Fixed Income Market Review and Outlook June 30, 2015
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1 Fixed Income Market Review and Outlook June 30, 2015 Market Overview It sounds like a movie plot to the next Fast and Furious sequel. On one side of a long, straight road, you have an older, not well maintained, but souped-up car poised to start. On the opposite side, is a sleek, new, German sports car. The participants are playing an old fashion game of chicken, where the drivers head towards each other on a collision course. Whoever swerves first is the loser. This time, the drivers are not Vin Diesel and Dwayne The Rock Johnson. In the older car, the driver is the Greek Prime Minster, Alexis Tsipras, defiantly proclaiming that Greece will not yield to demands for further austerity. In the German car, there are several people and it is hard to tell who is driving, but you can clearly hear German Chancellor Angela Merkel yelling instructions to the group. They start towards each other at a high rate of speed with both sides making moves to give the impression that they are not going to take action to avert a collision. They both very much want the same outcome of Greece staying in the Eurozone, but they cannot agree on the terms to make it happen. The referendum on July 5 resulted in a no vote. This did not solve anything, but will lead to further hurried negotiations and increases the possibility of Greece exiting the Euro-zone. Mark Foust Senior Portfolio Advisor 30 Years Industry Experience MBA - Pennsylvania State University BS - Carnegie-Mellon University Below is a chart that shows ten-year government yields in several major developed countries as of the end of the last three quarters. Ten year rates have increased for all of these countries this year despite fairly slow growth and the significant monetary easing that is occurring in all of these countries except the U.S. 4% 3% Ten-Year Government Bond Yields 12/31/2014 3/31/2015 6/30/2015 2% 1.59% 2.29% 2.32% 1.86% 1.76% 1.58% 2.02% 2.17% 1.92% 2.34% 1.19% 1.21% 1.29% 1% 0.76% 0.82% 0.31% 0.41% 0.45% 0.54% 0.18% 0.48% 0% Japan Germany France Spain Italy United Kingdom United States As of 6/30/2015 Source: Bloomberg The Greece situation took center stage in the second quarter. This was a change from the last nine to twelve months where the main focus of financial markets was the significant decline in oil prices and the strength of the dollar. In the second quarter, oil prices moved higher from the lows and stabilized while the dollar s path was mixed. The Federal Reserve continued to talk about raising the Funds Rate when appropriate later in 2015 and the market s expectations changed frequently depending on the data du jour. Interest rates in the U.S. and most developed countries moved higher during the quarter from the extremely low levels attained during the 1 st quarter rally. 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, Hungary, etc.). In fact, at current exchange rates, Japan and the ECB are purchasing $120 billion in assets each month, mostly government bonds. This should continue over at least the next year and possibly for much longer. Page 1
2 Market Overview (Continued) With U.S. Treasuries at higher yields than most developed countries and with the strength of the dollar, a significant amount of foreign capital has been buying treasuries. This is likely to continue with the higher and relatively more attractive yields that currently exist. The Barclay s Capital Aggregate returned -1.68% in the 2nd quarter of 2015, with the treasury portion of the index returning a similar -1.6%. This broke the five quarter streak of positive returns for the Barclay s Government Index, the longest winning streak in more than a decade. These losses were due to a rebound in economic activity after the very poor first quarter, a lack of liquidity, an even more significant rise in German bond yields, and yields that were extremely low at the beginning of the quarter. In addition, investor expectations, based on the fed funds futures market, are that the Federal Reserve will most likely increase the Federal Funds Rate later this year for the first time since Within investment grade securities, higher quality securities had less negative returns, but this was due to duration and not credit quality. BBB rated securities in the Barclays Aggregate have an average duration of 7.5 as compared to 6.9 for A, 5.7 for AA and 5.1 for AAA. Shorter duration securities held up better in the quarter due to the rise in interest rates. High Yield outperformed all other fixed income asset classes, partly due to shorter duration and to the higher yield that helped cushion the rise in rates. The following tables show the returns for the various fixed income sectors and rating categories for the 1st quarter. Sector 2 nd Quarter Indices Total Return* Credit Rating 2 nd Quarter Indices Total Return* U.S. Treasuries -1.6% Agencies -0.6% MBS -0.8% Inv. Grade Corporates -3.2% High Yield 0.0% Emerging Markets Debt -0.3% EMD Local -1.0% AAA -1.4% AA -1.8% A -2.2% BBB -2.3% BB -0.4% B +0.4% CCC +0.5% * Returns are from Barclays indices except Emerging Markets Debt, which is from JP Morgan. All figures as of 6/30/2015. U.S. Treasuries Treasury