-- Richard Fisher, President of Dallas Fed
3Q12 MARKET REVIEW: Continuing evidence of a slowing U.S. economy and a faltering global recovery dominated financial market headlines during 3Q12. Central banks responded with even more "balance sheet expansion" policies in hopes of promoting stronger economic growth. In the U.S., "grave concern" over the long-term unemployment rate and realization of potential downside risks to growth prompted the Federal Open Market Committee (FOMC) to institute yet another much anticipated round of Quantitative Easing ("QE3"). Unlike the first two rounds of QE, this program is open-ended and will further expand the Federal Reserve's already bloated $2.9 trillion balance sheet. Despite the unintended consequences of these unprecedented actions, investors responded convincingly as non-government "risk assets" posted strong performance results in 3Q12.
The additional clarity investors perceived from the recent round of monetary policy drove the S&P 500 to a healthy 2.58% return in September, an impressive 6.35% total return for 3Q12 and raised the YTD return to 16.50%. However, fixed income investors reacted to the Fed's latest action with skepticism, sending yields on 10-year and 30-year Treasury issues higher by 9bps and 15bps respectively during September. Consequently, Treasury returns were -0.31% for the month of September, and up a modest 0.57% in 3Q. But in a reversal from 2Q12, "spread product" rallied in 3Q, leading to positive nominal and excess returns across all non-Treasury sectors.
"IT'S THE ECONOMY STUPID." The FOMC's "all-in" action is the latest attempt to stimulate economic activity by increasing home sales, creating mortgage refinancing opportunities for homeowners and inciting a "wealth effect" by reflating risk assets. There is no doubt the monetary actions implemented since the financial crisis began have muted the negative effects of consumer and corporate deleveraging. Evidence also confirms a firming in economic activity that includes better retail sales, auto sales, consumer confidence and stronger consumer spending. There is even encouraging news in the housing sector, as both sales and prices have enjoyed a recent rise, while foreclosures are reported to be normalizing. However, the debate continues over whether extraordinary monetary policy measures have become ineffective.
One can argue the bond market's response to the stimuli is a clear indicator of a lack of confidence in central bank policies, as yields remain at or near historic lows while economic growth remains too low to stimulate any meaningful employment gains. One need look no further than the September employment report for a glimpse of the continuing malaise. Although the official rate of unemployment declined to 7.8% in September (the lowest since January of 2009 and surprisingly lower than July's 8.3%), the news raised deep suspicion about the accuracy and efficacy of the numbers. The Labor Department reported 873K new jobs via its volatile and imprecise surveying methodology, but 600K of the new hires were part-time workers, and the manufacturing sector actually shed another 16K jobs. A more empirical and reliable measure of job gains reported via payroll tax rolls tallied only 114K new jobs in September. For many, the more telling statistic is the broader measure of labor under-utilization that includes people involuntarily working part-time, which jumped 582K, sustaining the number of underemployed at 14.7%. We would argue the effectiveness of the Fed's policy tools have in fact been significantly reduced. Business confidence remains increasingly pessimistic and recent data indicates it is the lowest since 2009 – coincidently the end of the last recession. Capital expenditures, a major source of economic growth in recent years, have also fallen sharply in 3Q12. Consumer disposable income, adjusted for inflation, also declined during 3Q, while the savings rate continued to shrink to 3.7% vs. 4.1%.
As for housing, real estate prices have enjoyed some national recovery. However, the gains are only 8% versus the 35% peak-to-trough decline, and household net worth is still $5 trillion lower today than at the 2007 peak. Unfortunately, housing is also now only 2% of GDP and as estimated 11 million households are still upsidedown on their mortgage. Until businesses gain enough confidence to meaningfully increase hiring, unemployment and underemployment will remain unacceptably high, and corporate investment and consumer spending disappointingly low. Unfortunately, any hope of solace will not be found during 4Q12. As the U.S. prepares for the November elections, congressional leaders will only be incented to seek temporary solutions for the real underlying structural problems.
THE FEDERAL RESERVE & INTEREST RATES: The official announcement of QE3 at the August FOMC meeting came as no surprise. While the open-ended nature was a new wrinkle in modern monetarism, the result was as many anticipated: higher instead of lower long rates. Instead of lowering rates in a flattening of the yield curve, the market reaction was the opposite, with long rates initially rising modestly in a yield curve steepener. Versus June 30, 3Q12 ended with the 2-30 year U.S. Treasury yield curve steeper by 14bps, and the 2-10 year curve steeper by 6bps. However, compared to a year ago, the 2-10 and 2-30 curves are flatter by 27bps and 8bps respectively and nominal rates are modestly lower, again begging the question of whether the massive amount of monetary stimulus has in fact been effective.
