Friday, July 8, 2016

Economic Review 2Q 2016

Barbara Williams, CFA
Managing Director
Bridgebay Financial, Inc.

The economic data releases of personal consumption, auto sales, personal income, and home prices during May were generally positive. The market expected that the Fed would raise rates in July, however, at the June 15 FOMC meeting, the Fed postponed raising rates due to global uncertainty, a weak labor-market report in June and the pending “Brexit” vote.

Economic data was improving and yields had been rising until the June 23, 2016 “Brexit” referendum results stunned the markets.  The UK vote to leave the European Union (EU) threw global financial markets into turmoil and engendered a flight to quality. Treasury yields dropped precipitously and the yield curve flattened.

Treasury Yields
The global markets have had a critical impact on the Treasury market movements. Most of the world’s sovereign rate markets are now generating negative yields making the Treasury yield curve one of the few offering positive yields. With negative government debt yields in Germany, Switzerland and Japan, global investor appetites for U.S. credit and Treasuries have risen sharply causing the U.S. yield curve to flatten.

Bond market estimates show that nearly $11 trillion of bonds have yields below zero. Another study concludes that over 60% of the world’s bonds with positive interest rates are denominated in USD. This has caused global investors to rush into the U.S. fixed income market. 

Before the “Brexit” vote the expectation had been for the yield curve to steepen.   Instead, the uncertainty and fear in the market has led to the flattening of the U.S. Treasuries yield curve, bringing the 10-year yield down to 1.37%.  This high demand for USD fixed income pushed rates down to exceptionally low levels.  Demand for U.S. equities and bonds made the USD stronger as a safe haven currency.

A firming labor-market, positive wage growth, service sector inflation, a tight housing market, and energy price increases may lead to modestly higher core inflation. 

U.S. Federal Reserve
The Fed decision in the U.S. to not raise rates was anticipated as the economic data after the March Federal Open Market Committee (FOMC) meeting was weak.  The FOMC Summary of Economic Projections indicated that the Fed would be restrained in 2016.  The Fed also mentioned uncertainty in raising rates before the June 23 “Brexit” vote.    There are some market participants that believe the Fed may move to lower rates rather than raise them.  This appears highly unlikely because the U.S. economy is stable and not showing signs of recession.  Personal income and spending demonstrate that the consumer’s financial condition is in good shape.

Following the FOMC’s meeting and accompanying statement on April 27, economic expectations remain subdued.  FOMC, in April, concerned by international developments and volatile risk markets, further slowed its approach to gradually raising rates.  The Fed reduced its planned trajectory for raising rates and will be slower than previously indicated.  Concerns over the “Brexit” vote also delayed any actions at that time.

U.S. Credit
Investment grade corporate bonds and spread product lagged in the June rally, though it was a risk-on market for the quarter.  High yield corporate bonds performed well over the second quarter of 2016.  Rising energy and commodity prices improved results in addition to industrial sector.

Regulatory changes continue to impact the short end of the yield curve.  There has been an increase in commercial paper issuance to meet the increased demand from money market funds. 

Financial institutions whose earnings are limited by persistent low interest rates recovered from 1Q 2016 to outperform Treasuries.  Asset-backed bonds and commercial mortgage-backed securities followed the same pattern, resulting in positive excess returns for the quarter. Mortgage-backed fixed rate paper managed to produce returns similar to Treasuries, helped by the carry but naturally lagging in price performance during the rally.

Global Central Banks
Central banks around the world adopted a wait-and-see approach in April.  The European Central Bank (ECB), Bank of England (BOE), and Bank of Japan (BOJ) all chose to forgo adding further monetary stimulus at their most recent central bank meetings.  They opted to maintain current policies and wait for their impact to flow through to growth and inflation.

Central bank involvement continued to focus on regulatory reforms and open market operations in the securities markets.   During the quarter the ECB announced additional quantitative easing, revealing its intention to directly purchase non-financial Euro corporate bonds.

Central banks have been desperately lowering rates and using accommodative measures with the ECB buying corporate bonds, and investors looking for yield globally. The technical bid for U.S. bonds continued strong while the fundamental strength of the U.S. economy remained steady yet slow. 

Continued Volatility
Global malaise, pockets of financial uncertainty, geopolitical risks, and terror concerns all influenced investor anxiety and fueled the need for safe-haven investments.  All of these factors enable central banks to generate negative sovereign bond yields.  In the wake of “Brexit” and with the U.S. presidential election looming large, investors will increasingly focus on political factors. The appetite for taking on risk may be subject to abrupt changes with risk-on/risk-off transactions. 

Markets continue to adjust to the global central bank extensive participation and hope for interest-rate normalization.

Monday, June 27, 2016

Impact of the ‘Brexit’ on Global Markets

Nicholas Zaiko, CIMA®
Senior Investment Consultant
Bridgebay Financial, Inc.

