On February 01, 2017
HIMCO Market Updates
(All Outlooks As of December 31, 2016)
Municipal Bond Market Outlook
The municipal market ended the 4th quarter with a strong December, but it was not enough to offset the severe rate selloff and spread widening in November following Trump’s election victory. Trump’s pro-growth agenda resulted in inflation fears and higher rates, combined with his proposed tax reform, which negatively impacted the municipal market with a further steepening of the yield curve. The Bloomberg Barclay’s Municipal Bond Index (BMBI) returned -3.62% during the quarter, finishing the year end with a total return of 0.25%. December’s total return was 1.17%.
Looking back over the year, 2016 was a tale of two halves. In the first half of the year, interest rates fell along with oil due to heightened geopolitical anxieties and a weaker global economic outlook driven largely by concerns about Chinese growth. That set the tone for a strong first half for the municipal market with the BMBI returning 4.30%. Demand was strong as municipal mutual funds experienced net inflows of roughly $21 billion during this six month period.
However, the second half of the year was a different story as volatility picked up and intermediate and long rates sold off approximately 100 basis points (bps). From August to October, rates rose about 40-50bps due to rising inflation expectations stemming from stronger economic data (i.e. U.S. payrolls, GDP, etc.), uncertain European Central Bank (ECB) tapering, and less accommodation taken by the Bank of Japan (BOJ). Municipals sold off in connection with this weakness exacerbated by record primary market supply during this time. Supply was about 40-50% above the market’s 10-year average for this three-month period. The year ended with $446 billion of issuance, which was the largest amount of supply on record compared with the previous record high of $433 billion in 2010. It was led primarily by a substantial pickup in refunding activity in the second half of the year as municipal issuers looked to access the market prior to the U.S. election and the Fed hiking cycle.
Then, of course, there was Trump’s surprising victory in November and the Republican Party sweep in Congress triggering a “risk-on” trade, resulting in a selloff in fixed income securities. 10-year tax-exempt rates increased roughly 80bps in November. Mutual funds experienced seven consecutive weeks of outflows during November and December equal to $15 billion, which caused significant selling pressures in the market. Therefore, most of the performance gains achieved in the first half of the year were given up in the second half.
Heading into the New Year, we expect performance to improve based on positive technical conditions and the so called “January Effect” where reinvestment flows pick up with limited supply. However, as we move through the quarter, we expect performance to be challenged when seasonal technicals turn weaker including an increase in issuance and some selling pressures related to tax season. Also, more volatility will likely occur as headlines emerge regarding Trump and the GOP’s tax reform policies. Ultimately, we believe this should give us a better buying opportunity at that time.
High Yield Fixed Income Market Outlook
The High Yield market continued to trade higher in the 4th quarter with similar themes from the previous three quarters driving performance, including stable to increasing commodity prices as oil, copper and iron ore proved the low levels of February were a floor for 2016 and also a distant memory. OPEC (Organization of the Petroleum Exporting Countries) also announced cohesive action in November represented by a controlled production cut agreed to by its members in order to balance global oil supply and demand. Couple this with continued easy central bank policy around the world as the U.S. Federal Reserve (Fed) eased its way into its recent tightening bias with a lone December interest rate hike while the European Central Bank (ECB) and the People’s Bank of China (PBOC) re-iterated loose monetary policies in order to stimulate their slowing economies. Also, as the surprising “Brexit” vote in 2Q16 (the 2nd quarter of 2016) allowed for an increase in risk and volatility, the Bank of England (BOE) responded with additional accommodative measures in order to ensure an ease in the UK’s upcoming transition out of the European Union.
And, as if the market didn’t need another reason to rally, Donald Trump won the U.S. Presidential election in surprising fashion, providing a boost for U.S. equity and credit markets as investors digested what a Trump/Republican administration could mean for the United States and other economies around the world. Given the backdrop, risk was “on” again in 4Q16 (4th quarter 2016), as the Bloomberg Barclays U.S. High Yield Index returned 1.75% for the quarter and closed 2016 +17.13% on a year to date basis.
During 4Q2016, the lower quality sectors and capital structures within the high yield market outperformed as CCC’s rated returned 4.75% followed by B’s (+2.01%) and BB rated (+.44%). The distressed part of the high yield market (rated CA/D) continued its march higher from early February lows, returning close to +20% in the 4th quarter and a staggering +83.14% year to date. From a sector standpoint, commodities again were the place to be as energy (+5.81%) and basics driven by metals & mining (+3.06%) were the top performing sectors along with financials (+4.75%) and industrials (+3.52%). Lagging sectors included consumer non-cyclical (-1.42%), electric utilities (-0.66%) and banking (-0.05%). The 4th quarter performance was indicative of the year to date numbers as CCC rated returned 31.46% and was the top performing quality bucket year to date, while B’s (+15.81%) and BB rated (+12.78%) both trailed the market. The top performing sectors year to date included energy (+38.15%), basics driven by metals & mining (+36.96%), industrials (+23.25%) and technology (+16.13%) while banking (+3.92%), consumer non-cyclical (+6.35%) and transports (+9.79%) lagged the market return in 2016.
