Fixed Income Market Review and Outlook September 30, 2015

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1 Fixed Income Market Review and Outlook September 30, 2015 Market Overview The China Syndrome, starring a young Michael Douglas, was a 1979 movie about an accident at a nuclear power plant. The name refers to the scenario in which a meltdown at a U.S. nuclear power plant could tunnel through the earth all the way to China. This movie title seems apropos for the 3 rd quarter as the financial markets acted like a reverse China syndrome. Markets were in turmoil as investors believed that a tanking Chinese equity market, partly caused by weaker economic growth, would spread through Asia, across Europe and around the globe, eventually contaminating the United States. Equities markets throughout the world declined significantly with extremely high volatility. High quality bonds rallied due to the ensuing flight-to-quality. Emerging market equities negative return of -17.8% was at the low end of the return spectrum while the positive end was represented by the ten-year treasury return of +3%. Below is a chart with returns of various asset classes. Mark Foust Senior Portfolio Advisor 30 Years Industry Experience MBA - Pennsylvania State University BS - Carnegie-Mellon University Source: Bloomberg, MSCI, Barclay s Yields in most developed countries moved lower with the German ten-year yield falling to 0.59%, France to 0.90%, Italy to 1.72% and the U.S. to 2.04%. Oil once again dominated headlines as prices resumed the downward slide that began in mid Most other commodity prices declined as expectations for China s demand for raw materials decreased. The U.S. Federal Reserve seemed poised to raise the Funds rate for the first time since 2006, but decided to hold off in September due to the increased uncertainty caused by the global market turmoil. The biggest surprise was how much weight the Fed is suddenly giving international economic and financial market developments. Outside of the U.S., most central banks were still providing significant monetary stimulus, either by quantitative easing (Japan and ECB) or by reducing interest rates (China, India, Russia, Norway, Canada, etc.). At current exchange rates, Japan and the ECB are purchasing $120 billion in assets each month, mostly government bonds. This could continue over at least the next year and possibly for much longer. Page 1

2 Market Overview (Continued) The Barclay s Capital Aggregate returned +1.23% in the 3rd quarter of 2015, with the treasury portion of the index returning a strong +1.8%. These gains were due to a flight-to-quality caused by large declines and significant volatility in equity markets, and fears of weaker global economic growth. Within investment grade securities, higher quality securities had stronger returns, led by treasuries and followed by mortgages and investment grade corporates. In contrast to last quarter, high yield underperformed all other U.S. Dollar fixed income asset classes due to its more equity-like nature. The following tables show the returns for the various fixed income sectors and rating categories for the 3rd quarter. Sector 3 rd Quarter Indices Total Return* Credit Rating 3 rd Quarter Indices Total Return* U.S. Treasuries U.S. Treasuries 1.8% Agencies -0.2% MBS 1.3% Inv. Grade Corporates 0.8% High Yield -4.9% Emerging Markets Debt -1.7% EMD Local -10.5% AAA 1.5% AA 1.2% A 1.5% BBB -0.7% BB -3.1% B -5.6% CCC -7.3% * Returns are from Barclays indices except Emerging Markets Debt, which is from JP Morgan. All figures as of 9/30/2015. Treasury prices rose and yields fell for all maturities during the 3rd quarter. Concerns about China s economic growth and volatile equity markets led to a flight-to-quality that pushed treasury prices and other higher quality fixed income securities higher. In addition, the Federal Reserve did not raise the Funds Rate higher in September as was expected by some investors. About a week after the Fed left rates unchanged, Yellen stated that conditions will likely entail an initial increase in the Federal Funds Rate later this year. But if the economy surprises us, our judgments about appropriate monetary policy will change. Her comments were made before the weak employment report was released on October 2. The market s expectations for a rate increase have changed significantly since mid-september, moving lower after the Fed remained on hold on September 17 and then moving even lower after the employment report was released in early October. A chart showing how much the probability of a 25-basis point hike changed over a three week period appears below. At this point, the markets are saying that the Fed will most likely wait until at least March to raise rates for the first time. Source: Bloomberg Page 2

