There’s No Such Thing as Normal Anymore

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no normal

Is the bond market finally getting nervous? The Federal Reserve will end quantitative easing in October and is widely expected to hike rates next year for the first time since 2008. High-yield bonds began to sell off in late June, capping an unprecedented five-year rally during which spreads fell from a high of 1,900 basis points to a low of 290 basis points. Investors pulled more than $6 billion out of the high-yield market in July, and yields have risen from an eight-year low of 5.16 percent on June 24 to 5.92 percent on Aug. 11. Treasury yields have risen significantly, too, with those on two-year notes climbing from a recent low of 0.3 percent in February to 0.43 percent in August.   It’s tempting to see these moves as the beginning of a larger interest rate shift – the first of many consequences of the “normalization” of monetary policy. But Credit Suisse Senior Advisor Robert Parker points out that “normal” is a slippery concept these days. Consider economic growth, which is normally stronger at this juncture in an interest rate cycle. China’s growth is slowing, European and Japanese GDP will each grow just 1.3 percent this year, and the U.S. is clocking in at an anemic 2 percent. “We live in a world where any pickup in inflation is minor, and economic growth figures are not what I would call stellar,” Parker says. “You can put forward a case that bond yields should be higher and that the credit rally that’s been going on since November 2008 looks exhausted. But it’s tough to argue that we’re going to have a huge reversal.”   Instead, Parker expects a “slow burn” over the next 18 months in which bond yields do rise but still remain well below their historical averages. Credit Suisse expects 10-year Treasury yields to end the year where they started, around 3 percent, up from 2.44 percent in mid-August. Even by mid-2015, the bank only expects 10-year notes to hit 3.5 percent, well below the 6.5 percent average of the last half-century.   While Parker doesn’t see much further upside for corporate bonds, he also doesn’t foresee a massive selloff in their future. For one thing, most credits have been performing. Even the riskiest U.S. corporates are experiencing very low default rates by historical standards – just 1.9 percent in the second quarter of 2014, compared to 3 percent last year and 10.1 percent in 2009, the height of the financial crisis. Corporations are also sitting on plenty of cash and are less leveraged than in recent years. Debt as a percentage of market value has declined from a recent peak of 84.4 percent in the first quarter of 2009 to 45.4 percent in the first quarter of 2014. Investment grade bond spreads have widened to 62 basis points from a previous low point in spreads of 55 in early July, but Parker expects they will only reach 65 to 70 basis points over the next three months. High-yield bonds are at greater risk. Spreads have widened from a low of 291 basis points in June to 344 basis points as of August 5, and Parker believes they will widen to 370 basis points percent over the next three months.   The limited upside in fixed income suggests that investors will remain focused on equities. But since valuations are not as inviting as they once were in the U.S. or many emerging markets – the S&P 500 P/E ratio is about 18.5 compared to a long-term average of 15.4, while the Philippine Stock Exchange index P/E ratio is at 23.6 – investors need to be choosier about where to invest.   Parker points out three major equities rotations that present interesting investment opportunities. First, he expects expensive Southeast Asian markets to underperform, while North Asian ones such as Japan, South Korea, China, and Taiwan look relatively attractive for various reasons. In Japan, for example, the potential for more quantitative easing bodes well for equities. Meanwhile, diminishing investor fears of a hard landing have drawn risk-seekers back to Chinese stocks. These heretofore underperforming markets are also relatively under-owned by both foreign and domestic investors compared to Southeast Asian markets such as India and Indonesia, where the election of new reform-oriented leaders has resulted in significant foreign inflows in recent months.   Meanwhile, small-cap stocks are reversing course (and heading in opposite directions) in the U.S. and Europe. After an impressive five-year rally during which the Russell 2000 index rose 103 percent, U.S. small-cap stocks have become vulnerable to interest rate concerns, says Parker. In Europe, meanwhile, a central bank program announced in June aimed at increasing bank lending to small and mid-sized European companies has strengthened the investment case for such stocks.   Finally, says Parker, German stocks now look relatively cheap when compared to Italian and Spanish equities, as do central European markets knocked off kilter by the Russia-Ukraine conflict.   We live in interesting times. Economic growth is still sluggish despite several years of extraordinary central bank intervention. At the same time, multi-year rallies in both stocks and bonds have investors wondering how much longer either can last. Unlike in cycles past, then, the end of Fed easing doesn’t imply a return to some familiar place called normal. And the hunt for alpha is only getting tougher.

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