INSIGHTS

On August 04, 2016

HIMCO 2nd Quarter 2016 Updates

Investment Grade Credit Market Outlook (as of June 30, 2016)

During much of the second quarter, market participants hotly debated the likelihood of the United Kingdom (U.K.) electing to leave the European Union and what that decision would mean for an already fragile global economy. On June 23, voters marched to the polls and chose to “Brexit.” While much is not known about how and when (or even if) the U.K. will exit, or what the economic impact will be, what can be said is that most of the investment grade credit market took the news surprisingly well. The option-adjusted spread of the Barclays U.S. Credit Index finished the first quarter seven basis points (bps) tighter at 147, just 7bps wide of the pre-Brexit level.

Post the recent decision by the U.K. to exit the European Union (EU), we have turned more cautious on investment grade credit. While a strong global bid for yield in a world awash in negative yielding assets should help prevent a material spread widening, we believe the increased economic and political uncertainty that has now been introduced into the market commands a higher risk premium. Credit spreads are very near their long run average at a time when issuer fundamentals are weakening and the business cycle is aging. We see fair value for spreads about 15bps wider than current levels.

In our commentary for the first quarter of 2016, we spoke to our fondness of the banking sector. While we remain ardent in our belief that the fundamental health of the banking sector is strong, we acknowledge bank spreads are likely no better than range-bound in a world of low growth and low rates.

We believe the market is currently in a delicate balance with strong technicals offsetting deteriorating fundamentals. While a material spread widening is not our base case, the risks to the downside have increased somewhat as a result of the U.K. referendum. We expect the market to remain volatile in the second half of 2016 as we learn more about the economic (domestic and global) ramifications of the U.K.’s decision to leave the EU. Overall, we believe corporate spreads are biased to move modestly wider, and that returns will be dominated by carry and security selection.

The biggest risks we see to the investment grade credit market include disappointing global growth, central bank policy error, and a retracement of commodity prices.

REITs (Real Estate Investment Trusts) Market Outlook (As of June 30, 2016)

REITs continued their recent string of outperformance in the second quarter of 2016 as the Russell 3000 REITs Index rose 7.5% in the period (+13.9% year to date (YTD)), significantly outpacing the broader S&P 500 Index’s 2.5% second quarter return (+3.8% YTD). The British referendum to leave the European Union (“Brexit”) in late June sparked an initial equity sell-off and rate rally, and while the sell-off in equities was largely recovered by the end of the quarter, the rally in yields on the 10-Year U.S. Treasury continued, ultimately ending the quarter near all-time lows at 1.47%. The reach for and outperformance of yield noted in our 1^st quarter review persisted in this backdrop as dividend sectors were bid up, with REITs joining utilities (+23.4% YTD) as two of the year’s best performing sectors so far. Further, year-to-date, the highest dividend-yielding stocks outperformed the lowest-yielding peers by 19% after outperforming by 6% in the quarter. Within REIT sub-sectors, industrial REITs outperformed in the quarter, returning 15.3%, leading healthcare (+11.9%) and diversified REITs (11.8%) higher while hotels continued to lag (-2.9%).

We believe that the post-Brexit rally in both equities and rates is indicative of investors placing tremendous confidence on global central bank accommodation and believe that Brexit with likely lengthen the current lower-for-longer rate environment. We expect REITs to thus remain attractive to yield-focused investors as the sector is currently delivering a 4% yield but caution against viewing the asset class as a fixed-income proxy and remind investors of the potential of loss of capital. From the technical perspective, however, we expect a boost in investor interest in the asset class as GICS (Global Industry Classification Standard) is set to separate REITs from financials into a new 11^th sector in September as generalist managers move to close underweights. From a fundamental perspective, our analysis indicates adjusted funds-from-operations (AFFO) payout ratios currently remain attractiveand REITs have continued to generate strong cash flows to support their dividend payments. We also see balance sheets holding low levels of long-term debt, with low levels of rate-sensitive floating rate debt. Valuations, however, have been neutral in the wake of the continued rally as AFFO and FFO (Funds from Operations)multiples are at highs not seen since the beginning of 2015. In our view, the biggest risk to REITs moving forward is interest rate policy and while we believe fundamentals wouldn’t be significantly affected, we also believe multiples are likely to contract in the run-up to the Federal Reserve’s next rate hike.

Possible risks to our outlook include changes to the pace of interest rate increases, commodity and realized volatility, heightened geopolitical tensions, international monetary policy, strong wage growth, and unexpected weakness in economic indicators.

