Fixed Income Investment Outlook
Osterweis Capital Management
October 18, 2010
Historically, increased economic activity has been preceded by predictive signposts, such as lower Treasury yields, tighter corporate spreads over Treasuries, an increase in corporate debt issuance, rising capital expenditures by corporations, monetary easing, and a rising U.S. dollar. We have some of these positive indicators currently, but the direction of the economy is not entirely clear. A few negative undercurrents may help explain why the economy remains moribund and why equity markets remain range-bound.
Treasury bond yields have declined over the past six months sparked by the rally which gathered steam when European banking and sovereign debt problems emerged in the second quarter. Although yields on corporate debt also declined nominally during this period, corporate spreads over Treasuries actually widened. Corporate bond spreads have usually reflected the market’s confidence in underlying economic strength, and by association, default expectations. Tighter spreads typically signaled economic strengthening, while widening spreads typically signaled economic softening. While low yields have historically been considered a positive indicator, the recent widening in corporate bond spreads may be a reflection of the anemic economic rebound and continued fears of a double-dip recession.
Since May of this year, there has been a steady rise in corporate debt issuance. While availability of credit is normally a positive macro indicator, it is important to note that corporations are currently motivated to issue debt to take advantage of low yields and to refinance upcoming debt maturities at attractive interest rates, rather than to deploy the capital to productive investments. Corporations have been under-investing in capital equipment relative to sales for the past few years. So we do expect capital spending to recover at some point, which would help manufacturers and exporters of capital equipment. Unfortunately, there is scant evidence of increasing capital expenditures at this time. For this to happen, businesses will need to gain comfort around issues affecting them, such as taxation, regulation and real demand growth.
The Fed has resumed actively purchasing Treasuries in the open market, thereby increasing liquidity to Treasury holders, particularly commercial banks. We believe these actions mark the stealthy beginning of quantitative easing part deux (QE2), the much ballyhooed next leg of monetary stimulus. Normally, monetary easing would be a positive for future economic growth, but given that the massive liquidity injections in 2008 & 2009 and near zero percent short-term interest rates have not yet created robust economic growth nor led to job creation, the continuation of this policy may be futile, as there seems to be plenty of liquidity on the sidelines at present.
The U.S. dollar has made gains against several world currencies lately. This would normally be a reflection of greater economic strength in the U.S. Unfortunately, the real reason for its appreciation is more likely related to currency intervention by governments globally. Japanese officials unilaterally intervened in September to weaken the Yen. They feared damage to their export trade with the U.S., and also wanted to stem the decline in their competitiveness versus China and other Asian export nations. Similarly, China, Singapore, Taiwan and South Korea all actively pursue interventionist currency policies to remain competitive exporters. In Latin America, Brazil’s Finance Minister, Guido Mantega, indicated recently that the Brazilian government will purchase more dollars in the spot market to curb the Brazilian Real’s appreciation. Will the spread of currency interventionism mark the end of free markets and the beginning of trade protectionism? We hope not, given the lessons learned during the Great Depression. Distortions in markets can eventually lead to painful corrections, which we fear are possible now. This, unfortunately, adds another layer of complexity for U.S. companies doing business globally, causing them to delay the deployment of growth capital and possibly extend our economic malaise.
In sum, low yields, high corporate debt issuance, increased monetary stimulus and the rising dollar do not yet lead us to conclude that growth will accelerate any time soon. As a result, we have not materially changed our outlook of a slow and meandering recovery. Corporations continue to rebuild balance sheets and margins at the expense of hiring and investment. While this bodes well for future debt repayment, the outlook is not rosy for job seekers. It is unclear what it will take to create meaningful reductions in unemployment. When the job outlook does change, however, and the economic pulse quickens, the era of low interest rates could end quickly. We hope that happens sooner rather than later.
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Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
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