4Q12 BHMS OUTLOOK: In the short term, investors face several serious issues: the November elections, the looming 'fiscal cliff', continuing European solvency crisis, and slowing in China's and emerging market economies, all of which could undermine/destabilize the global economy. We expect the U.S. economy to remain near stall-speed mode during 4Q, but with plenty of liquidity from the Fed to mitigate market turbulence. After the election, the market's attention will turn to the "fiscal cliff" negotiations during the lame duck congressional session. It appears likely that Congress will provide a temporary patch into 2013 for most of the difficult issues in order to minimize any economic disruption, but some tax increases look likely as well. While the Federal Reserve's continued pursuit of QE through late 2015 may not generate sustainable growth, investors will eventually face "The Hotel California Dilemma": How does the Fed get out of a bloated balance sheet? In the interim, we believe the technical demand for fixed income assets will remain incredibly strong through 4Q12, and your current portfolio structure will prosper in the current market uncertainty.
3Q12 INVESTMENT GRADE (IG) CREDIT MARKET REVIEW: With U.S. Treasury yields at still miserly lows and stocks still highly volatile, investors continued a preference for the security of steady income in corporate bonds during 3Q12. The latest data (August) reveal fixed income markets have absorbed 12 consecutive months of positive fund flows totaling $32.4B, while equity flows over the same period were -$13.5B, and have been negative for 16 straight months. Much of that money flow has been directed to corporate bonds. Consequently, in a reversal from 2Q12, strong investor demand drove yield spreads 38bps tighter during 3Q, contributing to 3.54% nominal return and 2.96% excess returns in IG credit. Since YE11, spreads have narrowed 73bps and ended the quarter at 144bps, just 2bps above the YTD low. For the YTD and trailing 12-month periods, Credit has achieved a nominal return of 8.25% and 10.09%, and excess return of 5.67% and 6.40%. Financials, banks in particular, were a significant contributor to performance as the sector continued to rally on improving profitability and capital structure fundamentals. The sector produced nominal return of 5.05% and had the highest excess return of 4.45% during 3Q as spreads narrowed 74bps. Despite being 158bps tighter since the beginning of 2012, Financial spreads are still 55bps above their credit crisis-adjusted historical mean. Another big contributor to performance in 3Q12 was the Industrial sector with a nominal return of 3.26% and an excess return of 2.67%.
The supply of IG credit continued at a record pace. New issue supply totaled $815B during the first nine months of 2012, compared to $657B on year ago. Net new issuance currently stands at $497B versus $461B for all of 2011. The bulk of the new supply has been in Industrial issues (44%) with Financials a distant second (26%). From a quality perspective, the majority of issuance has been in "BBB" (39%) and "A" (36%) rated issues, confirming the continuing migration lower in overall credit quality of corporate America. Interestingly, YTD issuance of 30-year IG corporate bonds is at a 17 year high, as corporations have eagerly tapped long maturity borrowing at record low rates.
BHMS STRATEGY AND OUTLOOK: Maintain overweight while closely monitoring market uncertainty that may result from QE3 and the pending 'fiscal cliff'. With the incremental yield spread available in Credit still wide of the historical mean, we believe an overweight in IG credit in client portfolios is still warranted. We also believe fundamental and technical factors will continue to support our thesis. We continue to favor Financials and banks in particular because of their strong capital ratios and solid financial metrics that will provide operating flexibility in a challenging fiscal cliff environment. Within Industrials, we favor Media and Telecom holdings because of the annuity-like streams these companies benefit from. Our Energy exposure is in Oil Service, E&P and Pipeline companies, while remaining cautious on the impact of supply constraints and geopolitical tension on global energy prices.
The continuing rally in Credit that has taken spreads back toward the long term mean, and the uncertainty inherent in the current macroeconomic environment magnify the importance of security selection through fundamental analysis. Open-ended QE3 will continue to anchor rates at historic lows, but we are skeptical whether the program will ignite growth. Without top line revenue growth, earnings are at risk. S&P Capital IQ estimates earnings for 3Q12 will decline 4.5% from 2Q12, and 1.3% year-over-year for the first time since 2009. Consensus 2013 estimates also appear overly optimistic and subject to downward revisions. Our fundamental security analysis will scrutinize individual names that can maintain or increase credit ratings, while avoiding the turbulence of shareholder-friendly initiatives via additional balance sheet leverage.
HIGH YIELD (HY) CREDIT REVIEW: The search for yield continued in earnest during 3Q12, as investors poured more money into the high yield (HY) market. The YTD inflow into HY mutual funds stood at $35.4B by the end of 3Q, an all-time record. This demand has driven the yield on HY bonds down to 6.46% as of 3Q12, marginally above the 6.2% record low of September 14. The sharp decline in yields has propelled HY to equity-like returns but with less capital risk. The Barclays Ba/B High Yield Index generated nominal return of 4.40% in 3Q12, bringing the YTD and trailing 12-month returns to 11.51% and 18.21% respectively.
