INSIGHTS

On September 18, 2017

AAM Viewpoints – The Stretch Run

Heading into the most interesting fourth quarter since last year – at least that is what I am expecting from some headlines over the next two weeks – it seems an appropriate time to accentuate our attention span decline and look at how we see the final three months unfolding in a few key areas.

First and foremost, take a snapshot of the myriad of current issues ranging from economic, militarily, geopolitical, and political polarization. Now transpose yourself to five years ago and estimate what the markets and economy would be with all of these events occurring in an 18-month timeframe. I’m pretty sure most would have invested heavily into shovels and mattresses back then. The pessimist would say the current levels are running at levels of increased obliviousness. The optimist would asses that this is the natural “wall of worry,” and perpetuating the “ignorance is bliss” symptom to the pessimist. More than likely, the truth is somewhere in between.

The wind that fills the sails starts with the overall economy and then becomes impacted by some longer-term subtleties that often are invisible until they are front and center. The economy was humming at some good growth numbers until the unfortunate natural disasters of hurricanes Harvey and Irma made landfall. As an example, the Atlanta Federal Reserve GDP forecast started the quarter at 2.95% at the beginning of July. A month later it was pointing at 4.02%. The day that Hurricane Harvey hit, it stood at 3.41%. After the devastating impacts of Harvey was coupled with Irma’s impact, the GDP forecast has dropped to 2.248%. The impact of events like this is often “stealing from Peter to pay Paul.” The amount of GDP lost to the immediate impact is often gained back in the following quarters as the rebuilding and releasing pent-up credit or cash flows into the economic system.

The sets of sentiment numbers are broken into two areas in our minds. The consumer and corporate sentiment number needs to be separated from investor sentiment numbers. There are four scenarios with these two: one is treated as a contrarian and the other is looked at confirmation of immediate emotions. The latter is the consumer and corporate sentiment numbers which have been steadily rising for the last year.

Source: Bloomberg, University of Michigan, Conference Board and National Fed of Individual Business

The magnitude of these increases is substantial and depending upon one’s political affiliations, they can be easily explained. However, nothing in the markets and economy or anything that has human kind as a participant in its exercise is ever easily explained.

We would expect GDP in the third quarter to come in the 2 – 2.5% range; the broad range based upon the natural disasters’ impact, however, it is appearing as if a print of 3.5% is in the cards for the fourth quarter.

The scenario for interest rates is one that has both a heavy contingent of quantitative effects as well as a steady dose of subjective influences. We have often said that the effects of The Great Recession and credit crisis that ensued has not been seen since The Great Depression. There are some broad similarities but many more differences; the main comparison is the sense that another calamity is right around the corner and could happen at any time. Think of it as a constant state of a high anxiety of economic Jenga where each individual pulls a block not knowing why but expecting collapse at every turn.

Two big shifts have occurred in the last year. The Federal Reserve has formally and consistently stated its intent to raise rates to get us to a normal yield curve while also stating their desire to unwind their balance sheet. The FOMC (Federal Open Market Committee) is outright stating their intent and yet the credit markets are disregarding their intent. We get it, the Fed and prognosticators have been discussing higher rates for some time with little success. Consider though that the environment is one where economic growth is on an accelerated path compared to the average GDP growth rate of 2.1% since the end of The Great Recession, corporate earnings have been increasing in the last year and the unemployment rate is not just low in its headline numbers, but showing the first signs of wage inflation via labor shortage and/or lack of trained candidates. The environment has never been more palpable for the Fed to transition from accommodative to less accommodative to a bit more hawkish moving forward.

One area that is pointing to higher wage inflation in the near future is the NFIB (National Fed of Individual Business) quality of labor situation. The current level hasn’t been seen since the 1998-2001 range where wage inflation averaged 3.9% versus the long-term average of 3.0%. To accentuate this consider the NFIB small business expenditure plans is at the highest level since the last recession ended and is on its longest period of sustained increases since being measured.

On top of this you also have the European Central Bank stuck in a serious quandary on whether to continue the path they began years ago or begin projecting a mitigated quantitative easing program. With the growth in the European area, despite some of the economic, political and cultural challenges, benefitting from the synchronous global growth scenario, they are beginning to see an open window to begin the transition. Do not forget that as a group of countries, inflation is a four-letter word and has always been the alarm that caused swift action even when it was just an anomaly. We would caution them not to confuse hiccups for heart attacks.

In investing, we believe in never fighting the Fed; however, that doesn’t mean one simply invests with where they put their money. One’s timeframe, risk tolerance and ability to add liquidity often doesn’t match that of the central banks. There are some examples where this works and you have to choose them appropriately, however, we think the best method is to look where their influence has significant impact on markets. These inflection points can point to extreme value options or also extremely risky scenarios. One area in the market to caution against investors is the European Credit market.

• Austria just issued a 100-year government bond that was extremely well received at a 2.21%. Pensions and insurance companies loved them, however, I doubt many investors have this timeframe in their portfolios. The modified duration for this issue is 42.07. If rates go up 100 basis points this issue theoretically would lose 42% of its value. Here is to hoping the euro increases dramatically to mitigate this potential risk. Though if this were to happen, a rise in the euro of that magnitude would surely cause a recession for the region. Also, this isn’t AAA rated, but rather at an Aa1/AA+.


• The Bloomberg Barclays Pan European High Yield index is at some absurd levels as well. The index has a current level of yield to maturity is 3.25%, a yield to worst of 2.52%. A decade ago these measures where 7.97% for the YTM (Yield to Maturity) and 7.92% for the YTW (Yield to Worst). At its extreme the YTM hit a 23.66% in December of 2008. Though extreme and unlikely to hit these levels again, it shows what can happen in just 16 months.


• The low volatility of nearly all asset classes which have been influenced by extreme excess liquidity, there is now a measure of High Yield ETFs (Exchange-Traded Funds) volatility. Not surprisingly, this is at near all-time lows as well. The current reading is 6.18, much closer to its all-time low of 4.75 set a few months ago. Though only measured for the last two years, it hit a high of 24.21 in December of 2015, which corresponded to a six month negative return of 6.85 for the Barclays Bloomberg US High Yield index. There are no signs that any stark shift is about to occur, however we have slowly initiated better credit quality from our over weighting credit risk from the last few years. We would not make a tectonic shift but rather a gradual shift.


• As a byproduct of the low interest rate scenario, the issuance of Emerging Market debt has surged to all time levels due to the growth rate increases. The biggest surge in issuance is from Asian emerging markets with markedly higher issuances from the Middle East and African region.

We are maintaining our equity bullish signs, though we are entering the time of the season that could present a pullback that has been sorely missing this year. This still has to do with the supply-demand metrics that we have discussed ad nauseam and still greatly influence the limited drawdown. Many bearish pundits seem to confuse optimism for euphoria, when in reality there is an extreme lack of euphoria, as pointed out by cash on hand by fund managers, largest short interest in the S&P 500 in a year, one of the highest amount of hedging of equity positions by fund managers and bearish sentiment about anticipated returns in equities moving forward.

We would use the next quarter and beyond to matriculate to higher credit quality on a steady process. It is too early to add convexity but that opportunity may present itself in the next 18 months; until then we would still prefer a higher coupon. We would begin removing the foreign debt risk in Europe and Emerging Markets and would use that money to distribute among floating-rate structures with high initial coupons or high floating rate.

Get ready for the most intriguing stretch run since the last stretch run and before the next one begins. If you find this a maddening time for investing, consider it’s a better lot than comedian Steven Wright found himself when he self-diagnosed himself, “Right now I’m having amnesia and déjà vu at the same time.”

CRN: 2017-0905-6130R