May 2013 - Print Money or Disappear
Macro-economic data in April provided different views of growth rates around the world: US data in April was mixedto-poor (the ISM Manufacturing index dipped but new orders rose), confirming our vision of a US 2013 GDP rate growing below capacity around 2%. European and German data in particular, have been poor recently and Spanish youth unemployment hit a record high of 55.9%. In China we also saw weaker April manufacturing numbers and Q1 GDP slowed unexpectedly to 7,7%. Japan’s economic numbers have been strong on the other hand: strong exports to China (helped by the weaker Yen) and household spending rose at its fastest pace in 9 years. It seems the QE war is currently being won by Japan, where growth expectations are rising.
Generally speaking, trend GDP growth is simply not strong enough to help developed economies deal with excess debt and excess unemployment. The paradox is that politics today forbid bailouts, defaults and austerity as methods to reduce this excess debt. This leaves central bankers solely in charge to pursue one solution: print money and reflate asset prices aggressively until growth resumes. This is why reflation assets such as Japanese equities are the 2013 winners so far (up more than 30%).
In Europe, as widely expected (by 45 out of 70 economists), the ECB lowered the refi rate by 25bp to 0.5%. The deposit rate was left unchanged as uniformly expected. We believe Draghi will keep the door open to lower the refi further - but the focus should shift back to non-standard measures. ECB officials also cautioned not to expect too much support for the economy from a small rate cut alone. Tackling tight credit conditions and weak demand in the periphery may require additional action.
In a world of zero rates, where according to Bank of America, $19.4 trillion of government bonds (that’s 48% of the total market) is trading below 1%, its little wonder the “hunt for yield” is as strong as it is. Just as an example, this week Apple managed to raise a record $17bn of financing through several bond issues at historically low levels for corporate debt (one tranche of the AAPL bond deal offers a mere 2,3% yield for 10-years of maturity).
Our strategy is to remain constructive on financial markets through our overweights in US High Yield bonds and High Dividend Yielding Equities. A big correction in these assets right now requires either A) a central bank policy mistake (e.g. the Fed withdrawing its QE program too early) or B) data weak enough to hurt markets and cause GDP downgrades. In its absence, investors will continue to be forced to invest in the riskier assets as the QE experiment to recreate growth continues. No one knows if the QE experiment will ultimately prove to be successful. But we do know the journey involves asset price inflation.
In terms of our bond allocation, we continue to play it through a long position in short-duration high yield bonds. In wednesday’s FOMC statement the Fed Reseve made it very clear that they are completely data dependent in both directions – now explicitly pledging to “increase or reduce” the pace of QE depending on the status of its dual employment and inflation mandate. Clearly the recent slowdown in the economy means that the probability the Fed will turn up the QE volume has increased. All in all, we remain cautions at the current yield levels and believe there is very limited upside here given the current record absolute yield level. Especially when considering the positive news from the US housing market recovery. Hence our preference for short duration bonds.
As High Yield interest rates are setting new lows and the new issue calendar remains heavy, the anecdotal evidence is accumulating of certain deals featuring some of the characteristics investors associate with an overheated market environment. Clearly we are seeing some aggressive deals being printed in some categories (like LBO’s or other deals with too high leverage), yet the broader picture still suggests that for every deal that matches this description there are still a few that are standard high yield deals. We will obviously remain cautious and monitor further credit deterioriation in the new issue market going forward and act accordingly if needed.
As always, please don’t hesitate to get in touch with us to discuss our investment views.
Now more than ever, with bank deposit rates being so low and valuations in some corners of the market looking expensive, good name picking and rigorous risk management are essential.