The impact of the Brexit vote on June 23, 2016 is expected to lead to weaker global growth and apply pressure on Central Banks to keep interest rates low for longer than had previously been anticipated. 

Although global stocks regained some of the losses following the Brexit results, the markets will continue to be volatile with periodic flights to quality and safety.  The US stock and bond markets are seen as safe-haven assets and should be the beneficiaries of more international uncertainty.   On July 5th the flight to safe haven assets intensified with foreign investors pouring money into US fixed income markets.  High yield bonds saw massive inflows.  The 10-year treasury yield fell to 1.37%.  

There will be continued economic, political and geopolitical uncertainty that will create heightened volatility.  Increased political uncertainty combined with moderate to slow global growth and continued accommodative central bank low rate policies will keep markets nervous. 
The EU could try to discourage other countries from leaving the economic union by punishing the UK capital markets that currently benefit as a gateway to the EU. 

The UK leads Europe in capital markets and other financial services. As much as 85% of hedge fund assets, 78% FX trading, 74% interest rate OTC derivatives trading, 64% private equity and 50% of all European fund management goes through London.

The UK vote to leave the European Union (EU) has started a long period of political, economic and market uncertainty for both the UK and EU.  Markets will continue to have increased volatility with periodic sell-offs in stocks and other global risk assets as the Brexit process evolves.  The EU is also threatened from within by populist groups that may also want to leave the EU, though the Spanish elections following the Brexit vote retained the current Rajoy government that favors remaining in the EU.  Italy has a referendum vote in October.

Political Turmoil
UK Prime Minister David Cameron, who favored Remain in the EU, will resign by October, 2016.  Already the Conservative Party is having other leadership issues as well as the head of the Independent Party’s resignation.  Essentially, the UK is experiencing considerable political infighting and turmoil.   Ironically the referendum is considered non-binding but no leader has the political will at this time to challenge it.  This may be an opening for the next prime minister.
Additionally, Scotland may call for another independence referendum to leave the UK in order to remain in the EU.  Northern Ireland had also voted to Remain and they too may seek to leave the UK in favor of remaining in the EU.

The UK exit is expected to be complicated as decades of negotiations and trade agreements are laboriously unwound.  Per the Treaty on European Union Article 50, the UK will have 2 years from the date the UK officially notifies the European Commission (EC) of its intention to leave the EU
To complete its exit.  The earliest departure would be June, 2018.  Any potential savings from leaving the EU are expected to be overrun with losses in services, new investment flows and exports resulting in a net loss to the UK economy.  The Brexit will most likely lower UK growth and investment and potentially lead to higher UK unemployment and inflation. 

The EU loses a global financial center with strong access to world markets.  Many banks have already indicated that they may re-locate operations from London.  US Banks and other global organizations with operations based in the UK will most likely reduce both their presence and investment inflows in the country.

Another loss to the EU is the UK’s contribution to the EU budget.  This leaves Germany and France as the major EU budget contributors.  The EU has already begun to expand its base of members and privileges in an effort to replace the potential loss of the UK.   

Bank of England (BOE) Governor, Mark Carney, announced that it has been providing liquidity to some banks and announced that its top priority is to provide liquidity to avoid any financial stress in the UK market.  The BOE had been expected to gradually raise rates but will now be lowering them and being more accommodative to markets.  The British pound fell to 31 year lows and will continue to be volatile as more political news evolves.  Interest rates in the UK may be cut and the BOE will use all of its tools including quantitative easing. 

Both S&P and Fitch promptly lowered the UK debt rating from AAA to AA with Negative Outlook and Moody’s placed the UK on Negative Outlook with the expectation that they will soon follow with a downgrade.  The rating agencies have stated that the decline in the country rating will not impact the credit rating of UK-based companies at this time.

GBP Currency
The British pound has already weakened and may decline further as the markets decipher the impact of the UK leaving the EU.  This will lead to a temporary spike in inflation. The Pound is the most liquid UK financial asset and the immediate victim of the Leave vote. 

Euro Currency
The euro has declined in response to the UK vote.  A weaker currency will negatively impact foreign investors invested in EU stocks.  Even if stock prices rise in the near-term, it will not be enough to offset the decline in currency.  Economists are now expecting lower growth and increased job losses across Europe.  High quality (German, French) European government bonds continue to be in high demand in spite of negative interest rates. 

Other Global Markets
The UK represents only 4% of the global economy.  The US and Asia markets have been slightly affected by the UK’s exit from the EU and in some cases US bonds and Japanese stocks have benefited as investors seek out safe haven assets.  In the UK, large cap UK companies with global operations will actually benefit from the drop in the British pound as 75% of them generate revenues outside the UK.  They will outperform the domestically focused UK stocks that will experience the adverse effects of a UK recession. 

Friday, April 8, 2016

Economic Review 1Q 2016

Barbara Williams, CFA
Managing Director
Bridgebay Financial, Inc.

