the waiting is the hardest part
Randy Masel, Managing Director (April 11, 2017)
The first quarter of 2017 proved very friendly for most risk assets. The S&P 500 posted a total return of 6.06% while the Bank of America Merrill Lynch High Yield Master II Index (BAML HY II Index) returned 2.71%. In investment grade corporate bonds, the BAML U.S. Corporate Index generated a 1.42% total return while the index’s spread over Treasuries narrowed 6 basis points to 120 basis points. Enthusiasm for the “Trump trade” - a belief that the changes in Washington will create tax reform, a reduced regulatory burden, and greater infrastructure spending - helped spur first quarter results. Indeed, the S&P 500 peaked the day after President Trump’s State of the Union address.
The subsequent Republican failure to pass an Affordable Care Act (ACA) replacement planted some seeds of doubt in investors’ minds regarding the ease and speed of changes coming out of Washington, and the S&P 500 has sloshed around at slightly lower levels over the last three weeks. Still, the markets remain relatively becalmed; the average daily percentage movement of the S&P 500 during the first quarter was at its lowest level since 1967. The calmness in overall stock indices belies some turmoil beneath the surface as sectors that fell into favor post the elections fell out of favor in the first quarter. For example, the financial sector of the S&P 500 jumped 21% in the fourth quarter of 2016 and crawled at a 2.4% pace in the first quarter of this year. Conversely, the utility sector of the S&P 500 was up a measly 0.1% in last year’s fourth quarter but rose 6.4% in the first quarter of 2017. This rearrangement of deck chairs on the good ship S&P 500 reflected the latest recalculation of the potential winners and losers from the goings-on in Washington. Still, the overall market has not moved a whole lot despite the failure to pass an ACA replacement, a Fed rate hike (more on that later), and heightened tensions with Russia over Syria.
The current steadiness of the equity market is supported by two factors, in my view. First, the global economy is strengthening and correspondingly, corporate earnings are improving. The International Monetary Fund is projecting global economic growth of 3.4% in 2017, up from 3.1% in 2016. In the U.S., although down a bit, the Citi Economic Surprise Index is poking around three year highs. FactSet is estimating first quarter 2017 S&P 500 earnings growth of 8.9%, which, if realized, would be the largest year over year growth since fourth quarter 2013. I would point out that first quarter 2017 U.S. GDP estimates have come down and GDP is now expected to grow a modest 1.8% versus the previous quarter (source: Bloomberg). However, as I have mentioned previously, there may some additional seasonality that is not captured in the first quarter GDP numbers, as the first quarter has been the weakest quarter for GDP growth in six of the last ten years. This feeds into another discussion about the disparity between “soft” economic numbers, such as consumer confidence and purchasing managers indices, which are at or near multi-year highs, and “hard” economic data, such as GDP, which are sitting at more historically modest levels. The current disparity in data makes sense to me, however. Consumers, business owners, and managers have become more optimistic about the future given the potential for meaningful tax, regulatory and fiscal changes. At the same time, given the high uncertainty over exactly what will be enacted, people (and businesses, in particular) are being cautious in their actions. For example, if new capital equipment becomes immediately expensable, as has been suggested in some tax proposals, you may as a small business owner wait for more clarity before buying a piece of machinery.
The tremendous uncertainty and range of potential outcomes regarding tax and policy changes that I just mentioned above provides the second prop stabilizing the market. I think most investors (including me) are reluctant to pare equity exposure until a somewhat clearer picture emerges. With earnings on a solid growth path once again and the economy chugging along, investors are much more concerned about missing out on another leg up in the market than they are about a sell-off induced by disappointing results out of Washington. Consequently, equities overall could continue to trade in a narrow range while churning below the surface until the fog lifts from D.C.
The high yield market is a trickier proposition at present, in my view. The BAML High Yield II Index is currently yielding 5.78% to the worst call date with a spread of 400 basis points over Treasuries. This compares to an average yield and spread to worst over the last seven years of 6.80% and 547 basis points, respectively. The chart below tracks the price of a barrel of oil (CL1) versus the iShares High Yield Corporate Bond ETF, which have moved largely in lockstep over the last year. Today, however, the energy sector of the BAML U.S. High Yield II Index yields just 0.39% more than the index as a whole; last year at this time the energy sector was yielding 5.64% more than the overall index. Consequently, energy prices are more likely to pose greater risk as a negative catalyst to high yield than a positive catalyst given current pricing levels.
Interest rates have rallied in recent weeks and 5-year Treasury rates are slightly lower than where they started the year. This is also something of a reversal of the “Trump trade” as the new calculus suggests tax and policy changes might not be as stimulative as previously thought. A cooler running economy, the thinking goes, will keep a lid on rates. This thinking ignores the risk that the Federal Reserve hikes the targeted Fed Funds rate another two times this year as it has suggested. Given that the unemployment rate is down to 4.5% and inflation, as measured by the Personal Consumption Expenditure (PCE) deflator, is over 2% for the first time in five years, I am willing to take the Fed at its word this time around. There is also a strain of thought that the Fed will pause the pace of rate hikes as it begins to unwind its holdings of U.S. Treasuries. But to me, this is just a pick your poison problem. If the Treasury market does not sell off once the Fed begins reducing its horde of Treasury bonds, it will resume the process of interest rate normalization. High yield has historically proven resilient in rising rate environments and I anticipate high yield bonds will weather rate increases better than lower yielding fixed income investments. But given current low yields and tight spreads, the high yield market is unlikely to be immune from a few more rate bumps. Consequently, we have been contently raising cash in high yield through redemptions, calls, and an occasional sale. We have let our durations shorten as our portfolio ages, and continue to favor fixed to floating rate structures as good defensive investments. In equities, we have made few significant changes in our ETF-based portfolios as chasing changes in sentiment around political outcomes can cause whipsawing. We are willing to wait things out in Washington, which is a hard thing to do.
Randy Masel manages a high yield corporate bond strategy that he created and launched upon joining Granite Springs Asset Management in January 2014. He also manages Granite Springs’ Tactical Equity strategy.
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