Utilities Market Outlook (As of June 30, 2016)

The S&P 500 Utilities Index continued to rally in the second quarter, returning 6.8% (+23.4% YTD) as the broader benchmark S&P 500 Index gained 2.5% (+3.8% YTD) in the period. The British referendum to leave the European Union (“Brexit”) in late June sparked an initial equity sell-off and rate rally, and while the sell-off in equities was largely recovered by the end of the quarter, the rally in yields on the 10-Year U.S. Treasury continued, ultimately ending the quarter near all-time lows at 1.47%. The reach for and outperformance of yield noted in our 1^st quarter review persisted in this backdrop as dividend sectors were bid up, with utilities joining telecom (+24.9% YTD) as the year’s two best performing sectors. Further, year-to-date, the highest dividend-yielding stocks outperformed the lowest-yielding peers by 19% after outperforming by 6% in the quarter.

We believe that the post-Brexit rally in both equities and rates is indicative of investors placing tremendous confidence on global central bank accommodation and believe that Brexit will likely lengthen the current lower-for-longer rate environment. We expect utilities to thus remain attractive to yield-focused investors as the sector is currently delivering a 3.2% yield but caution against viewing the asset class as a fixed-income proxy and remind investors of the potential of loss of capital. We remain cautious of merchant generators’ direct exposure to commodity prices. Conversely, any macroeconomic weakness or continued market volatility could serve as a tailwind as investors would likely continue to seek safety. In this light, we believe that the biggest risk to utilities moving forward is interest rate policy, and we believe multiples are likely to contract in the run-up to the Federal Reserve’s next rate hike.

Possible risks to our outlook include changes to the pace of interest rate increases, commodity and realized volatility, heightened geopolitical tensions, international monetary policy, strong wage growth, and unexpected weakness in economic indicators.

High Yield Fixed Income Market Outlook (as of June 30, 2016)

The high yield market continued to trade higher in the second quarter of 2016 with similar themes from the first quarter driving performance, including stable to increasing commodity prices as oil, copper and iron ore proved the low levels of February were a floor so far this year and also a distant memory. Couple this with the continued easing of central bank policy around the world as the U.S. Federal Reserve (the Fed) stepped away from its recent tightening bias while the European Central Bank (ECB) and the People’s Bank of China (PBOC) re-iterated its loose monetary policy in order to stimulate their slowing economies. Given the backdrop, risk was “on” in 2Q16, as the Barclays U.S. High Yield Index returned 5.52% for the quarter and +9.06% Year to Date (YTD).

During the 2^nd quarter, the lower quality sectors and capital structures outperformed as triple C-rated bonds returned 12.06% followed by single Bs (+4.86%) and double Bs (+3.64%). From a sector standpoint, commodities were the place to be as independent exploration and production returned a whopping 24.34%, followed by oil field services (+18.18%), metals & mining (+14.99%) and midstream energy (+10.85%). Lagging sectors included financials (+1.88%), consumer staples (+1.95%) and healthcare (+2.02%). The 2^nd quarter performance is indicative of the YTD numbers as triple-Cs have now returned 16.15% as the top performing quality bucket YTD, while double Bs (+7.62%) and single Bs (+7.56%) continue to fight it out for second place. The top performing sub-sectors YTD include metals & mining (+29.13%), independent energy (+19.91%), midstream energy (+17.99%) and oil field services (+15.71%) while pharmaceuticals (-3.58%), refiners (-.93%) and banking (+.83%) have been the worst performing sub-sectors in high yield so far in 2016.

After hitting YTD wides of +839 option adjusted spread (OAS) on February 12, the market has staged a meaningful recovery as global recession fears have eased, central banks have committed and re-committed to accommodative policy and quarterly earnings reports have generally been supportive for credit and risk. The high yield market also benefitted from a strong move higher in oil from $25 to $50/barrel over the last two quarters as well as further stabilization in copper and iron ore pricing. The strong U.S. dollar that has been a headwind in the 4^th quarter of 2015 and the 1^st quarter of 2016 has shown signs of abating in recent weeks. Also, with the U.K. vote to leave the Eurozone (“Brexit”) in mid-June, we think the path of monetary policy will continue to be easy for the foreseeable future as central banks look to provide stability and snuff out any market volatility. In our view, all of these factors allowed spreads to rally another 62 basis points tighter this quarter to close at +594 OAS even in the face of increased uncertainty around the implications of what Brexit means for the U.K., Europe and the global economy.

Over the next 12-24 months, there are many factors to consider as we think about relative value in the high yield bond market. Currently, given our outlook of slow to moderate economic growth, stable commodity prices and continued easy monetary policy coupled with the current credit cycle which we see as having peaked this year as far as credit quality, defaults and recovery rates, we see +600 OAS as fair value in the current credit environment and pricing in all of the above. Potential risks to the downside include slower U.S. and global growth than anticipated as economic activity slows and the market begins to question the ability of central banks around the world to stimulate global growth and the potential for a U.S. recession is put back on the table. In this case, we could re-test February levels of approximately +800 OAS. We think the spread range stays in the +575-675 area for 2016 with a floor of +550 and a ceiling of +725 and these levels will likely be driven by the global economic picture as well as commodity pricing and currency shifts.