The markets were adversely impacted with heightened volatility during this quarter.  Fears of a global recession slammed the markets hard as oil, China, and drastic credit downgrades dominated the fixed income markets.  The case for positive growth in 2016 is underpinned by the strength of U.S. consumption, household balance sheets and the labor market. 

US Federal Reserve 
The FOMC’s forecasted average Fed Funds rate for 2016 is 1.375%.  The forecast average for 2017 was reduced to 2.375% and 2018’s forecast average was revised to 3.25%. The longer run average remains unchanged at 3.5%.

Despite easing financial conditions and positive domestic data, the Fed was concerned about global risks and may tighten more gradually than originally intended. The Fed’s March, 2016 projections to raise rates twice in 2016 confirmed market expectations reflected in the Fed Funds futures that implied 2 rate hikes this year.  There may be more market volatility as the Fed normalizes policy, the business and credit cycles mature, and new risks are exposed.  A steady monetary policy, stabilizing economic factors, a slower pace of rate hikes and a pause in the U.S. dollar’s rise are positive factors for the markets in the near term.  Recession risk is low although there may be a period of sluggish growth and muted returns.

Central Bank Actions
On March 10, 2016 the European Central Bank (ECB) surprised markets by cutting interest rates and expanding its asset-purchase program to 80 billion euros or $88 billion (including non-financial investment grade corporate bonds) a month in a bid to boost inflation and stimulate a weakening eurozone economy. The ECB cut its deposit rate to -0.4% and its main interest rate to zero. The euro fell more than 1% against the dollar following the announcement. The ECB announced another set of targeted long-term refinancing operations (TLTROs).

The Bank of England (BoE) kept the base interest rate at +0.5% at its March meeting. The BoE also announced during the month that they will offer three additional liquidity auctions in June, 2016 in an ongoing effort to mitigate risks from a potential UK exit from the EU (Brexit).

USD Currency
A moderation of the USD currency’s rise in the first part of this year has eased pressure on other markets including emerging markets and commodities.   The largest factor in the USD valuation was the lowered market expectations for the Federal Reserve (the Fed) to continue hiking rates after the December, 2015 increase.

Bond Yields
Bond yields across global markets were volatile and fell during the quarter as a result of global policy and economic uncertainty.   The US 10-Year yield fell to 1.74% and has remained around this level.  The UK 10-Year yields fell over concerns surrounding monetary policy decision-making and the potential implications of a “Brexit.” Japanese 10-Year government bonds were auctioned at a negative yield for the first time, as the Bank of Japan (BoJ) continued to apply easy monetary policy in an effort to boost inflation and increase bank lending.

US Corporates
Rising corporate leverage is another key risk. Leverage has been increasing rapidly as companies take advantage of historically low rates to issue cheap debt in the U.S. to enable shareholder friendly transactions such as M&A and stock buy-backs. Many companies have used the proceeds to buy back shares or acquire other businesses, rather than to finance capital spending projects that could boost future profits. These actions make corporate balance sheets more sensitive to an economic slowdown. The excesses are concentrated in the energy sector, specifically in the high yield fixed income market.

Credit Quality
Recently there has been a noticeable deterioration in credit quality as newly announced M&A transactions are leading to high new corporate debt issuance by the acquiring companies. These companies in turn are being downgraded by the ratings agencies although the overall credit quality is expected to improve over the next 18 months. 

Corporate Tax Inversions
The US Treasury Department issued a new tax interpretation of corporate inversions, specifically, the Pfizer/Allergan $160 billion merger that would have been the largest to date.  In response, the deal was canceled given the new interpretation.  The Treasury’s suit to stop the Halliburton Baker Hughes merger may also stymy other transactions. 

Money Market Reform
Effective October, 2016 Money Market fund reforms will have been fully implemented. SEC Rule 2a7 money market funds will differentiate between institutional prime and government funds.  Prime will be marketbased, floating NAV funds with prices rounded to $1.0000 while government funds will continue to use amortized cost with the price rounded to $1.00.

Money market fund sponsors have been restructuring their funds.   Overall the industry has added 12 government institutional funds and closed 31 prime institutional funds. It has not yet been determined if money funds will continue to be rated by the NRSROs. There is a wide range among money funds as to how many intraday FNAVs they will provide.

Prime funds will be subject to liquidity fees and redemption gates. Stronger diversification requirements include that less than 10% of the money fund total assets can be subject to guarantees or demand features from a single institution. Different affiliated credits in the funds will be aggregated and limited to a 5% maximum.  ABS sponsors are treated as guarantors.

Effective April, 2016, money fund sponsors must have an enhanced website that provides increased disclosures in their SAI (statement of additional information) that include any time a fund receives sponsor support or buysout a problematic security. Funds must disclose daily and weekly liquid assets ~30% of assets, liquid assets, net shareholder inflows and outflows, and post marketbased NAVs for prime funds. They also need to show 6 months of historical information. The prime funds must also pass enhanced stress testing before April, 2016.