Market Commentary

A banker is a fellow who lends you his umbrella when the sun is shining and wants it back the minute it begins to rain. ~Mark Twain (1835-1910), American Author
Ken Leech
Chief Investment Officer

Executive Summary

  • Swings in global growth and inflation are likely more important to the economic outlook than whether the federal funds rate is zero or just near zero.
  • Fixed-income spread sectors have come under meaningful pressure. Just as the US growth picture is brightening, the global outlook has dimmed.
  • Holding extra duration and a yield curve flattening position has proved beneficial.
  • The US inflation picture has stabilized, but the broad collapse of commodity prices exacerbates an already downward trend in global inflation.
  • The question for investors is how to benefit from continued US growth while providing some protection against weaker global inflation and growth. One of the opportunities we feel is particularly attractive is investment-grade long maturity corporate bonds.
  • Investment-grade credit valuations relative to fundamentals are so compelling that we believe they are likely to hold up well even in the event of a more challenged economic environment.

Whether and when the Fed raises the funds rate is a major issue for fixed-income markets, but it is not the main event. The larger issue is the divergence of US and global growth and even more importantly, inflation. The conditions for an interest rate increase that Fed Chair Janet Yellen has laid out, stabilization in the inflation rate and continuing improvement in the labor market, have been sufficiently met to justify an interest rate increase. We suspect the Fed will start the process of inching the funds rate off zero later this year. But whether the funds rate is zero or just near zero is less important than the path of growth and inflation going forward. Here, the global environment once again suggests downside risks have risen.

Three months ago when we wrote our mid-quarterly note, the financial markets were brimming with the “reflation” theme. Equity markets were vibrant—particularly the Chinese stock market, which seemed to be perpetually ascending. Oil prices seemed to have stabilized around $60 per barrel, and high-yield bonds were outperforming. Treasury yields were rising, and the global markets were particularly focused on the collapse of the German bunds. Market optimism seemed to be focused on the expected benefits of policy accommodation. Despite a trend of mediocre economic data, markets seemed to be looking forward to a pickup in activity.

Our thought at the time was that while we continued to be proponents of the “recovery” thesis, some caution was warranted. We felt adding some long duration by taking advantage of the spike in long Treasury yields would be helpful should the growth optimism prove unfulfilled. Additionally, we favored a yield curve flattening position. Just as yield curves have typically steepened prior to Fed tightening cycles of recent decades, so too have they typically flattened once that tightening actually got underway. The subdued inflation also worked to make a flattening trade attractive, as did the fact that such a position could provide important ballast to our overweights to credit spreads.

How did that turn out? Well the good news is that we were right to be cautious. The bad news is that we needed to be cautious. Exhibit 1 shows the performance of the Treasury yield curve since the end of June. Long Treasury yields have declined roughly 40 basis points, while short term rates have actually risen.

Exhibit 1
US Treasury Performance
Source: Bloomberg. As of 20 Aug 15.

The challenge has been that fixed-income spread sectors have come under meaningful pressure. Just as the US growth picture is brightening, the global outlook has dimmed. The US inflation picture has stabilized, but the broad collapse of commodity prices exacerbates a global inflation trend that had already turned down. Exhibit 2 shows the price trends of several key commodities.

Exhibit 2
Price Trends of Key Commodities in US Dollars
Commodity units priced in US Dollars. Source: As of 31 July 2015.

China shocked global markets and policymakers with its abrupt change in currency policy, removing its currency peg and letting the yuan float. The sharp 4% devaluation, while startling, was not by itself threatening to the global outlook. China’s desire to add currency flexibility on top of extensive policy accommodation measures taken already this year, and coming after the sharp plunge in Chinese stock prices, clearly adds to market anxiety that Chinese growth is insufficient.

