Economic Review 1Q 2016

Barbara Williams, CFA

Managing Director

Bridgebay Financial, Inc.

www.bridgebay.com

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 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.

Irrational Investing: A Behavioral Finance Primer

Nicholas Zaiko, CIMA®

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

Much to the chagrin of traditional economists and financial academics, the pristine mathematical models used to describe the movements in asset markets falls short of accurately representing the real world.  The foundation of classic economic theory relies on the premise that all investors and market participants act in their own self interest and are rational at all times.  Yet in practice, we see that markets do not always work in a rational way.  Markets may act irrationally because ultimately, markets are made up of people who are motivated by emotions.

Rather than attempt to predict or quantify investor behavior, behavioral finance seeks to at least identify and categorize the myriad of human responses to investment related stimuli.  Most frustrating to traditional financial academics is the phenomena of the same stimuli eliciting different and sometimes contradictory responses from different investors, making reliable predictions of human behavior all but impossible.  Behavioral finance endeavors to acknowledge the overwhelming and unpredictable impact of investor behavior and identify patterns that may explain the discrepancies between the financial industry's rational-based models and the irrational nature of the real world.  

Overconfidence

Studies have conclusively demonstrated that people in aggregate are overwhelmingly overconfident.  A simple experiment will reveal the truth of this statement.  Ask anyone if they consider themselves to be better or worse than the average driver.  Without hesitation, the majority of people will respond that they are in fact better.  Obviously, this cannot be true, by definition, half must be better and half must be worse.

Overconfidence is most noticeably manifested in the realm of investment behavior when we look at the trading activity of different investors.  Overly confident investors tend to have higher turnover with more frequent trading.    A study published in the Journal of Finance¹ in April 2000 demonstrated that though the gross returns of accounts with high turnover were similar to those of accounts with very little turnover, the net returns for high turnover accounts were significantly lower than their low turnover counterparts.   Close to 30% of the net return was lost to the transaction costs of the high turnover portfolios.  Overly confident investors think they can beat the market more frequently which results in higher trading volume and ultimately lower net returns.

Gender and marital status plays a major factor in an investor's individual risk tolerances.  A February 2001 study published in the Quarterly Journal of Economics² examined the investment results of single and married men and women and revealed some interesting patterns regarding risk profiles.  Single men were by far the most aggressive with their investments, generating the highest average returns accompanied by the highest volatility.  The next riskiest investors were married men, followed by married woman, then single women.  More overconfidence leads to taking on higher levels of risk.

Regret and Pride

Psychologists have identified the feeling of regret as one of the most powerfully uncomfortable emotions a person can experience.  Throughout history, people have gone to extraordinary lengths to avoid this particular emotion.  And so it is with investing.  The typical behavior most commonly associated with regret avoidance involves the tendency of investors to sell their winners and hold on to their losers.  Realizing gains from the sale of a successful stock holding is an enjoyable experience whereas realizing a loss and admitting defeat by selling at a loss is a painful one.  This type of behavior leads to portfolios overweighted with underperforming assets.  Harvesting gains at the expense of harvesting losses will also generate increased taxes on top of the unrealized losses still trapped within the portfolio.  A 2010 study published in The Psychology of Investing³, verified that after a significant rally in any particular stock, abnormal trade volume increases.  Similarly  immediately after a stock has fallen significantly, trade volume decreases dramatically.

Regret avoidance is also at the root of a very common behavior involving the concept of sunk cost.  Rather than admitting defeat and enduring the pain of selling a declining security before losses get even larger, many investors will tend to double down, throwing good money after bad.

Past Performance Risk Taking

Another common fallacy is the investor belief that past success or failure will somehow influence the odds of success or failure in the future.  While it is certainly true that good managers can add value through active security selection and tactical allocations, the probability of future success in any one security or investment depends on its future prospects and may be is independent of its past performance.  This phenomena is also described as the "gambler's fallacy".  Simply put, if an investor experiences success early on, they tend to increase their risk tolerance and make more aggressive trades.

Another component of this behavior is the idea of using house money;  taking on more risk with the winnings of earlier success.  Alternatively, investors who experience losses early on typically react in one of two contradictory ways.  Some investors reduce their risk tolerance as a result of early losses, the "snakebite effect", while others increase their risk- taking in an effort to make up for lost ground.  In a purely rational world, a methodical and static risk tolerance should drive the investment process.  Yet in reality we see that risk tolerance is highly dependent upon the individual's recent investment experience outcome and we find that it is anything but static.  Reality is perception for investors and their view of risk changes from day to day and year to year.