3 U.S. Treasuries (Continued ) In the 3rd quarter, yields declined for the two-year Treasury by 2 basis points, while the five, ten, and thirty-year Treasuries decreased by 29, 31, and 27 basis points, respectively. The yield of the two-year note closed at 0.63% while the ten-year Treasury fell from 2.35% to 2.04%. The Economy U.S. Economic activity rebounded in the 2nd quarter with a very robust +3.9% growth after weak 1 st quarter growth of +0.6%. Activity held up reasonably well in the 3rd quarter despite the declining stock market, with the consumer leading the way. The first report of 3 rd quarter GDP will be released on October 29. Consumer spending is expected to be a positive contributor as stronger employment and lower gasoline prices boosted household buying power. Most estimates are for growth of between 2% and 3% during the second half of Below is a chart of U.S. GDP growth since the beginning of Source: U.S. Department of Commerce, data provided including revisions through 09/30/15. Retail sales and consumer spending were stronger in the third quarter, even excluding gasoline and auto sales. Overall, retail sales rose +0.2% in August and +0.7% in July while retail sales excluding autos and gasoline rose +0.3% and +0.7%, respectively. Consumer spending grew by +0.4% in both July and August. Motor vehicle sales were strong during the quarter with an annual rate in September of over 18 million units, up from 17.2 million in June and 16 million units in the 1 st quarter. Consumer sentiment fell more than six points to 85.7 as the weaker stock market seemed to leave consumers a little unsettled. Despite the decline, this was the nineteenth consecutive month with the index above 80. Housing has been a slight positive driver of growth over the past few months, with sales of both new and existing homes moving higher. However, housing starts are not at particularly strong levels. Most measures of manufacturing continue to be weak as compared to 2014, with factory orders, industrial production and durable goods orders all declining or remaining subdued from earlier in the year. Factory orders fell -1.7% in August after a small gain in July while durable goods orders fell -2% in August after a 1.9% gain in July. The labor market showed mixed results during the 3rd quarter with the unemployment rate falling, but with payroll gains and hourly earnings being lackluster. The unemployment rate declined from 5.3% to 5.1%, the lowest level since April of This compares to 6.7% at the end of 2013 and 5.6% at the end of Non-farm payroll exhibited a much smaller gain in September of only 142,000 jobs with downward revisions totaling 59,000 to July and August. The three month average fell from 213,000 in the first half of the year to 167,000 in the 3 rd quarter. Gains over 200,000 are considered to be representative of a healthy economy. The participation rate fell to 62.4%, the lowest rate since 1977 while average hourly earnings were flat in September, leaving the year-over-year gain at 2.2%. The Fed would like to see wages rise at least 3% as an additional sign that employment is on a sustainable path. Initial jobless claims have slowly moved lower over the past nine months and the 4-week moving average was 270,750 at the end of the September, down slightly from 274,750 in June and 290,750 in December. Initial jobless claims remain at historically low levels. Page 3

4 Spread Products Spreads widened significantly in non-treasury sectors during the quarter, caused by a flight-to-quality as well as concerns over potentially weaker global economic growth. The more equity-like sectors, such as high yield, performed very poorly while higher quality and longer duration sectors performed better with, for example, investment grade utilities posting strong positive returns. Investment grade corporates widened by 24 basis points during the quarter to 174 basis points over Treasuries and are trading much wider than long-term averages. The utility sector was the best performer versus financials and industrials mostly due to its longer average duration. Mortgage spreads widened slightly in some segments of the market despite continued positive fundamentals. High Yield declined significantly, mostly due to the higher correlation to equities and the high weighting of energy bonds. Spreads widened by 158 basis points to 672 basis points over Treasuries. Average high yield prices fell 6 points to The current spread for High Yield is much wider than long-term averages, and the yield-to-worst rose from 6.57% to 8.04%. The yield and spread are at levels not seen in over three years. Default and distressed exchange activity has increased and has been dominated by the energy and coal sectors so far in Despite the increase, the twelve month default rate remains low at 2.3% on a par-weighted basis and 2.5% on an issuer-weighted basis. This is still well below historical averages of around 3.7%. Most forecasts for defaults have risen due to the decrease in oil prices. The Barclay s High Yield Index is composed of 13% energy companies and defaults would most likely continue to rise if oil prices remain below $60 for a sustained period. Another sector that could go through increased restructuring or defaults, metals/mining, comprises almost 5% of the index. Emerging Markets Debt declined in the 3rd quarter by -1.7% with spreads widening by 80 basis points. EMD spreads closed at 433 over Treasuries with yields at 6.32%. Local currency EMD again saw large declines, returning -10.5% as most EM currencies continued to decline versus the US dollar; the few exceptions included Poland, Hungary and Romania. Inflation Commodity prices, including oil, declined during the quarter and pushed overall inflation lower. The Bloomberg Commodity Index was down -14.5% for the quarter, driven by concerns about weaker growth in China. Oil prices led the decline from a headline standpoint, but weakness was widespread as corn, soybeans, wheat, coffee, cotton, hogs, nickel, and copper also fell more than -10%. The Fed targets an overall annual inflation rate of 2%, a pace it views as appropriate for economic growth and price stability. Current inflation, as measured by the year-over-year Consumer Price Index (CPI) and Producer Price Index Final Demand (PPI), remained low over the past quarter and year. The CPI fell -0.1 in August and is up only +0.2% year-over-year, while Core CPI grew by +1.8% over the past year. The PPI final demand was flat in August and declined -0.8% year-over-year. Core PPI increased +0.9% year-over-year. The Fed s preferred measure is the price index for Personal Consumption Expenditures (PCE). This measure has remained low, with an overall year-over-year increase of just +0.3% and a Core PCE deflator increase of +1.3% over the past year. Also, Euro-zone inflation turned negative in September with an annual rate of -0.1% while the Core inflation rate rose by +1.0%. In summary, inflation is below the Federal Reserve s target and will give the Fed leeway to hold rates very low even if economic conditions continue to improve. Page 4