Market concerns have switched from reflation to deflation. Emerging markets and high-yield bonds, particularly those most exposed to commodities, have underperformed meaningfully. Investment-grade corporates have also struggled, as have mortgage securities. Until recently, equity markets have remained near their highs. Suddenly, though, global fears have forced a violent re-pricing of these markets as well.

Just as we felt market optimism was too robust last quarter, now we feel market pessimism may be getting carried away. We feel strongly that this downshift in global growth will not lead to a recession. The global recovery theme is intact, even with the downshift in global growth and inflation expectations. Moderate growth in the US and improvement in Europe should continue. Monetary policy remains extraordinarily accommodative. Chinese growth is manageable and both monetary and fiscal stimulus should increase. Lower for longer inflation rates mean a further extended period of low interest rates. Lower commodity prices, while a sign of weak global demand, are not without their benefits. They also represent a potential wealth transfer to countries with the vast proportion of the world’s GDP.

We continue to believe spread sectors should outperform government bonds. But respecting the challenges from today’s strong disinflationary climate, we have chosen to keep some extra duration as well as leaving our lower quality positions unhedged.

As the sector in which to add, we have chosen investment-grade bonds, where we feel the risk/reward is the most advantageous. Investment-grade credit will not do as well as lower-quality sectors in a sharp rebound.But valuations relative to fundamentals are so compelling that investment-grade should hold up well even in the event of a more challenged economic environment.

Investment-grade corporate bonds have come under meaningful stress recently. This is particularly true for BBB corporates and even more so for long maturity bonds. Indeed, the spreads available in today’s markets for long-term corporates are at levels surpassed only by those of the 2000-2002 recession, the 2007-2009 financial crisis or the recession/euro break-up scare of 2011, all of which were episodes of extreme stress in financial markets. Many would argue that the torrent of corporate supply combined with low Treasury yields is the proximate cause of the elevated spreads. Liquidity concerns are another factor pushing spreads wider. But irrespective of the causes, basic financial principles still apply. The extra yield will accrue to bondholders as long as the bonds do not default.

Exhibit 3 displays the valuation opportunity for long corporates in two ways. The first just shows implied breakeven 5-year default rates compared with actual historical default experience. The implied probability of default for long maturity BBB corporates is 19.57%. Not only has such a rate never been seen, it is also twice the level of the default rates experienced during the Great Depression. Of course, as total return investors, the change in long corporate yield spreads can have a powerful effect on returns as well as default experience. The effects of changes in yield spreads will usually dominate the additional carry of long corporates over the short term. To address this question, we have also displayed breakeven yield spreads assuming recent default and recovery rates. As you can see, over a 5-year period, in order for corporates not to outperform Treasuries, yield spreads would have to attain levels experienced only during the 2008-2009 financial crisis.

Exhibit 3
Cumulative 5-Year Default Rates and OAS Spreads
Source: Top Chart–Moodys, Western Asset. As of 11 Aug 15. Bottom Chart–Barclays. As of 31 Jul 15.

To us, there is a real disconnect going on in the financial markets. The extreme stress in credit markets is strongly suggestive of fears of worsening economic conditions. Yet looking at the trend of US economic data suggests a more benign environment. Investment-grade bonds, in our minds, are the prime example of this market schizophrenia. Yield spreads adequate to absorb Great Depression default rates are persisting even as the US economy is judged to be strong enough to justify rate hikes. We think the risk/reward of long investment-grade corporates is particularly appealing.

We are living through an extraordinary period in the financial markets. Policy experimentation has never been tried on such a grand scale. Investors need to be very thoughtful in reacting to changing economic conditions, realizing the enormity of forecast uncertainty. At this moment, disinflationary pressures are very strong, thereby increasing downside economic risks. Arrayed against this are global policies designed to create inflation and broaden global growth in the future. We remain highly cognizant of the present risks, and we have utilized macro strategies designed to help portfolios even during this lengthy credit bear market. But we continue to believe the future will show greater promise. Spread sectors seem braced for the worse. We doubt they will see it.

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