Global economy facing rate normalization crosswinds
Global financial markets have continued to price in rising expectations for the tapering of the Federal Reserve’s large scale asset purchase program (LSAP). As such, global sovereign debt yields have been grinding higher. The unwinding of global carry trades has pressured emerging market currencies/equities/bonds. Countries with high current account deficits have been particularly impacted e.g. India, Indonesia, South Africa, Turkey and Brazil. Across the broader credit spectrum, longer duration fixed income instruments have also seen a rise in yields e.g. U.S. investment grade corporate debt (e.g. LQD ETF, 3.8% yield) and U.S. municipal debt (e.g. MUB ETF, 3.1% yield). Our preference remains for low duration non-agency MBS whereby prices have been sticky. U.S. equities are trading 3.3% off their recent highs (now at 1652, S&P 500). We are avoiding rate sensitive equity sectors such as utilities, MLPs and more expensive equity segments such as consumer discretionary and small caps. We have a preference for large cap, cash rich sectors such as technology and healthcare.
Since Ben Bernanke’s Congress testimony tapering hints in late May, financial markets have been re-pricing the global cost of capital and consequent capital outflows from higher risk geographies. Long duration credit instruments that benefited from an over-reach for yield have also experienced re-pricing. In the Treasury market, China and Japan accounted for $40 billion of Treasury outflows in June. Foreign investors hold $5.6 trillion of Treasury debt. Realistically, as the composition of the Fed’s balance sheet is dominated by longer Treasury maturities ($2 trillion), there may be more steepening risk for the back-end of the Treasury curve. From a historical perspective, the spread between the 10 Year Treasury Yield and the Federal Funds target rate has typically been less than 400 basis points; with a high of 368 in the 1990s vs. the current spread of 262 bps. We note that we are in historically uncharted waters as the LSAP has never been implemented before. Hence, even though the Fed Funds target rate may stay well anchored, there is still potential upside risk on the aforementioned spread. Therefore, we are still avoiding longer duration fixed income instruments.
Given the above global and U.S. rate normalization crosswinds, we are assessing the health of the U.S. housing market and how it may impact consumer spending trends. In particular, we are focusing on household confidence and the likely path for housing activity. Mortgage rates have tracked Treasury yields higher and first-time mortgage applications have been weakening as of late. The rise in mortgage rates will likely be a headwind for the housing recovery. However, in the current housing recovery, a large portion of home purchases has been funded by cash i.e. due to large investor flows. In addition, we note that housing affordability is still attractive on a historical basis and renting costs have continued to rise. From a multi-decade perspective, housing activity is still at subdued levels. Even at a slower pace, we are cautiously optimistic that the housing recovery will endure. Thus, household wealth perceptions should remain supportive for consumer confidence and spending.
In conclusion, the global economy remains in transition as global liquidity is facing crosswinds and capital is re-allocated away from higher risk geographies such as emerging markets. September is likely to be a pivotal month for both U.S. monetary and fiscal policies. The Federal Reserve will have to make a decision on the timing, magnitude and composition of its tapering plan. The Fed may lean on less Treasury purchases vis-à-vis agency MBS purchases i.e. in an attempt to contain mortgage costs. On the fiscal side, the 2014 budget will take center stage in September as Congress returns from summer recess. The Federal debt ceiling, government spending and funding for the Affordable Care Act are likely to be hot topics for both political sides. From our point of view, we seek to be nimble in allocating capital as favorable risk-reward opportunities present themselves.
Christos Charalambous CFA
Senior Strategist
christos.charalambous@edgewealth.com
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