Senior Consultant
Bridgebay Financial, Inc.
Outlook
The outlook for 2015 is for good economic growth ranging from 2.5% -
3.0%, low inflation at 1.5%, and for the unemployment rate to be less than
5.5%. However, there are some
indications at quarter end that the economic recovery might be losing some
momentum. The Fed is expected to raise
its target range for the federal funds rate in 2015 even if inflation remains
below its 2% target.
Inflation appears to be low and may give the FOMC reason to be slow in
raising rates. The Fed is expected to be
slower in the pace and size of rate hikes than in previous periods such as the
2005-2007 hiking period. The final rate
is also expected to be lower than historically.
Federal Reserve
US growth will maintain a modest, but above-trend, pace of growth for
the remainder of 2015. Inflation should
begin to rise gradually towards the Fed’s target of 2%, though potential
currency and commodity influences will be closely monitored. The Fed is anxious to begin the process of
unwinding its massive accommodation program but as of now, only one Fed rate
hike is likely in 2015.
Christine Lagarde, IMF chief, made statements during the quarter that
it would be best for the US Fed to postpone raising interest rates this
year. Although the Fed responded that
they were independent, it appears that the most recent dovish FOMC comments did
recognize a concern for international financial events.
The Fed has now indicated that international considerations will also
be an important factor in determining the timing, frequency and scale of its
rate hikes. The Fed has now begun to
focus on the recent Greek financial distress, China’s slower growth, and their
potential impact on market volatility.
Trade also continues to be a primary focus for the Fed. Concern about
economic growth, the strength of the USD and the effects of lower energy prices
were prominently mentioned in the Fed minutes.
The Fed is positive about the underlying consumer spending over the
medium-term, improvement in jobs, the wealth effect from improved housing and
stock valuations, stronger consumer balance sheets, lower energy prices and
higher consumer confidence. The Fed is
tracking payroll gains and labor market slack with less emphasis on wage
growth. The recent economic data
indicates that the economic recovery is starting to lose momentum.
Interest Rate Hikes
The FOMC lowered their interest rate forecast by 50 bps in 2015. FOMC continues to be dovish, now signaling a
September rate hike to be unlikely. Most
market participants expect one modest rate hike by year-end 2015. The continued global disinflationary trend and
the limited supply of conservative bonds will help keep interest rates low.
Inflation
The lack of inflationary pressures in the US will keep long-term rates
low, however the longer the Fed delays raising short-term rates the greater the
chance of rising inflation expectations.
Fixed Income Markets
Two-year Treasury yields ended June 9 basis points higher quarter over
quarter at 0.65% after hitting a high of 0.73% in mid-June. The impasse between Greece and its European
creditors led to a flight to quality as Treasury yields partially reversed
their rise over the quarter. Yields ended the month 3-14 basis points higher
across 2 year to 5 year maturities as the curve steepened by 12 basis points.
Yields climbed higher during the quarter, and the yield curve
steepened. The US economy continues to improve, with the employment situation
improving at a healthy pace. This is
beginning to shorten investors’ expectations for the first Federal Reserve rate
hike.
Credit spreads widened as market participants dealt with heavy new
issue supply in the face of growing concerns over the liquidity available in
the corporate bond market. Lower quality
and off-the-run securities experienced the most spread widening.
Corporate yield spreads were wider in June as record issuance year to
date, lower liquidity and ongoing developments in Greece are pressuring
secondary markets. Demand for new issues remains robust. Short duration
corporate yield spreads are back to the wide levels of early 2015.
Despite the higher yields and wider spreads, investment grade corporate
bonds managed to generate a meager positive return for the quarter due to the
higher coupon income offered over Treasury and agency securities.
Leverage continues to rise in industrials. Idiosyncratic risk is rising
due to ongoing M&A activity and shareholder activism. Financial balance
sheets are strong as asset quality continues to improve and capital levels and
liquidity remain solid. New issue supply
will be driven by M&A activity and banks issuing to reach required capital
levels.
Liquidity
The cost of liquidity has risen with wider bid-offer spreads due to the
lack of dealers willing to be market-makers.
The amount of time needed to transact increases as traders seek
liquidity sources. Investors can expect longer holding periods and less trading
of their investment positions. Declining liquidity may also increase
volatility. Smaller dealer balance sheets, an overall risk averse tone to the
market and robust new issue supply all contributed to weak liquidity in the
market during the quarter.
Bank Credit Ratings
Moody’s concluded their review of global investment banks with results
better than expected. S&P results
are still pending.
Moody’s updated bank rating methodology incorporates several solvency
and liquidity factors. Their intent is
to predict bank failures and determine how each creditor class may be treated
when a bank fails. The new approach is
based on their experience from the global financial crisis and changes in
banking regulation.
Greece, Puerto Rico and China
Developments in Greece and Puerto Rico heightened the potential for
event risk and volatility during the quarter.
China’s domestic equity dramatic sell-off raised concerns.
All three areas were distractions to the markets during the quarter
contributing to increased market volatility.
Greece and the Euro
The likelihood of Greece exiting the Eurozone increased dramatically as
Greece missed a €1.6 billion payment to the IMF, stopped negotiations to call a
national referendum on a bailout proposal, and imposed capital controls when
the ECB halted expansion of Emergency Liquidity Assistance (ELA) funding for
Greek banks. Greek voters rejected the bailout proposal which caused the crisis
to worsen immediately. The Greek crisis has settled down with the recent 3-year
bail-out agreements being hammered out.
A Greek exit might have triggered unexpected systemic risks and
impacted Europe’s economic recovery which has been responding well to the ECB’s
aggressive stimulus program.
Puerto Rico and the US Municipal
Market
The market is now awaiting further news as to the fiscal situation in
Puerto Rico which has adversely impacted some sectors of the municipal bond
market. A study published in June
recommended debt relief as part of a comprehensive package of economic and fiscal
reforms for Puerto Rico. Governor Padilla
later announced that Puerto Rico’s level of debt was unsustainable. This raised serious concerns about the
Commonwealth’s ability to pay its debt.
A default event could trigger wide volatility in US bond markets,
specifically the municipal market.
China and China-A Shares
The coordinated aggressive Chinese banking, brokerage and government
stimulus program now appears to be taking effect by stabilizing the domestic
Chinese equity market’s dramatic sell-off.
Fortunately, the sell-off was limited to Chinese domestic retail
investors and did not impact foreign and US markets.
