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It’s been relatively easy to be overweight credit (high-yield, investment-grade corporate and emerging-market bonds) the past five years. But with economic activity accelerating and a sniff of potential inflation in the air, our emphasis has begun to take on more balance.
Given that we believe interest rates are more likely to rise than fall over the course of the year and into 2015, we think being short duration and being flexible with our yield-curve positioning could potentially generate returns on par with—if not superior to—being overweight credit. Driving this thinking are two factors: 1) a somewhat “mature’’ credit run, and 2) historical relationships between growth, inflation and rates.
First, the credit story. It’s still solid, just not great. High-yield and investment-grade bonds continue to benefit from solid corporate balance sheets and earnings, and from an economy entering its fifth year of expansion on arguably its most solid footing since the recovery began. But with spreads—the gap between yields with comparable maturity Treasuries—already trading below historical medians, investors are playing for limited upside.
EM may be better
In fact, on a relative and absolute basis, emerging-market (EM) securities may be the better credit story right now. There are sensitive spots—notably Iraq, Russia and Argentina. But the bulk of the global EM bond market is benefitting from improving Western economies and is operating against a backdrop of relatively positive fundamentals, reasonable valuations and pretty heavy demand—factors that make EM bonds attractive, particularly given their higher yields relative to the U.S. and Europe.
It’s getting ‘noisy’ in here
It’s been fashionable—if not legitimate—to dismiss this year’s economic disappointments to the unusually bitter winter. But we are watching closely the recent moves up in various inflation measures (CPI, PPI, even the Fed’s preferred PCE) as potential evidence that the Fed is finally accomplishing its goal to reduce the risk of deflation. Thus, we were a bit surprised by Fed Chair Janet Yellen’s somewhat dismissive answer when questioned about this issue in June’s post-meeting press conference. While agreeing some readings have been on the “high side’’ of late, Yellen termed the inflation data as “noisy’’ and said policymakers still view the inflation trend as falling in line with Fed objectives.
The problem with this is the Fed has been saying all along that it will be data dependent when it comes to any potential changes to monetary policy. So if it’s dismissive of data that doesn’t fit with its view, then that suggests it’s digging in its dogma. Our take is Yellen clearly is signaling that the Fed is going to remain very dovish and continue to be very accommodative. While this could allow for a continued constructive environment for risk assets, it could be accompanied by increasing volatility both in rates and spreads.
On rates, a question of when, not if
Thus, we’re not convinced the bond market is going to let this pass without some cost. At some point, the bond vigilantes are going to weigh the traditionally strong correlation between economic growth, inflation and rates, take note of what by all accounts is a significant late spring-early summer rebound in economic activity—manufacturing, job growth, auto and retail sales, ISMs, wages, even housing of late—and start driving up yields, particularly in the belly of the curve (2- to 5-year maturities).
If anything, we believe there is the potential for significant tail risk if the market begins to think rising inflation won’t be as transitory as Yellen seems to think. A reasonable estimate is that nominal rates should be consistent with GDP, and projections are for GDP growth to be around 3% or higher the remainder of this year—this is the Federated house view—and for inflation to be at or near the Fed’s 2% target. If this is the case, why should the yield on the 10-year Treasury be hanging around the 2.50%-2.60% range? It shouldn’t.
There are other factors that arguably could be acting to hold down longer yields, led by the European Central Bank. In many ways, the ECB finds itself in the same position the Fed was four years ago, taking extraordinary accommodative steps to try to boost growth and prevent deflation from taking hold. But that’s the point—that’s where the Fed, and the U.S. economy, was four years ago. It’s a different story today, one that we believe merits being ready to capitalize on rates when they do start to move. We don’t believe it’s a question of if, only when. And when may come sooner than some think.
So the bottom line is we still like our (somewhat reduced) overweight credit call, but believe positioning for rising rates also offers the potential for excess returns. On the scale of 100, perhaps it’s a 50-50 split between the two.