5 Portfolio Positioning In the Government sector, our Core and Core Plus portfolios have durations that are currently very close to the benchmark. We continue to have a small position in inflation-indexed U.S. Treasuries (TIPS) and have an underweight to Treasuries as we find better value in the Corporate sector. The timing of the first Fed rate hike continues to be the main focus of Mortgage investors. The weak October jobs report pushed the expected first Fed rate hike into Mortgage spreads to Treasuries remained close to unchanged for the 3Q, but have widened since the beginning of the year by 27 bps as measured by the current coupon spread to the 5-yr Treasury. The 30-year effective mortgage rate now stands at 4.21%, down by 14 bps in the 3 rd quarter. Mortgage prepayments have increased marginally as 10-year treasury rates fell 31 bps this quarter. The anticipated Fed rate hike timing is a tradeoff between yield and duration extension. Positioning too early for a rate hike (move to higher coupon issues, reducing duration) can result in a yield give-up over an extended period while neglecting the possibility of higher rates (staying in lower coupon issues, maintaining duration) can result in duration extension that could be detrimental to performance as rates rise. We have positioned our mortgage portfolio with a slightly shorter duration as we await the Fed s rate action. Our CMBS exposure is slightly overweight to the benchmark while we are underweight Asset-Backed-Securities. Our Credit strategy focuses on issues with the potential to outperform the benchmark on a risk-controlled basis. We continue to believe that investment grade corporate bonds represent one of the better opportunities in the investment grade fixed income markets and hold an overweight of about 5% to this sector. Spreads moved wider this quarter, and are above long-term averages. We believe that corporates will outperform Treasuries over the next six to twelve months because of the combination of the yield advantage over Treasuries, supportive credit fundamentals, and moderate economic growth. With the recent spread widening, there are beginning to be more undervalued corporates. As far as industries, we are overweight banking and insurance companies where we see good value. We also have small overweights to the basic industry and REIT sectors. Security selection will be important due to the potential for rate hikes, the volatility of commodity prices, and the lack of liquidity. High Yield declined significantly due to the decline and volatility in equity markets. Yields, spreads and prices are much more attractive, but further concerns about the Fed, the equity market, or renewed volatility in oil prices could lead to further declines in high yield. We selectively added some new positions as the market declined, particularly in the energy sector. Security selection will be very important in this environment and we continue to believe that there is better value in specific lower priced and distressed securities. We hold a positive outlook for Emerging Markets Debt over the next 3 to 5 years, but there will be headwinds in the nearterm. Our positive long-term outlook is supported by our view that valuations are fairly cheap and our belief that the credit fundamentals in many EM countries will continue to support their economic growth and social development. In the shorter-time horizon, weaker global growth, low commodity prices, volatile equity markets and unstable currencies could lead more investors to stay away from EMD. However, we do believe that many investors are monitoring the market looking for an attractive entry point to allocate to the asset class. In hard currency, the long-term returns for Ukraine, Venezuela, and Argentina continue to appear favorable. The Ukraine government has agreed on terms to restructure their sovereign debt and some of their quasi-sovereign bonds and the resolutions are favorable to bond holders. We are also holding some select Chinese corporates that we feel have good value. In regards to local currency, we continue to be cautious due to the possibility for further appreciation in the U.S. Dollar. In non-u.s. dollar securities, we favor longer maturities in Mexico. Page 5

