Barbara Williams, CFA
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).
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 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.
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.
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 2a‐7 money market funds will differentiate between institutional prime and government funds. Prime will be market‐based, 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 buys‐out a problematic security. Funds must disclose daily and weekly liquid assets ~30% of assets, liquid assets, net shareholder inflows and outflows, and post market‐based 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.