A Super Committee in Name Only

You actually have to accomplish something to be “super”

 

Most observers felt it most likely the U.S. Congress Joint Select Committee on Deficit Reduction (the super committee) deliberations would yield no new agreement and that the $1.2 trillion in “sequestrations” (i.e. “money you can’t spend”) passed in August would remain in place and allow for an additional increase in the U.S. debt ceiling. The super committee has resigned itself to stalemate. Given the limited progress apparent as the deadline approached, its likely market participants have accounted for this outcome. As such, we anticipate at most a marginal direct impact onfinancial assets.

 

We’ve known this potential outcome since early August, and ratings agencies have likely already factored such an outcome into their methodologies and ratings for the near term. S&P has announced that they assumed a super committee “failure” in their August downgrade analysis.  While failure to reach any more broad-reaching compromise represents a lack of political will on the part of both major parties, it’s unlikely this outcome will result in any ratings changes from the three major ratings agencies at present. The very real threat exists, however, that all three major ratings agencies place the U.S. long-term rating on negative watch for a potential future downgrade. Fitch has previously warned of such a move. There is still much more work for elected officials to do in terms of addressing longer-term management of the enormous federal debt burden and aligning spending with collectable revenues. The agreed upon sequestrations would cut only a quarter of the estimated deficit over the next ten years, and simply cut spending growth rates rather than absolute spending. We’ve also now heard unwelcome rumblings of efforts to water down those sequestrations. As potential negative watch status would emphasize, a further long-term downgrade by S&P and initial long-term downgrades by Moody’s and Fitch may well be in the cards should elected officials fail to agree to further fiscal consolidation measures — let alone try to work around the already legislated spending adjustments. Congress simply can’t continue spending sums of money it doesn’t have or that tax revenues are unlikely to generate. Even with the risk of further long-term ratings downgrades, we do not currently foresee any change in the A-1+/P-1 U.S. short-term credit rating.

 

Invesco’s viewpoint

While this stalemate announcement from the super committee brings a disappointing end to a chapter in the overall effort to address long-term U.S. fiscal issues, the nearer-term European sovereign debt issues continue to serve as the chief driver of financial market performance and volatility. Any potential resolution of the European crisis would likely magnify the importance of the super committee’s inaction and the prospects of and hopes for further progress in Washington. As long as investors perceive Europe lacks a comprehensive and detailed strategy to address their significant debt problems, this market driving status will continue to hold, and the direct impact of the super committee announcement may be muted or even hidden. Add the traditional lighter trading volumes heading into year-end, and we foresee continued market volatility as investors shift between risk-off and risk-on psychology where they either want to own seemingly any and all credit risk or purely high quality sovereign debt.

Asset class outlook

Cash

• Cash is experiencing a historic low yield environment with heightened attention on safety and liquidity
• Continued pressure on supply of high quality, short-term instruments
• Regulators and industry discussing best solutions to further strengthen money market funds

Municipals

• Low investment grade municipal yields balanced by a limited outlook for supply
• High yield valuations offer an attractive entry point compared to investment grade while default levels have remained within their low historical norms
• Potential across the board spending cuts as a result of the failure of the super committee may result in additional pressure on municipal budgets which is why we are continuing to focus on essential service revenue sectors where revenue streams are more predictable

Structured securities

• Select securitized assets, most specifically within commercial mortgage-backed securities (CMBS) and non-agency residential MBS, still offer opportunity as a high-quality investment option for select investors
• We believe the current income advantage over other high-quality fixed income investment options could serve risk-tolerant investors well over the long-term

 

U.S. investment grade

• Investors are searching for yield and the entry point to extend credit risks with extra yield remains the principal challenge given the global uncertainties
• The financial sector remains most volatile within the credit sector, and further stress is likely in the near term given unresolved crisis and forthcoming policy actions
• Corporate balance sheets and credit metrics are strengthening, that provides a strong fundamental backdrop for a longer-term U.S. investment grade asset allocation even if the market is volatile in the near term

Global investment grade

• We believe markets will remain volatile as the solutions to the European union debt crisis are politically dependent and austerity policy implementation risks are high
• Corporate bond spreads are wide but reflect worries about a disorderly Greek default and potential wider contagion effects
• Though there’s no agreement for further fiscal consolidation, investors may take some comfort in the fact there are real cuts on the table from the agreed-upon sequestration
• The European sovereign debt crisis remains the dominant issue for global investors; super committee failure seen as less significant by comparison to the dislocation in Europe and specifically, to concerns over Italy and Spain
• Indeed, the reserve currency status of the U.S. dollar and investor preference for U.S. Treasuries in troubling or uncertain market environments may trump immediate concerns over the deficit given the broader turmoil elsewhere in the developed sovereign debt markets; U.S. Treasury yields could rally

 

Bank loans

• Senior secured loans have reacted in-line with the broader capital markets and the general volatility in appetite for credit-driven assets, but are offering historically attractive yield and current income; the broader loan market is trading at a $0.90 price and yielding 7% over the U.S. dollar London Interbank Offered Rate (Libor) as of Nov. 21, 2011
• Notwithstanding the buffeting global headlines, balance sheet fundamentals in the asset class are quite healthy and the market’s default rate is below 1%
• Default forecasts for 2012 are between 1% to 2%, which would correlate to a continued excess risk premium for the senior secured loan asset class today

High yield

• Risks related to the U.S. growth scare over the summer have abated, but risks related to the European sovereign debt crisis have intensified; European sovereign debt issues raise the risk of a European recession and renewed credit contraction which both raise risks of contagion to other global regions
• The market appears braced for elevated defaults at current valuations, a level in excess of our expectations
• We believe continued slow growth in the U.S. remains likely; in this type of environment, high yield has historically performed  well

Emerging markets

• Stronger emerging market fiscal positions versus the U.S., Europe and Japan create a positive backdrop for economic growth, but well-documented growth headwinds in the developed world may weigh on these export-oriented economies
• Emerging market currencies should be generally well supported as the interest rate differential versus developed markets seems likely to stay wider for the longer term

 

(c) Invesco

www.invesco.com