-through securities are overvalued. We expect this sector to underperform US Treasuries and other non-Treasury sectors given current tight spreads and the substantial extension risk inherent in mortgage backed pass-through securities.
Overall, we are closer to fair value. Selectively, we still see some value, but you need to be careful. In this environment, don’t try to create an “opportunity” when the market isn’t giving you one.
On the municipal front, there are positive technical factors such as strong demand. In general, investors increased their bond allocations after the crisis. Higher tax rates are widely expected. Money market yields near zero are driving investors out the yield curve into bonds. The ratio of Treasury to municipal yields still looks attractive, especially for investors in top brackets. Adding to the positive technicals, the tax-exempt supply is significantly reduced due to the issuance of taxable “Build America” bonds by many municipalities.
Though supply/demand technicals are very favorable for municipal bonds, we see negative credit fundamentals. Tax revenue collections are experiencing ongoing declines. Large structural deficits are difficult to close. And rating agency downgrades are a risk. While credit problems were immediately evident in corporate markets during 2008 and early 2009, it takes longer for these issues to surface in municipal credits. So we caution against going too far down in quality or too far out the yield curve in municipals.
So on to our investment outlook:
- We are positioned to benefit from a steep yield curve. We remain duration neutral, but emphasize securities with attractive yield curve “roll down” (bonds that were originally bought on the steep part of the yield curve and represent higher total return potential as time passes and they roll down to lower yielding, higher price points).
- Added value can be found in investment grade corporate bonds – particularly financials – and selected mortgage backed and asset-backed securities. Financials benefit from improved liquidity, less leverage and a steep yield curve. We look for selective opportunities in senior classes of asset backed and mortgage backed securities.
- There is still good relative value in high quality municipals. Be careful not to go too far out the yield curve or too low in quality.
- In a higher risk environment, risk control is critical to a bond strategy’s long-term success.
In closing, I wanted to take a moment to acknowledge an important milestone for our team. While our core team has worked together for 27 years, we are celebrating the 10th anniversary of the launch of the Baird Bond Funds.
About Mary Ellen Stanek, CFA
Mary Ellen has over 30 years of investment experience managing various types of fixed income portfolios. Prior to joining Baird Advisors, Mary Ellen was President and Chief Executive Officer of Firstar Investment Research and Management Company (FIRMCO) and was Director of Fixed Income. She is responsible for the formulation of fixed income strategy as well as the development and portfolio management of all fixed income services. Baird Advisors manages $15 billion in fixed-income assets.
Baird is an employee-owned, international wealth management, capital markets, private equity and asset management firm with offices in the United States, Europe and Asia. Established in 1919, Baird has more than 2,400 associates serving the needs of individual, corporate, institutional and municipal clients. Baird oversees and manages client assets of more than $78billion. Committed to being a great place to work, Baird ranked number 11 on FORTUNE’s “100 Best Companies to Work For” in 2010 – its seventh consecutive year on the list. Baird’s principal operating subsidiaries are Robert W. Baird & Co. in the United States and Robert W. Baird Group Ltd. in Europe. Baird also has an operating subsidiary in Asia supporting Baird’s private equity operations. For more information, please visit Baird’s Web site at www.rwbaird.com.
Important Disclosure Information:
This is not a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. The information has been obtained from sources considered reliable, but we cannot guarantee the accuracy. The source material for all statistical data cited is available upon request.
In a rising interest environment, the value of bonds generally decreases. Investments in mortgage- and asset-backed securities which include interest rate, prepayment and default risks more pronounced than those of other fixed income securities.
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