Market Memo: Positioning for cautious optimism
With economic data of late continuing to surprise to the upside and with sequestration’s impact so far appearing to be well less than feared, Federated’s fixed-income team has decided to tweak its recommended strategy to reflect a slightly higher risk-on bias.
Specifically, investment-grade corporate bonds have been raised from underweight to neutral, reversing a shift made late last year, when Washington dysfunction raised concerns about policy mistakes that could undermine a still fragile economy. And duration was lowered from neutral to 95% on expectations interest rates are more likely to rise than fall in the current macro environment.
Recent events have negated some of the worries that had made us more defensive on high-grade corporate bonds. The initial implementation of the $1.2 trillion sequester (which effectively represents only $40 billion or so of cuts in the current budget year that runs through September) doesn’t seem to have slowed the economy, although we recognize it could take several months before the cuts start to bite and to generate potential multiplier effects.
Moreover, Washington for now is playing nice. Both the House and Senate appear to be moving toward adopting a continuing resolution that would push a potential contentious budget showdown down the road. And President Obama has actually been meeting with Republicans and talking about his desire for a potential “Grand Bargain’’ that would tackle entitlement and tax reforms, an outcome the markets clearly would welcome but have yet to price in. All of this, of course, is simply political theater for now. But the much more cordial, discerning and respectful tone emanating from both the White House and Capitol Hill is a noticeable improvement.
Layered over this has been a series of reports suggesting the economy actually may be strengthening despite higher taxes and gasoline prices that arrived with the New Year. Auto sales are picking up, homebuilding and manufacturing are accelerating, retail sales and consumer sentiment are rising, and the labor market is firming. February’s 236,000 increase in payroll jobs was well above consensus, and the latest reports on initial unemployment insurance claims indicate employment’s momentum has carried over into March.
Caution is the new optimism
Finally, corporate balance sheets are in solid shape, cash flow remains strong and earnings have been OK. Granted, during analysts’ calls in the just-completed earnings season, corporate guidance was cautious. But as Senior Portfolio Manager Mark Durbiano recently noted, managements have been expressing caution about the future since 2008—a sign he views as a positive, not a negative, as it reflects the boardroom’s desire to maintain a close eye on costs and efficiencies. As one colleague put it, “caution is the new optimism.’’
In addition to raising the outlook on investment-grade corporates, the fixed-income team also is maintaining overweight positions in high-yield and emerging-market bonds, and commercial mortgage-backed securities (MBS).