prices declined and yields rose for all maturities during the 2nd quarter. More moderate economic growth, higher and more stable oil prices and a lack of buyers combined to drive treasury yields up from the very low levels of the 1st quarter. Since the conclusion of the Federal Reserve s bond purchase program last October, investors have been focused on the wording in the Fed s statements and its comments to the media. In a press conference that Janet Yellen conducted after the last Fed meeting, she reread the end of the official statement that said The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run. In addition, Fed officials lowered their central tendency for growth from a range of 2.3% to 2.7% in March to 1.8% to 2.0% in June. This was due to the negative GDP in the first quarter as well as only moderate growth in the 2nd quarter as the impacts of harsh weather and the port strike dissipated. Investor expectations are that the Fed will move the Funds Rate up by 25 basis points sometime between September and December. In the 2nd quarter, yields rose for the two-year Treasury by 9 basis points, while the five, ten, and thirty-year Treasuries increased by 28, 42, and 58 basis points, respectively. The yield of the two-year note closed at 0.65% while the ten-year Treasury rose from 1.92% to 2.34%. Page 2
3 The Economy U.S. Economic growth for the 1st quarter was a very disappointing -0.2%, pushed into negative territory by the harsh winter weather, the stronger dollar, and the port strike on the west coast. Activity picked up in the 2nd quarter, particularly in May and June with consumer spending leading the way with strong auto sales. Consumer spending is expected to be a positive contributor in the second half of 2015 as stronger employment and lower gasoline prices boost household buying power. Many estimates are for growth of between 2% and 3% in the 2nd quarter and higher than 3% during the second half. Below is a chart of U.S. GDP growth since the beginning of % 5% 4% 3% 2% 1% 0% -1% -2% -3% U.S. GDP Growth Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q Source: U.S. Department of Commerce, Data provided including revisions through 06/30/15. As mentioned earlier, retail sales and consumer spending were stronger later in the second quarter, even excluding gasoline and auto sales. Overall, retail sales rose +1.2% in May and +0.2% in April while retail sales excluding autos and gasoline rose +1.0% and +0.2%, respectively. Consumer spending grew by +0.9% in May and +0.1% in April. Motor vehicle sales were strong during the quarter after slower sales earlier in the year. The annual rate in June was 17.2 million units, up from 16.2 million units in February. Auto sales boosted economic growth in 2013 and 2014 and could continue to add to overall growth in the 2nd half of Consumer sentiment jumped nearly four points to 94.6, but is still below the eight year high of 98.2 that it reached in mid-january. This was the sixteenth consecutive month with the index above 80. Housing has not been a strong positive driver of growth over the past year, but sales of both new and existing homes accelerated over the past few months. However, housing starts are not at particularly strong levels. Most measures of manufacturing have been weaker, with factory orders, industrial production, and durable goods orders all declining from a weak 1st quarter. Factory orders fell in May for the eighth decline in the last nine months. The labor market continued to show improvement during the 2nd quarter. The unemployment rate declined from 5.5% to 5.3%, 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 showed healthy gains, even after revisions, in all three months with gains of 187,000, 254,000 and 223,000 in April, May and June, respectively. The three month average rose from 195,000 in the 1st quarter to 221,000 in the second. Gains over 200,000 are considered to be representative of a healthy economy. However, the participation rate, the number of people either employed or looking for work, fell slightly to 62.6%, one of the lowest levels level since Average hourly earnings were flat in June, leaving the year-over-year gain at 2.0%. The Fed would like to see earnings rise closer to 3% as an additional sign that employment is on a sustainable path. Initial jobless claims have slowly moved lower over the past six months and the 4-week moving average was 274,750 at the end of the June, down slightly from 285,000 in March and 290,750 in December. Initial jobless claims are at historically low levels. Page 3