Equity Market Outlook (as of June 30, 2016)

Equity markets are placing tremendous confidence on central bank accommodation. In the run-up to Brexit, the S&P 500 had spent the quarter in a tight 50 point trading range. The aftermath of Brexit widened this range to 100 points (2000 to 2100) and left the index returning +2.5% for 2Q16 (+3.8% YTD). Volatility behaved similarly, with VIX (volatility index) trading between 13 and 16 (after averaging 20.5 in the 1^st quarter of 2016) and jumping to 26 after the Brexit vote. The move was short-lived, as expectations of accommodative central bank policies drove VIX back into the range, and the S&P 500 closed the quarter close to pre-Brexit levels and a stone’s throw away from all-time highs.

Energy (+11.6%) was the best performing S&P 500 sector for the quarter, as crude rallied >25%. But defensive sectors and income vehicles like telecom (+7.1%) and utilities (+6.8%) continued to perform well. Less-defensive information technology (-2.8%) and consumer discretionary (-0.9%) were the only sectors to post negative returns in the quarter. Year to date, defensive telecom (+24.9%) and utilities (+23.4%) have outperformed the index, while financials (-3.1%) and information technology (-0.3%) have lagged. The reach for yield noted in the 1Q16 outlook continued, as the highest dividend-yielding stocks outperformed lower-yielding peers by 6% in the quarter (19% YTD). We expect this trend to continue as risk-free yields continue to rally.

Looking at the rest of 2016, we believe equities have the potential to return 1-2% from current levels but we remain wary of risk to the downside. We have reduced our estimates for returns in order to reflect ~200 basis points (bps) of earnings headwinds from slower international growth and currency pressures post-Brexit. Fundamentals appear level, but not improving, and 2016 sell-side expectations for earnings growth are now at +0.5%. We remain concerned that earnings growth estimates for 2017 likely need to come down materially from the current +14% year over year level. In our view, top line pressures from lackluster growth and weak capex, and margin pressure from wage inflation and less operating leverage do not appear baked in yet. Paying greater than 17x P/E (price per earnings) appears to be an exercise in trusting central bank easiness. We are mindful that the bearish call may be off and we are keenly focused on M&A (mergers & acquisitions) activity that could validate and further inflate multiples, stronger than expected international growth, or a strong U.S. consumer as potential indications that our concerns about these current estimates are unwarranted.

Additional risks to our outlook include commodity and realized volatility, heightened geopolitical tensions, global monetary policy, strong wage growth, and unexpected weakness in economic indicators.

Municipal Bond Market Outlook (as of June 30, 2016)

Credit fundamentals across most municipal issuers continue to be supportive of price performance for tax-exempt debt instruments. As the U.S. economy continues its expansion, albeit at a tepid pace, economically sensitive sources of tax revenue owing to income growth, consumption and real property values remain supportive of securities backed by one or more sources of tax revenue. The economic expansion has also been beneficial to the more cyclical revenue bond sectors like healthcare and transportation. In general, capital spending remains restrained, and historically low interest rates afford issuers the opportunity to extract savings though ongoing refinancing of older, higher cost debt structures, enhancing budget surpluses and easing debt burdens. 

There are, however, isolated pockets of credit stress, which have in some instances created the potential for compelling investment opportunities in our opinion. For example, there are several U.S. states that have migrated down the ratings spectrum because of structural budgetary imbalance and unfunded pension liabilities. We believe solutions to these financial difficulties will ultimately be found because these states have large and diverse economies, as well as a broad authority to raise revenue and reduce expenditures.

Technical conditions governing supply and demand for municipal securities represent a further enhancement to performance thus far in 2016. Through June 30, 2016, overall new issue volume has declined 3.2% when compared to the same period of 2015. At the same time individual demand for tax advantaged income via direct and intermediary participation remains robust, as evidenced by the $33.0 billion in funds flowing into municipal bond funds year to date.

Price performance within the sector as a result of these fundamental and technical conditions has been strong thus far in 2016. As earlier anxieties over the prospects for the emergence of a less favorable interest rate environment have subsided, municipal returns have proved among the most attractive of all fixed income classes over a rolling 12-month period ending June 30, 2016. Given this strong relative performance, the value proposition in municipal bonds is less compelling now, with yields below those of comparable quality, taxable alternatives available elsewhere in the fixed income arena.

CRN: 2016-0802-5489R

Past performance is not indicative of future results.

AAM is not affiliated with The Hartford Financial Group, Inc. or HIMCO, and was not involved in the preparation of this article. The opinions expressed herein are solely those of HIMCO, and do not necessarily reflect those of AAM.

The forecasts, opinions and estimates expressed in this report constitute HIMCO’s judgment as of June 30, 2016 and are subject to change without notice based on market, economic and other conditions. The assumptions underlying these forecasts concern future events over which we have no control. The assumptions may turn out to be materially different from actual experience. There can be no guarantee that any target or forecast will be realized.

Any securities or sectors referenced should not be construed as a solicitation or recommendation or be used as the sole basis for any investment decision. The information provided does not constitute investment advice.