INSIGHTS

On April 26, 2012

A U.S. Double-Dip Recession Unlikely

So far in 2012, we have witnessed a market that is haunted by familiar demons; the Euro-Crisis, Mid-East tensions and high oil prices, stubborn U.S. unemployment, a crippled housing market, and soaring U.S. deficits. They roiled the market last fall and have never gone far away, but nevertheless the S&P 500 rose 12% in the 1st quarter. The corporate bond Index, the Merrill BBB 3-5 year Index, had a return of 3.83%, the best 1st quarter since 2009's 5.05% and before that in the last 20 years only topped in 2001, 1995 and 1993.

Turn the page and in the first three weeks of April the S&P 500 Index has now dropped 3% due to a refocusing on the usual suspects that been concerning the market for over a year.  The bond Index, however, has managed to scrape together a positive 39 basis point return in April on the back of a 22 basis point reduction of yield on the 5-year U.S. Treasury, back down to 81 basis points (0.81%), falling from 1.11% on April 3, on the same concerns troubling the stock market and keeping gold in the mid-1600s.

We seem to have grown more comfortable with these devils we know, perhaps because they aren't getting worse but nevertheless are bumping along fairly close to the bottom.  Besides the "fix" in Greece, most of these problems are pretty much the same as they were during the market correction last summer/fall.  We likely need only a new catalyst event to trigger another stock market sell-off to more like the 15% slide we saw in August.

We also saw credit spreads in the bond Index go from inside of 200 basis points in late July to almost 325 in early October.  They have since dropped steadily throughout the 1st quarter to just over 250 basis points, a level we find attractive verses long-term spread levels and noticeably enhanced on a relative basis by the historically low levels of U.S. Treasury yields, as the long-term credit spread levels are against much higher average U.S. Treasury yields than today's levels.

Offsetting all these vexing problems, of course, is the amazing strength of corporate profits, hitting new all-time highs despite all the low-hanging fruit for doomsayers. Therein lies the core strength of a corporate bond investment strategy at this time, in our opinion:  You are not catching a falling knife; profitability has been strong.  Credit risk has been further reduced by the easy access to capital the market has offered corporate bonds issuers for the past three years as investors sought income and security.  As a result, balance sheets have very high levels of cash, average interest costs have been reduced, and debt maturity schedules have been extended and credit agreements fine-tuned. 

If a double-dip global recession is in the cards, which is not our expectation in the near-term and we feel is very unlikely in 2012, corporate bonds should survive the ordeal noticeably better than the 2008 bottoming by virtue of the lesser need for near-term financing which their very strong balance sheets provide, and the positive investment returns corporate bonds demonstrated for buyers in the last downturn.

Our expectations in the near-term is for continued volatility between corporate earning seasons, with a relative high vulnerability to external shocks triggering a market sell-off, such as new military action in the Middle East, and an equally high exposure to disappointments in corporate earnings, it being the one leg of the stool holding everything together right now.  We see only minor incremental progress on the unemployment and housing fronts this year and next to nothing on the U.S. budget issues in this election year, which itself is a ticking time bomb of very large automatic budget cuts and tax increases next January without intervention.  Along with the Mid-East powder keg scenario, and the ripple effect of the attempts at austerity in Europe, we anticipate that the market will continue to vacillate between risk-on/risk-off sentiments with stocks generally moving higher overall on the strength of earnings and the dividends they can support, and the relative unattractiveness of cash interest rates and U.S. Treasury bond yields. 

We expect that BBB corporate bond credit spreads will range between pushing inside on 200 basis points if stocks can achieve a sustained rally over several weeks, and drifting quickly towards 300 basis points on renewed signs of stress in the system. 

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com

The information contained herein is obtained from Dial Capital Management, LLC and believed to be reliable. The information is not warranted as to completeness and accuracy and is subject to change without notice. The foregoing has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security.

Advisors Asset Management, Inc. (AAM) and Dial Capital Management, LLC are not affiliated and the views expressed in this commentary are not necessarily that of AAM.