After hitting year-to-date 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 been supportive for credit and risk. The high yield market has also benefitted from a strong move higher in oil from $25 to above $50 per barrel over the last four quarters as well as further stabilization in copper and iron ore pricing. The strong U.S. dollar that had been a headwind in 4Q2015 (4th quarter 2015) and 1Q2016 (1st quarter 2016) has shown signs of abating in recent months. Also, with the UK voting to leave the Eurozone (Brexit) in mid-June, the path of global monetary policy will likely continue to be easy for the foreseeable future as we believe central banks will look to provide stability and limit any market volatility. Along these lines, a Republican administration led by President Trump has been viewed as business friendly and pro-growth. In our view, all of these factors allowed spreads to rally another 81bps this quarter to close at +408 OAS which is basically the year to date tight and just over 250bps tighter than where we started the year.
Over the next 12 months, there are many factors to consider as we think about relative value in the high yield 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 peaked as far as credit quality, defaults and recovery rates, we see +400 OAS as fair value in the current credit environment and pricing in all of the above. Risks to the downside include policy error (either Trump or central bank) along with slower U.S. and global growth than anticipated as economic activity wanes and the market begins to question the ability of central banks around the world to stimulate global growth and the possibility of a U.S. recession is put back on the table. In this case we could re-test February levels of approximately +800 OAS. Given that we see the previous scenario as a low probability event, we think the spread range stays in the +350-450 area for 2017 with a floor of +325 and a ceiling of +475 and these levels will likely be driven by the global economic picture as well as Central Bank and Government policy, commodity pricing and currency shifts.
REITs (Real Estate Investment Trusts)
REITs underperformed in the fourth quarter of 2016 as rates rose, with the Russell 3000 REITs Index returning -2.9% (+9.6% YTD) as the broader S&P 500 Index returned +3.8% (+12.0% fiscal year 2016). The underperformance was primarily driven by a combination of post-election expectations of large-scale fiscal stimulus and higher inflation in addition to a December rate hike by the U.S. Federal Reserve that pushed the yield on the 10-Year U.S. Treasury from 1.60% to 2.45% by year’s end. Within REIT sub-industries, hotel and resort REITs (+20.2%) was the only sector significantly positive on growth expectations while a weak brick-and-mortar shopping season drove retail REITs (-10.4%) lower with heath care REITs (-10.2%) close behind driven by post-election uncertainty in the health care space.
Looking into 2017, security-specific fundamentals are likely to take a backseat to policy anticipation as investors reposition for large-scale fiscal stimulus and higher inflation. Specifically, we believe lower corporate tax rates, inflation, and infrastructure spending could significantly impact U.S. real estate prices with health care REITs especially vulnerable if the Affordable Care Act (“Obamacare”) is meaningfully reconfigured. REIT valuations are moderately attractive as our analysis indicates adjusted funds-from-operations (AFFO) payout ratios are slightly below historical averages. Fundamentals remain sound as low interest rates have allowed REITs 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.
In this backdrop of sound fundamentals and post-election macro uncertainty, we look to add REITs opportunistically on pull-backs as the sector continues to deliver a robust 4% yield. We also continue to caution against viewing the asset class as a fixed income proxy and remind investors of the potential of loss of capital.
Utilities were largely flat in the fourth quarter of 2016 as the S&P 500 Utilities Index returned +0.1% in the period (+16.3% year to date (YTD)) as the broader S&P 500 Index returned +3.8% (+12.0% fiscal year 2016). Performance during the quarter was driven primarily by the sharp jump in the 10-Year U.S. Treasury from 1.60% to 2.45% on post-election expectations of large-scale fiscal stimulus and higher inflation in addition on top of a hike by the U.S. Federal Reserve in December. Within utilities sub-industries, multi-utilities (+1.7%) led as independent power producers (-3.3%) and water utilities (-2.8%) lagged.
Looking into 2017, we remain cautious on fundamentals as utilities are particularly susceptible to rising rates. In addition, if higher growth expectations come to fruition, we expect utility multiples to contract on a relative value basis as utility growth rates remain stable. In this backdrop, we note utilities remain attractive to yield-focused investors as the sector is currently delivering a 3.8% yield but remind investors of the potential of loss of capital.
Investment Grade Credit Market Outlook
We believe the election of Donald Trump to the office of President on November 8th helped the investment grade credit (IGC) market close out 2016 on a strong note. The option-adjusted spread of the Bloomberg Barclays U.S. Credit Index finished the fourth quarter 13 basis points (bps) tighter at 118 (37bps tighter year to date, and 82bps tighter than the worst levels touched in February)2. Market participants anticipate the new administration’s policies, in conjunction with a Republican controlled House and Senate will be “pro-business” and supportive of economic growth. In addition, OPEC’s agreement to cut production helped extend the rally, as markets anticipate a more balanced oil market which is supportive of the energy sector.