6 The Look Forward The best advice we can give to start the 4 th quarter is the same as you sometimes hear from a pilot while flying: Please return to your seats and keep your seatbelt fastened as we will be going through some turbulence. In the short-term, financial markets will remain volatile and more challenging to navigate. In the movie The China Syndrome, the nuclear meltdown through the center of the earth fortunately did not happen. In the current financial market China syndrome, a meltdown could occur if global economic growth continues to decline. Similar to what we have been saying for several years, we believe that economic activity over the next twelve months will be between 2% to 3%, the same range that the U.S. has experienced since Inflation should remain at or below the Fed s target of 2% with Core PCE currently at 1.3%. Commodity prices, in general, will most likely remain volatile, but subdued, and will help keep inflation in check. Furthermore, the strength of the dollar will lower import prices and reduce exports, with both helping keep interest rates reasonably close to current levels. Non-farm payroll numbers have declined recently, but it would not surprise us if the 3Q payroll numbers get revised upwards in the future. The Federal Reserve is on hold for the time being and probably will not move rates higher until at least early in If economic growth is below its expectations or if global financial markets remain turbulent, the Federal Reserve might continue to delay the rate hike much longer. Furthermore, the Fed has stated that it will move the Funds Rate up gradually and at a measured pace when it is appropriate to move rates higher. Growth in China has slowed and Japan and Europe, despite significant quantitative easing, will probably have growth below 2% for the foreseeable future due to their structural problems. Finally, geopolitical tensions continue in some regions and it does not appear that these situations will be resolved soon. With this underlying environment, Treasury yields may remain in a range close to the levels we have seen so far in It is also possible that we will see a further shock to the system (political, military, or economic) over the next year or two. The combination of global economic weakness, extremely low policy rates in most countries, low commodity prices and high volatility will present a challenging environment for global central banks. We believe returns will be modestly positive for fixed income over the coming twelve months, but volatility will remain high. The non-treasury U.S. fixed income markets are much more reasonably priced now than earlier in the year. Spreads in investment grade corporates, high yield and emerging markets debt are much more attractive and wider than historical averages. We are cautious, but see value in some sectors and specific securities. We feel we are positioned to take advantage of these opportunities without taking excessive risks. Long-term value is the key to investing in these low yielding and uncertain markets. With the slower growth in many countries, low inflation, and geopolitical uncertainties around the world, it does not seem wise to decrease the protection that fixed income provides. You should fasten your seatbelts, but be confident that the pilot will get you to your destination safely. To summarize our outlook: 1. Volatility will remain elevated in fixed income markets. 2. The Federal Reserve will most likely not raise the Funds Rate this year. 3. We expect U.S. economic growth of approximately 2.5% over the next 12 to 24 months. 4. The stronger dollar will gradually reduce the extent of global growth imbalances. 5. Core inflation will remain at or below the Fed s target of 2% over the next six to twelve months. 6. We do not expect interest rates to move significantly higher over the next six months; short rates would move higher if the Fed gets closer to tightening. The Ten Year Treasury seems likely to remain in a range between 1.75% and 2.50%. 7. Growth in China will be lower, but they have the resources to keep growth at 5% or higher. 8. Growth in Europe should be close to 2% due to the weaker Euro and much lower oil prices; however, the long-term structural problems remain 9. Very accommodative monetary policy across the globe may last a long time. 10. Caution is warranted, but opportunities exist. Page 6

7 About our Firm DuPont Capital has a long history of institutional asset management. Our parent company, DuPont, established a retirement pension plan for employees in 1942, and in 1975 created a separate pension management division. In 1993, DuPont Capital was established and became an SEC registered investment advisor. We share our parent company s history of innovation and, over the years, have been on the forefront of developing global investment opportunities in both traditional and alternative strategies across equity, fixed income, and alternative investments. Fixed Income Team Summary 7 Portfolio Managers 5 Research Analysts/Traders 1 Portfolio Advisor Fixed Income Capabilities Core Fixed Income Core Plus Fixed Income Emerging Markets Debt High Yield Stable Value For additional information please contact: Mr. Timothy Sweeney Managing Director Business Development and Client Service (302) Mr. Brendan Naughton, CIMC Principal (302) Mr. Marek Michejda Principal (415) Mr. William Smith, CFA Principal (302) The information contained in this memorandum is intended for the sole use of prospective investors in understanding and evaluating the impact of market events and is not designed or intended to be used for any other purpose. The document may contain forward-looking statements, which are based on current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in forward-looking statements. An investment in securities includes risk of loss. There is no guarantee that any investment in the securities mentioned will be profitable. This document is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument or as a recommendation to invest in any of the securities or financial instruments discussed herein. Page 7

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