¹ Brad Barber and Terrance Odean, Journal of Finance, "Trading is Hazardous to Your Health" (April 2000, page 775)

² Brad Barber and Terrance Odean, Quarterly Journal of Economics (February 2001)

³ John R. Norsinger, The Psychology of Investing, Prentice Hall, Upper Saddle River, New Jersey (2010)

Economic Review 4Q 2015

Nicholas Zaiko, CIMA®

Investment Consultant

Bridgebay Financial, Inc.

www.bridgebay.com

 

US Federal Reserve

On December 16, 2015 the Federal Reserve raised the Fed Funds rate target range to 0.25% - 0.50%.   The low interest rate environment has been in place for several years at the 0.0% - 0.25% range.

Fed policymakers concluded the benefits of the zero interest rate policy were being outweighed by the costs, specifically the misallocation of capital into riskier and higher-yielding sectors.

The FOMC stated that the pace of rate increases will be gradual and monetary policy will remain highly accommodative.  Expectations are that there will be 3 – 4 additional rate hikes in 2016. 

Given the turmoil in the markets so far in January 2016, fewer rate hikes may actually occur, but the Fed is still indicating 3 to 4 rate hikes. Fed funds futures contracts show that traders expect the central bank to raise rates at least twice in 2016, and are reducing bets on a third hike by December, 2016.

At the September 17, 2015 FOMC meeting, the Fed had cited global financial and economic developments that could impact and restrain US economic growth and keep inflation low.  This may delay further hikes. 

Reverse Repo Program (Fed RRP)

The Fed raised the overall cap on the overnight Fed New York (Fed NY) RRP to $2 trillion from $300 billion. The Fed NY RRP is an important policy tool for managing the fed funds rate floor, now 0.25%, and meeting money market fund demand.  Without sufficient RRP there would be potential disruptions in repo, securities lending, T-bills and other funding operations. The sizeable increase in RRP provided funding market stability. 

FOMC Forecast for Fed Funds

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%. 

Employment

The US economy created around 292,000 net new jobs in December or 257,000 private payroll jobs, exceeding the 252,000 increase in November that was stronger than previously estimated.  The unemployment rate held at a seven-year low of 5%.  Some analysts, however, noted that many of the December jobs were part-time delivering no wage growth.

China

Investors focused on volatility in Chinese markets after the country sought to quell losses in equities and stabilize its currency. Fresh concern that China’s slowdown will hamper global growth has emerged again.  Policy makers are struggling to revive an economy that’s the world’s biggest user of resources. China Securities Regulatory Commission announced the suspension of a new stock circuit- breaker that forced local exchanges to shut for the second day in the first week of January. The move added to worry that policy makers are struggling with how to contain the months-long turmoil in its financial markets.

Global Growth

The World Bank cut its global economic growth forecast for 2016, saying the weak performance of major emerging market economies will hamper activity overall, as will anemic showings from developed countries such as the United States.

In the U.S., economic growth should increase slightly, from an estimated 2.5% in 2015 to 2.6% in 2016, with rising employment, wage growth and consumer spending countered by lagging capital investment and manufacturing.

Oil and High Yield bonds

Oil prices fell to 12-year low for a fourth day last week, lurching again to 12-year lows as new financial market turmoil in China brought a $32 per barrel price for the commodity.  Recently, oil’s close below $30 a barrel heightened fears of disinflation fueling concern that junk-rated energy producers won’t be able to stay solvent.  A collapse in commodity prices has been the main driver for high-yield’s setback since September and there may be some defaults in energy-related credits.

Junk Bond Selloff

The high yield market sell-off was sparked by declining oil prices and concerns about energy and commodity companies. The closure of a Third Avenue bond mutual fund sparked a wider sell-off in the credit market.  Several high yield bond ETFs were hit with major redemptions as a result of the junk bond selloff. 

Inflation

Headline consumer prices remained flat in November, in line with consensus expectations, pulled lower by declining oil and food prices. Headline inflation is now up 0.5% from November 2014, while the energy index is down 14.7% in the same time. Core CPI inflation increased to 2.0% year over year growth and improved by 0.1% month over month.