Barclays also reports all sectors of the HY market generated positive returns in 3Q12. The top performers were Financials, Consumer Cyclicals, Technology, Communications and Capital Goods. The worst performers were Energy, Basic Industry, Utilities, Transportation and Consumer Non-Cyclicals.
As in Investment Grade fixed income, investor demand was readily matched with new issue supply. Barclays reports gross supply in 3Q totaled $99.3B, including a record monthly issuance of $47.6B in September. The YTD new issuance total stands at $248.9B, only $13.8B shy of the 2010 full-year record. The HY Index now sits at $1.0T in assets.
While corporate balance sheets remain in solid condition and default rates near record lows, HY is not without risks. Significant investor demand has driven the Barclays HY Index spread below the 15-year average of +617bps to +562bps at the end of 3Q from +616bps in 2Q, reducing the cushion against potentially higher interest rates. Corporate earnings are also at risk of slower economic activity, which could undermine cash flows available for debt service. The yield available in HY is now lower than the 7.0% earnings yield of the S&P 500. Consequently, investors are well served to take a cautious approach, and favor more defensive exposure in the higher quality rating portion of the HY market.
BHMS STRATEGY: Maintain current but cautious exposure. In a still uncertain global environment, we continue to believe opportunistic / selective exposure in "safe" high yield names is appropriate. QE3 should maintain investor interest in income-advantaged assets. While spreads are noticeably tighter than YE11, the incremental income in credits having stable to improving underlying fundamentals warrant exposure. However, the compression that has already occurred in yield spreads however, minimizes the potential of significant further capital appreciation. We also believe investors should avoid "stretching for yield" and remain focused on the BB/B portion of the HY market, shunning the rising risk in CCC and below credits. Fundamental credit analysis will be the key driver of returns in the asset class, and close scrutiny of an issuer's sources and uses of cash, access to liquidity, debt maturity schedule and sustainable cash flow remains our focus.
3Q12 LONG CREDIT MARKET REVIEW: The Barclays Long Corporate Index returned 5.53% in 3Q12, 31bps ahead of the Long Credit Index which gained 5.22%. Despite trailing the Long Corporate Index for two consecutive quarters, the Long Credit Index continues to maintain a 9bps (11.25% vs. 11.34%) YTD lead. Non-Corporate Credit, which now represents 21% of the Barclays Long Credit Index, contributed to the slightly weaker performance in 3Q. Although Sovereigns and Foreign Agency issues performed well, Supra-ntionals and Local Authority (Build America Bonds) securities only gained 1.04% and 2.92%, respectively.
After being the laggard in 2Q12, the Financial sector came back strongly and posted a 7.69% nominal return for 3Q12. OAS spreads narrowed 59bps during the period, contributing to an excess return of 7.31%, the highest of any sector. The Brokerage and Banking subsectors were the best performers, as they returned 9.24% and 9.00%, respectively. The Industrials sector, up 5.32%, also showed strong performance during 3Q driven primarily by the Energy and Communications subsectors. On a relative basis, the Utility sector was the weakest performer with a nominal return of 4.12% and an excess return of 3.78%.
New issue supply in Long Credit securities was very healthy during 3Q, especially in 13+ years maturities. The YTD supply of 6-12 year maturity new issues stands at $311B, which is close to the $320B for all of last year. The $119B new issuance of 13+ year maturities has already surpassed last year's $97B. By credit quality, the bulk of YTD new issue supply has been in BBB-rated securities, which totals $234B versus $192B for all of 2011.
BHMS LONG CREDIT STRATEGY AND OUTLOOK: Continue to focus on credits that exhibit strong fundamentals while maintaining a keen focus on technical factors in the market. Although we continue to maintain the general themes in our portfolio of sound balance sheet leverage, solid cash flow and ready access to liquidity, we are constantly looking for ways to enhance the relative performance of client portfolios. Within Financials, we continue to favor money-center banks because of their continued emphasis on building capital and deleveraging. Our Industrial holdings, particularly Communications issues, have also contributed to strong performance as this sub-sector has also achieved strong +11.55% YTD performance. We continue to find better value away from Non-Corporate credit, preferring alternative sectors where our fundamental credit analysis can identify more favorable risk/reward opportunities. As performance has remained strong for long credit, we have become more diligent about revisiting our price targets.