4 Spread Products With the exception of Emerging Markets Debt, spreads were wider in non-treasury sectors during the quarter. Returns were mostly dependent on duration with most of the longer duration sectors posting more negative returns. Investment grade corporates widened by 16 basis points during the quarter to 150 basis points over Treasuries and are trading wider than long-term averages. The utility sector was the worst performer as compared to financials and industrials due to their longer average durations. Mortgage spreads widened in most segments of the market despite continued positive fundamentals. High Yield, with a return of 0%, was the only major fixed income asset class that did not have a negative return: spreads widened by 13 basis points to 514 basis points over Treasuries. Average high yield prices fell 1.5 points to The current spread for High Yield is close to long-term averages, and the yield-to-worst rose from 6.18% to 6.57%. The yield and spread are close to the levels of early January Default activity increased late in the quarter with the volume of defaults over $8 billion. In addition, there has been an increase in distressed exchange activity, particularly across the energy sector. Despite the increase, the twelve month default rate remains very low at 1.9% on a par-weighted basis and 2.1% including the distressed exchanges. This is well below historical averages of around 3.7%. Most forecasts for defaults have been increased slightly due to the decrease in oil prices. The Barclay s High Yield Index is composed of approximately 14% energy companies and defaults could continue to rise if oil prices remain below $60 for a sustained period of time. Emerging Markets Debt had a small negative return in the 2nd quarter (-0.3%) with spreads tightening by 16 basis points. EMD spreads closed at 353 over Treasuries with yields at 5.81%. US Dollar spreads are unchanged in Local currency EMD again saw declines, returning -1.0% as most EM currencies continued to decline versus the US dollar with some notable exceptions including Russia and Brazil. Inflation Higher oil prices in the quarter pushed overall inflation slightly higher, but core inflation by all measures remains muted. After the steep decline in energy prices from the middle of 2014 through March of this year, oil prices rose by 25% during the 2nd quarter to close at around $60 a barrel. Other commodity prices were mixed, but generally slightly higher for the past three months. The Bloomberg Commodity Index was up about 4.5% for the quarter, but is still down 1.6% for the year. This index consists of 22 commodities and about 31% are energyrelated with the balance in metals and agriculture. 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), moved higher over the last several months, but remained low over the past year. The CPI rose +0.4 in May but is flat yearover-year, while Core CPI grew by +1.7% over the past year. The PPI final demand declined -1.1% year-over-year while Core PPI increased by 0.6%. 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 +0.2% and a Core PCE deflator increase of +1.2% over the past year. Also of note, Euro-zone inflation remained at very low levels in June with an annual rate of +0.2% while the Core inflation rate rose by +0.8%. In summary, inflation is well below the Federal Reserve s target and will give it leeway to hold rates very low even if employment conditions continue to improve. Page 4
5 Portfolio Positioning Two major issues have the eye of the Mortgage market: the timing of the Fed rate hikes and potential Greece bankruptcy/eu exit. The higher volatility has driven mortgage spreads to Treasuries to widen 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 4.30%, up 30 bps in the 2 nd quarter. Mortgage prepayments have fallen in conjunction with the higher rates. 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 which could be detrimental to performance as rates rise. We have positioned our mortgage portfolio with a slightly shorter duration and reduced our lower coupon overweight, but are not underweight, as we await the Fed s rate action. The potential Greece default could translate into a flight to quality. A Greek default could have a negative effect on an underweight duration portfolio in the interim as investors flock to Treasuries. As the market realizes the contagion effect may be overstated, the flight to quality should recede. If the threat of Greece default subsides, markets should refocus on QE/economic recovery and rates should trend higher resulting in a positive effect on our portfolio. Our CMBS exposure is close to flat to the benchmark while we are underweight Asset-Backed-Securities. 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. High Yield has been more stable and performed well in the 1st half of 2015 and we believe valuations are close to fair-value. The average yield-to-worst for High Yield has risen from near historical lows of 4.91% in June of 2014 to 6.57% at quarter-end. Prices and yields are more reasonable now, but not cheap; further concerns about the Fed, the equity market, or renewed volatility in oil prices could lead to declines in high yield. 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. Our Credit strategy is to focus 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 6% to this sector. Spreads moved wider this quarter, and are slightly 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. Although it is more challenging to find undervalued corporates, opportunities still exist. 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. We hold a positive outlook for Emerging Markets Debt over the next 3 to 5 years. This outlook is supported by our view that valuations are slightly cheap and our belief that the improved credit fundamentals in many EM countries will continue to support their economic growth and social development. In the shorter time horizon, EMD could benefit from the search for higher yields and returns by investors. We continue to be cautious on local currency bonds due to the possibility for further appreciation in the U.S. Dollar. In non-u.s. dollar securities, we favor longer maturities in Mexico and the intermediate sector of Brazil. In hard currency, the long-term returns for Ukraine, Venezuela, and Argentina continue to appear favorable. The Ukraine government is in negotiations to restructure their sovereign and some of their quasi-sovereign bonds and we believe the resolutions will be favorable to bond holders. We are also holding some select Chinese corporates that we feel have good value. Page 5
