Risk-off in High Yields: Volatility in the credit markets during the third quarter resulted in quality outperforming and credit suffering losses. High yields declined for the first time in five quarters.
Interest Rates Remain Low: Global rates remain very low, even negative across many European markets’ short term bonds markets. This has helped buoy U.S. Treasuries and strengthen the dollar.
The global markets put in a sloppy performance during the third quarter as economic growth concerns and geopolitical events weighed on stocks and buoyed government bonds. The bright spot in the global economy is the U.S. as Europe flirts with outright recession and the Japanese economy has contracted in two out of the past three quarters. U.S. growth appears to be accelerating as the year progresses. First quarter growth contracted 2.1%, much of it explained away as weather related, while second quarter economic activity surged 4.6%. Labor market conditions remain solid as the economy has averaged 220,000 new jobs per month so far in 2014 and the unemployment rate dropped to 5.9% in September, a six-year low. All told, third quarter GDP is tracking near 3.5%, a respectable pace after 4.6% growth in the second quarter.*
The U.S. and Europe are now following different road maps with the U.S. Federal Reserve scheduled to cease their bond buying program in October while the European ECB is trying to stimulate a stagnating economy. In the U.S., the debate has turned to when the Federal Reserve will hike overnight interest rates. A growing consensus among economists is that the FOMC will begin to raise the fed funds rate sometime in the latter half of 2015. Historically, the Federal Reserve has begun hiking rates about twelve months after the end of an easing campaign. However, given the current growth trajectory of the U.S. economy, the rate hike could come sooner and we expect it to happen possibly as early as March 2015, and probably June 2015 at the latest. Even if the FOMC has the urgency to pull the trigger before mid-2015, we believe the earlier schedule would be largely immaterial to the economic environment.
Interest rates have remained very low globally. Short-term rates across many European markets did the unthinkable, with two year rates going negative during the quarter in many countries. Even European 10-year rates have plunged as Europe’s economy falters. German and French 10-year rates hit record lows and all of major Europe, and even the peripheral European counties of Spain and Italy, have lower 10-year rates than U.S. Treasuries. Treasury bonds remain buoyed by growth concerns in Europe and demand for U.S. bonds from abroad resulting in U.S. dollar strength. The trade weighted U.S. dollar has risen for 12 straight weeks and was up 7.72% for the quarter. The rising dollar makes U.S. based investments more attractive to foreign investors.
There was a lot of volatility in the credit markets during the third quarter with quality outperforming and credit suffering losses. For the quarter, the Barclays 7-10 Year Treasury index gained 0.47%, the Barclays Aggregate Bond index gained just 0.17%, and the Barclays High Yield index lost 1.87%. High yield bonds have performed very well over the past several years and the decline was the first quarterly loss in five quarters. In fact, it was only the second quarterly loss in three years. Credit spreads remain very tight historically and longer-term credit fundamentals remain well supported with a friendly Fed and a strengthening economy. There was a risk-off environment for high yield bonds as retail investors fled on the first hint of weakness, resulting in record outflows from high yield mutual funds and ETFs. However, so far institutions proved willing to buy high yield bonds as retail investors fled.
Q3 Portfolio Analysis & Performance
- BlackRock High Yield Bond
- Eaton Vance Income Fund of Boston
Credit markets were under stress during the third quarter of 2014, and returns in the Fixed Income Total Return (FITR) portfolio were therefore negative. The Barclays High Yield Corporate Bond index declined 1.87% for the quarter, while the Barclays Aggregate Bond Index rose 0.17%. Treasuries outperformed credit, as the market took a general risk-off stance. The FITR model was responsive to the market, as our model lost almost all of its strength during August and September. As it is now early October, our model is close enough for just a small amount of market weakness to trigger an exit of our high yield bond position. As a review, the Fixed Income Total Return (FITR) portfolio moved to a 100% fully invested position in high yield bonds nearly a year ago on July 18, 2013. The portfolio’s primary evaluation regarding which asset class to own involves comparing the relative strength of high yield bonds versus Treasuries. By that measure, high yield bonds currently have only a very slight edge on Treasuries. Our best forecast for the markets’ path this year predicted a more volatile and turbulent third and early fourth quarter – and that has indeed been the case. However, in a matter of days we enter a seasonally very strong time period. Historically the fourth quarter of a midterm election year is the strongest of any quarter in the midterm election cycle. In addition, signs of a short-term bottom and extreme short-term pessimism have begun to appear. While our model remains ready to go on the defensive if there is further weakening in the credit markets, we believe the intermediate term future looks brighter. That being said, as much as we believe in our forecast, the Fixed Income Total Return portfolio is not influenced by any forecast. It is only influenced by its model, and it remains watchful and ready to turn defensive upon further market weakness.
Based on the strength of the U.S. economy and macroeconomic research, U.S. interest rates could justifiably be 100 basis points higher than they are today. We feel they have been held lower by a number of factors including foreign inflows, the low rates globally, Federal Reserve bond buying program, and geopolitical turmoil. The U.S. economy is certainly doing well enough to suggest higher interest rates ahead. With quantitative easing ending in the U.S. this month and the U.S. Federal Reserve preparing investors for a higher federal funds rate in 2015, the stage is set for U.S. interest rates to move higher. That seems to be the consensus call, so we will be alert to what may be wrong about that scenario as we move forward.
We view the price weakness in credit over the last quarter was largely due to retail investors fleeing at the first hint of weakness, resulting in record outflows from high yield mutual funds and ETFs, and a record new-issue calendar in September that needed to be absorbed. The credit market handled the influences well and the markets seem to have stabilized. We think that the fundamental backdrop for credit risk remains very favorable from a top-down perspective as the economy continues to grow and corporate balance sheets remain healthy, which should entice those looking to allocate to high yield.
The correlation between credit and equities has been running at fairly high levels, although beta between the two asset classes has remained subdued. This is evident in the market corrections this year. For example, the S&P 500 has had three minor corrections so far this year, -5.72% in January, -3.85% in July into August, and -3.18% in September. High yield bonds corrected each time, but to a much lesser degree, -0.56%, -1.96%, and -2.48% respectively. The markets are now entering the most favorable seasonal period of the 16 quarters in the Presidential Cycle. The fourth quarter of the mid-term year is the strongest of the sixteen quarters, with the S&P 500 averaging a 7.5% gain since 1941. The catalyst to kick off this seasonal strength is the midterm elections, November 4th this year. Given the high level of correlations between stocks and high yield bonds, we expect credit to perform well should the equity markets move higher.
*Source: Bloomberg; Renaissance Macro Research.
The opinions expressed are those of Clark Capital Management Group Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. There is no guarantee of the future performance of any Clark Capital investments portfolio. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. For educational use only. This information is not intended to serve as investment advice. This material is not intended to be relied upon as a forecast or research. The investment or strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial circumstances. Past performance does not guarantee future results.
The S&P 500 measures the performance of the 500 leading companies in leading industries of the U.S. economy, capturing 75% of U.S. equities.
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