While we agree the successful introduction of the speculated changes in policy (e.g. corporate tax cuts, infrastructure spend, etc.) could extend an already stretched credit cycle a bit longer, we feel now is not the time to aggressively add risk. We believe valuations already reflect much of the “good” policies that could unfold in 2017, despite a lack of details regarding the proposed changes, and risks around their implementation. However, we believe the IGC market can benefit from a favorable supply and demand imbalance as expectations for lower issuance needs meet with the consistently strong global bid for yield.
For these reasons and more, we continue to recommend a cautious stance on IGC and believe current valuations are only fair. We do not foresee a significant sell off, but recognize the long list of potential spread widening risks on the horizon, including the implementation of new domestic policies, the pace of U.S. rate hikes, the potential rise of protectionism, and European elections. We believe the market will be less directional in 2017, and performance will be dominated by carry and security selection. While we’ll almost certainly witness bouts of volatility that will result in credit spreads overshooting in both directions, we expect IGC spreads to finish 2017 near current levels.
Equity Market Outlook
The anticipation of pro-business policies under a Trump administration drove multiple expansion as the S&P 500 rallied +3.8% in the fourth quarter to finish the year near all-time highs at 2239. Post-election expectations of stronger growth, less regulation, foreign cash repatriation, and lower corporate tax rates under President Trump overshadowed a December rate hike by the Federal Reserve. While volatility remained relatively muted (VIX largely trading between 12 and 14 outside of a pre-election spike), the 10-Year Treasury yield rose 87 bps in the quarter to end the year at 2.45% in anticipation of large-scale fiscal stimulus and higher inflation. The move in rates and policy anticipation shaped winners and losers, as financials (+21.1% 4Q16, +21.6% FY16 (fiscal year 2016)) was by far the best performing S&P 500 sector with energy (+7.3% 4Q16, +27.3% FY16) a distant second, while real estate (-4.4% 4Q16, +3.4% FY16) and health care
(-4.0% 4Q16, -2.4% FY16) lagged.
Overall, the S&P 500’s +3.8% fourth quarter capped a robust +12.0% FY16 total return, largely driven by a rebound in energy and rallies post-Brexit and post-election. In quantitative factor terms, the post-election rally was more “risk-off” as valuation and quality outperformed – this contrasts with the post-Brexit rally, which was more “risk-on” with high beta outperforming and quality underperforming. Notably, expectations of lower corporate taxes drove yet another leg of small cap outperformance in the quarter (Russell 2000 +8.8% 4Q16, +21.3% FY16 versus S&P 500 +3.2% 4Q16, +12.0% FY16).
Looking at 2017, we believe equities can achieve high-single-digit returns driven by pro-business policies under a Trump administration. Notably, security-specific fundamentals have taken a backseat to policy anticipation as investors reposition for large-scale fiscal stimulus and higher inflation. Specifically, we believe lower corporate tax rates and offshore cash repatriation will drive mid-single-digit earnings growth and expect multiple expansions to remain muted in light of the post-election rally.
Possible factors that could affect this outlook include: fiscal policy under-delivering, monetary policy tightening too rapidly, growth-reducing trade conflicts, commodity price volatility, and heightened geopolitical tension.
CRN: 2017-0201-5782 R
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 source of data presented in commentary is Factset unless otherwise noted and is as of December 31, 2016
Hartford Investment Management Company (HIMCO) is a registered investment adviser subsidiary of The Hartford Financial Services Group, Inc. SEC registration does not imply a certain level of skill or training; nor does it imply that the SEC has sponsored, recommended, or otherwise approved of HIMCO.
The forecasts, opinions and estimates expressed in this report constitute the firm's judgment as of December 31, 2016 and are subject to change without notice based on market, economic and other conditions. No reliance should be placed on any such forecasts or opinions when making an investment decision. 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. Past performance is no guarantee of future results.
The information provided does not constitute investment advice and is not an offering of or a solicitation to buy or sell any security, product, service, fund, UIT, or REIT. Sectors referenced should not be construed as a solicitation or recommendation or be used as the basis for any investment decision. All data referenced is from sources deemed to be reliable but cannot be guaranteed as to accuracy or completeness.
Past performance is no guarantee of future results. An investor cannot invest directly in an index.
Investment Risks: All investments are subject to risk, including the possible loss of principal. REITs are subject to credit and interest rate risk, as well as negative developments in the real estate industry, including high vacancy rates and economic difficulties. Investments in the utilities sector can be significantly affected by supply and/or demand for services or fuel, financing costs, conservation efforts, and government regulation. An issuer of a security may be unwilling or unable to pay income on a security. Common stocks do not assure dividend payments. Investments in small and mid-capitalization companies may involve a higher degree of risk and volatility than investments in larger, more established companies.
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 commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.