6 The Look Forward The Fast and Furious movie franchise has produced seven profitable films with each sequel usually coming out every two or three years. The eighth movie is already scheduled for a 2017 release. The financial problems in Greece are terrible for its people and certainly not entertaining, but their issues have not gone away and seem to come to the forefront of financial markets almost as frequently as the Fast and Furious movies. Despite the referendum vote and impending deadlines for interest payments, this story will not come to a final conclusion soon. We most likely will see another sequel sometime down the road. In the short-term, financial markets will continue to feel the effect as news is released. Regardless of the outcome, we don t feel that this will significantly affect financial markets over the long-run, particularly in the United States. Fixed income markets are much more reasonably priced now than at the end of the 1 st quarter. Ten year treasuries are yielding 42 basis points higher with wider spreads in most nontreasury sectors. The yields of the investment grade corporate index and high yield index are 45 and 39 basis points higher this quarter, respectively. Yields are still low historically, but much more reasonable after the recent decline in prices. We believe that economic activity over the next twelve months will be in the range of 2% to 3%, similar to what we have experienced over the last few years. Inflation should remain at or below the Fed s target of 2% with Core PCE currently at 1.2%. Commodity prices in general will probably not spike and will help keep inflation in check. Furthermore, the rise in the dollar will lower import prices and reduce exports; both assisting in keeping interest rates reasonably close to current levels. While non-farm payroll numbers have increased and the unemployment rate has fallen to 5.3%, the Federal Reserve is monitoring additional measures of employment that are not as positive, such as the participation rate, average hourly earnings, and the number of part-time workers who cannot find full-time work. Wage gains remain stuck close to 2% and the Federal Reserve would like to see sustained higher wages. Furthermore, the Fed has stated that it will move the Funds Rate up gradually and at a measured pace when it is appropriate. Growth in China has slowed and Japan and Europe, despite significant quantitative easing, will probably have growth below 3% for the foreseeable future due to their structural problems. Finally, geopolitical tensions continue in several regions and it does not appear that these situations will ease anytime soon. With this underlying environment, Treasury yields may remain in a range close to current levels through the end of They could easily move back towards the levels seen last quarter if consumer spending disappoints and growth is closer to 2%. It is also possible that we will see a shock to the system (political, military, or economic) over the next year or two. The combination of U.S. strength, global weakness, and lower oil prices could present a challenging environment for global central banks. We believe returns will be better in the second half of 2015 and positive for fixed income for all of 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 lower 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. To summarize our outlook: 1. The Federal Reserve will possibly raise the Funds Rate later in 2015, but any increases will be gradual and very modest. 2. We expect U.S. economic growth of approximately 2.0% to 2.5% over the next 12 to 24 months. 3. The much stronger dollar will gradually reduce the extent of global growth imbalances. 4. Core inflation will remain below the Fed s target of 2% over the next year. 5. We do not expect interest rates to move significantly higher over the next twelve months; short rates could move higher as the Fed gets closer to tightening. The Ten Year Treasury may remain below 2.5%. 6. Growth in Europe could move toward 2% due to the weaker Euro and much lower oil prices; however, the long-term structural problems remain. 7. Interest rate volatility will most likely remain elevated. 8. Caution is warranted. 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) t.sweeney@dupont.com Mr. Brendan Naughton, CIMC Principal (302) b.naughton@dupont.com Mr. Marek Michejda Principal (415) m.michejda@dupont.com Mr. William Smith, CFA Principal (302) William.wallace.smith@dupont.com 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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