With the drag from energy prices expected to fade in early 2016, headline inflation should also move closer to the Fed's 2.0% mandate in the medium term.

Manufacturing

In October, the Institute for Supply Management (ISM) reported that the U.S. manufacturing sector fell to 50.1, slightly above 50, the level between expansion/contraction.  This is a sign that the strong US Dollar and tepid overseas demand is weighing on manufacturers.

Corporates

corporate issuance returned to the market in January with over $19 billion in supply.  For 2016, economists are expecting corporate issuance to exceed $1.1 trillion, which would be in-line with 2015’s supply.

While investors cope with the turbulence sparked by China, another source of consternation is looming as the corporate earnings season begins.  Investors will begin to contend with another expected decline in corporate earnings.

During the quarter, investment-grade corporate bonds underperformed Treasuries and agencies amid the risk-off environment and credit spreads widened.  Treasury prices were volatile on speculation that China will continue to sell U.S. debt to raise cash to defend its currency and support its stock market.  Corporate profits are expected to slow due to falling energy prices and a high U.S. dollar.

During 2015, investment grade corporates issuance was 17% higher than 2014 with $1.33 trillion in new supply.  US corporate issuance in 2016 is expected to be as high as the acquiring companies in M&A deals continue to issue investment grade debt. 

Credit Quality

Recently there has been a noticeable deterioration in credit quality as newly announced M&A transactions are leading to high 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.  Issuance related to the M&A activity is especially pronounced in the below investment grade bond market. 

U.S. corporate defaults hit a four-year high for below investment grade bonds that increased from 2.1% to 2.5% in 3Q2015.   Investment grade bonds have also seen a downward trend in credit ratings. 

Interest Rates

Market sentiment has become cautious with heightened market volatility rising over the last 3 months.  The rate hike by the Fed was basically priced into the market.  The shorter-end of the yield curve has seen spread widening in anticipation of the Fed action.  During the quarter, the yield curve continued to flatten in December as rates on the 2-yr and 5-yr both climbed 12 bps for the period. The yield on the 10-yr rose 6 bps during the month, while the 30-yr rose 4 bps.

Negative market sentiment is not being driven by the Fed, but by the collapse of oil and commodity prices.  The OPEC meeting in mid-December did not resolve the supply glut. 

Banks that are lending to the energy sector or holding leveraged loans on their books may also have some credit problems on their books.  If lending to the weak high yield oil sector is stopped, some of those issuers may have liquidity problems. 

Higher quality, energy-related names may come under short-term pressure and their bonds will have spread widening.  Australian banks and some Canadian banks may be impacted if they have substantial loans to the energy and commodity-related industries. 

Third Avenue Focused Credit Fund froze redemptions and Stone Lion Capital Partners LP, a distressed-debt specialist, stopped redemptions on its credit hedge funds due to falling commodity and junk-bond prices in December.

Although the portfolio is all investment grade, our cautious view is that we may be entering into a period of credit spread widening, and overreaction by the ratings agencies, being quick to downgrade credits.  The pace of credit downgrades has been accelerating over the last few months.  

U.S. short-term and long-term rates are rising in contrast with other countries where rates are falling.  The USD is expected to continue strengthening against other currencies.

Liquidity

Liquidity in the US bond market has changed dramatically from the period before the financial crisis.  Historically, broker-dealers carried securities inventories on their balance sheets and were willing to make markets in securities and take market risk.  The change in making markets, and the record corporate issuances and low interest rate environment have made it difficult for broker-dealers to make markets and inventory securities.  Fixed income trading has become less liquid. 

Fixed income investors face longer holding periods than they would have considered in the past.  Lower turnover strategies have a lower impact on transaction costs on portfolio especially when there are changes in market liquidity.  Trading now requires a more deliberate approach to minimize transaction costs.  Conversely, there are attractive prices for buyers when there are forced sellers in the market. 

The liquidity in fixed income markets has changed across all sectors including Treasuries.  The ability to trade in large blocks has changed.  Primary dealers that purchase directly from the Fed have been buying fewer Treasures and volume has fallen.  The size of the Treasury market has doubled since 2008.  US and foreign investors have purchased a higher percentage of Treasuries sold by the Fed than the dealer community.