Long Munis outperformed US Treasuries and Corporate bonds last quarter.
Review
The table below shows returns for the 2nd quarter for a variety of Merrill Lynch Bond Indices. Intermediate Tax Free bonds lagged longer bonds as the yield curve flattened. Junk bonds, which have a high correlation to equities, also did well but lagged long Munis.
Inflationary Pressures May Be Building
Inflationary expectations have been well anchored which has allowed the Fed to continue its monetary easing without upsetting the Fixed Income markets. The bond vigilantes have been silent and are not expressing concern. However, we are seeing early warning signs that inflation is starting to pick up. The following chart shows the Core rate of the CPI since January 2008. The blue line is the year over year rate of inflation and is less sensitive to monthly changes in the index. It is increasing at a rate of 1.9% annually which is roughly in line with the Fed’s target. The red line is the annualized rate of the last 3 months of the CPI. It is more sensitive to recent monthly changes in the index. This shows a different story, as it is growing at an annualized rate of 2.8%. This is the highest this measure has been since early 2008. We view this as a red flag that inflation may be picking up. We will be watching this measure closely for further signs that inflationary pressures are building. Some of the factors contributing to the increase in prices are increases in the minimum wage, rising healthcare costs associated with Obamacare, and higher costs for services.
GDP Contracts In First Quarter
First Quarter GDP was revised downward to ‐2.9%. Much has been made of the cold weather during the quarter and the negative impact it has had on the economy. We do not believe all of this weakness can be attributed to the weather. Higher prices for oil and healthcare had a dampening effect on economic growth as well. The higher prices for gas and health insurance has left consumers with less money to spend on other items.
We believe negative demographic trends and an over indebted economy will also make it difficult for the economy to grow above trend for the rest of the year. Forecasts of a 3.0% growth rate for the year seem overly optimistic. We believe it will be difficult to achieve even a 2.0% growth rate for this year.
The Fed Will Not Be Bailed Out By a Strong Economy
The market has been discounting a stronger economy and higher rates caused by less aggressive Fed policy and a normalization of rates. Recent data does not validate this outlook. The tapering of Fed purchases of UST and Mortgages will probably continue until QE3 is done by the end of the year. Several studies have shown Quantitative Easing tends to give only a temporary boost to the economy and has a diminishing effect over time. It is also not without costs and unintended consequences. However, the ending of QE will occur against a much weaker economic backdrop than the Fed previously expected. After 6 years of monetary stimulus it is time for the economy to stand on its own.
The Bear Flattening Trade
When the Fed tightens monetary policy by raising the Fed Funds rate the yield curve tends to flatten. When the Fed eases monetary policy the yield curve tends to steepen. The chart below shows how this has worked since January 2000. The white line shows the Fed Funds rate and the yellow line shows the steepness of the yield curve between 5 to 10 years.
When the market anticipated Fed easing during 2000‐2003 and 2006‐2011 the yield curve became steeper as UST investors bought bonds in the shorter maturities more aggressively. Since 2011 the market has been discounting a normalization of rates and the yield curve is now about the flattest it has been during the last 5 years. Fixed income investors have had a strong preference for longer maturities, and have been avoiding the 5 year part of the curve. These types of trades are done by very large institutional investors and are duration weighted. We believe this is part of the reason the longer part of the curve has done so well in spite of Fed tapering.
World Bond Rates Are Also Low
The table below shows a comparison of yields for 10 year maturities for a variety of developed countries. Rates in the U.S. are higher than in France and Germany, and not much different than Italy and Spain. We believe this has also lent support to the market for UST. This should help mitigate a rise in rates in the U.S. caused by a “normalization” of rates by the Fed.
Credit Concerns: Puerto Rico
We do not have any exposure to the Commonwealth of Puerto Rico or debt of any of its public corporations. We have avoided these credits because they are clearly grossly over indebted for the resources they have and the population they serve. However, they are certainly a high profile credit in the Muni market and recent developments will likely have ramifications for the Muni market. The government of Puerto Rico has just passed legislation to allow certain Puerto Rico public corporations to restructure their outstanding debt. The weakest of these corporations is PREPA which supplies electric power to the island. This legislation suggests that PREPA is insolvent and the Commonwealth is no longer able/or willing to support them. There are roughly $8.6 billion worth of PREPA bonds outstanding. This legislation is very negative for PREPA bondholders and the possibilities of a default by this utility has caused their bonds to trade at dollar prices in the $35‐ $40 range, and have been downgraded to Caa2 by Moodys. Bond funds which hold these credits will also suffer declines in NAV, and bond insurers with exposure to Puerto Rico bonds will suffer. We would advise investors to continue to avoid Puerto Rico credits.
This is true not only for individual bonds, but also for bond funds. We would avoid bond funds with a heavy exposure to Puerto Rico credits. The economy is likely to experience subpar growth for the foreseeable future. Low rates in other countries, and the curve flattening trade should help mitigate any rise in interest rates caused by a “normalization” of rates by the Fed.