High yield bonds outperformed with equities to end the year up 15% (ML US High Yield BB Rated). While longer bonds were down slightly in Q4, they still posted strong gains for the year and outperformed shorter maturities by a wide margin. Treasuries, Agencies, Corporates, and Municipal bonds all performed well against a backdrop of falling rates.
Review
The table below summarizes the returns of some major BofA/Merrill Lynch fixed income indices.
Yield Curve Inversion as a Predictor of Recession
When the Fed was tightening in 2018 and early 2019 the bond markets began discounting a recession. This belief was based upon the popular narrative that a yield curve inversion was an accurate predictor of an upcoming recession in the next year. The chart below shows the spread between the 10 YR UST and the 2 YR UST. These maturities are our preferred gage of an inversion. The yield curve shows a modest inversion occurred. The NY Fed model which uses the spread between the 10 YR UST and the 90 Day T-Bill at one point was forecasting a 40% chance of a recession in a year. The Fed then began to lower short term rates and the probability of a recession occurring is now down to 23.6%. During this time we have still not had a recession. Investors should not rely on any single indicator as the ultimate fail proof sign of what is going to happen in the economy.
We also follow the Chicago Fed National Activity Index which is shown below. This index which consists of multiple indicators is not currently flashing a warning signal for the economy. It gives a warning signal when the 3-month moving average of the index falls below the bottom of the horizontal band.
Deflationary Forces vs Determined Governments
It is also important to examine the fundamental forces which are present in the economy. There are deflationary forces and possible inflationary forces which are currently battling each other in our global economy. The deflationary forces are over-indebtedness, negative demographics, and technological advances for most of the developed countries. Governments are extremely concerned about the possibility of deflation in an over-indebted world and appear to be willing to do “whatever it takes” to stop deflation. The U.S. is currently running $1 trillion a year deficits and is easing monetary policy in an effort to ensure we have economic growth. The Fed has not only lowered the Fed Funds rate, but they have also been engaging in Quantitative Easing (QE). They are being very pro-active with fiscal and monetary policy acting together to stimulate economic activity. This is occurring when the economy is still growing at about 2.0% annually. The chart below shows the quarter over quarter growth of GDP since 2000.
This is also taking place when we have a very low level of unemployment which is at a historic low of 3.5%. This type of stimulation by the government while the economy is still growing is unprecedented. We will be monitoring inflation indicators closely for signs the economy is over heating. Our research has shown interest rates are largely a function of the growth rate of the economy and the expected level of inflation.
Charter School Sector
Standard & Poors recently released their 2020 outlook for Charter School bonds. We believe S&P rates bonds in this sector very conservatively. We find ratings are typically a notch or two lower than we think is appropriate. There are certain key metrics which we like to see in these types of securities. First, the system should have an operating history for a network of existing schools. After the first Charter School is opened, if it is successful, there will be demand for more students to attend the school and a waiting list is created. When the list gets large enough a new school will be opened. As the Charter system grows the record of academic performance becomes more meaningful, and a financial history is created. We like to see the original charter being in existence for at least 8 years. Second, it is important for the school to demonstrate academic success. Schools with a strong record of academic achievement are much less likely to have a problem getting their charters renewed. Third, academic success creates demand for the school. One measure of demand is the size of the wait list to be admitted to the school. The best schools have wait lists that are large compared to the number of students attending the school. Fourth, we look for strong management and governance with a proven track record. The Charter schools that have already opened several schools on time and without cost overruns while meeting budget estimates are the most desirable. Finally, it is important for the investor to have a strong security interest in the property with a first lien on the facility and the network should have a strong historical record of economic soundness. The table below shows 9 of the largest Charter School Networks in the U.S.
Conclusion
This year should be an interesting year for both the economy and the bond market. It appears recession fears for the last couple of years have been overblown. The danger of a recession being imminent seems low. Governments appear to be determined to do whatever it takes to keep this cycle going for now.