AGENCY MBS REVIEW: Clearly, the story of 3Q was the much anticipated QE3 announcement, intended to drive mortgage rates lower in hopes of spurring economic activity. Prior to QE3, the MBS market had traded in a relatively quiet holding pattern. After QE3, the mortgage market enjoyed a significant rally. With the $40B of monthly mortgage purchases to be open-ended, investors soon realized the program would absorb an estimated 50-75% of all new MBS production. The supply/demand impact promptly drove 'current coupon' MBS prices sharply higher, and Agency MBS finished 3Q with a nominal return of 1.14% and an excess return of 0.71%.
The biggest benefactor of QE3 has been 30yr 3.0% and 3.5% coupons. 3Q closed with 3.00% coupons 2 1/2 points higher in price, with 3.5% coupons up 1 5/8 points since the announcement. Longer duration 30-yr issues also outperformed 15-yr issues, and Conventional issues (FNMA and FHLMC) outperformed GNMA issues. OAS levels also ended 3Q at the tightest spreads since immediately following QE1.
BHMS STRATEGY SHIFT IN 3Q. On the basis of our assessment of relative value and a desire to mitigate prepayment risk in higher coupon MBS, BHMS adjusted the size and composition of our MBS exposure before the QE3 announcement. In late July, we traded out of higher premium priced GNMA 6% pools issued prior to May 2009, which were the most vulnerable to much higher prepayment risk and lower cash flow yield. Simultaneously, we increased our exposure in the MBS sector to an overweight via purchases of 3% and 3.5% coupons which still provide solid 'carry' advantage and positioned the portfolio to benefit from potential QE3 action. These strategy changes proved very rewarding.
MBS OUTLOOK. Rates have reached a record low 3.36% for 30yr mortgages, not seen since the 1950s. Despite these lows, refinancing activity remains at roughly 50% of the previous May 2003 peak. While mortgage rates could conceivably move lower, a refinancing wave matching 2003 would only contribute an estimated 0.2% to annual GDP, while refinancing every mortgage would contribute less than 1%. Mortgage credit also remains very tight as banks have adopted extremely conservative lending standards and stringent documentation requirements. Because lenders have been asked to repurchase $66B in bad loans underwritten in the 2006-08 housing bubble due to faulty documentation, lenders do not want to have any mortgages that do not meet the strict GSE criteria. In addition, refinancing activity remains bifurcated with those who can refinance due to excellent credit and equity in their homes (i.e., those qualifying for the Home Affordability Refinancing Program), versus those whose credit conditions prohibit such access. QE3 has limited prospects.
BHMS STRATEGY. Maintain an overweight to the sector as strong technicals support valuations. We believe QE3 will support strong demand for agency MBS. Despite the technical support QE3 will have on the sector, we do not believe it will have a meaningful impact on improving the U.S. economy. Our current strategy is to remain overweight and positioned in securities that mitigate prepayment risk while maintaining higher cash flow yields.
CMBS SECTOR REVIEW: After hitting a "soft-patch" in 2Q12, CMBS came back strongly in 3Q12. The delinquency rate declined for the first time in five months to 10.13%, and the 21bps decline in September was the largest one month drop since November 2011. With CMBS loan rates now close to 4% versus 6.25% one year ago, new issuance has been strong in 2012. For the YTD, $28.5B of CMBS has been issued, compared to $30.8B in all of 2011. The sector produced a nominal return of 3.83% and an excess return of 3.32% in 3Q12.
Although commercial property prices are near a cyclical bottom, the recovery has been more robust in larger markets with higher quality assets, such as New York and Washington, D.C. Capitalization rates appear to have stabilized and in some markets are even trending lower. However, the low yield on the 10-year Treasury has also created a wider risk premium for commercial property investors.
BHMS STRATEGY: Maintain current exposure and focus on relative value. We will remain slightly overweight in CMBS as the sector continues to offer attractive relative value versus competing fixed income sectors. With a continued tailwind from strong supply/demand factors, and increased optimism that commercial real estate has bottomed, the CMBS sector should experience further spread tightening.
ABS SECTOR REVIEW: Investor demand for high quality and yield has continued to support the ABS sector through the first three quarters of 2012. As a yieldadvantaged alternative to U.S. Treasury or Agency securities, ABS new issue supply has remained strong through 3Q12. Issuance totals $150B YTD, far outpacing the $144B issued in 2011 and the $127B in 2010. During 3Q12, Credit Card issuance increased and now accounts for 18% of the ABS market. However, Auto issuance still dominates the sector with a commanding 43% market share.
BHMS ABS Strategy: Maintain current stance as fundamentals remain attractive. We added to our exposure during 2Q12 and early 3Q12, as the sector experienced strong issuance and renewed liquidity. We continue to favor the auto and heavy equipment over credit cards as these sub-sectors have stronger financial metrics with more stringent underwriting requirements. The yield advantage over other short duration alternatives makes ABS an attractive sector. We believe the positive fundamentals will persist into 2013, supporting our overweight.
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