The good news…growth is accelerating
After a weak start to the year, the economic picture is improving in the US as we move into the second half. There is a positive outlook for equities over the medium term, as softer data from the first quarter has been replaced with a clutch of figures that indicate an accelerating economy, although this does bode poorly for bonds.
This confluence of positive developments, though constructive for equities, is quite the opposite for bonds, as it increases the likelihood of a rate rise. The Federal Reserve (Fed) is already tapering its asset purchases, with the latest edition of quantitative easing drawing to a close in late October/early November. As this date approaches, a more natural supply/demand dynamic should take hold, and interest rates again will be determined by market participants rather than by a buyer with a printing press. Additionally, the cost of living continues to increase: US inflation climbed by 0.3% for the month of June, in line with the consensus forecast, bringing the gauge up 2.1% year-over-year. This marks the second consecutive month in which inflation has been higher than the Fed’s target of 2.0%. The combination of strengthening economic data and above-target inflation increases the probability of rising interest rates, perhaps even sooner than the Federal Reserve currently contemplates.
Interest rate increases will put downward pressure on the prices of fixed income securities, leading to mark-to-market losses for bond portfolios. We have expressed concern about rising rates for some time, and have advised clients to shorten portfolio duration, rotate from fixed-rate to floating-rate debt, and from public to private markets. We have been focused on taking credit risk (rather than duration risk), allowing us to remain comfortable with an overweight in high yield bonds for much of 2014, though recent developments warrant a reassessment of this positioning.
Absolute yields and credit spreads for the high yield complex have fallen to levels that suggest an increasingly asymmetric risk-return profile for the asset class. The deterioration in credit underwriting standards for the leveraged loan market is also troubling. This is a trend that has been a focus of our concern for some time now, and recently has been highlighted by the Federal Reserve as a source of potential problems if it continues unabated.
Given these concerns, we have taken the decision to lock-in profits in high yield bonds and leveraged loans, and rotate the proceeds into cash, for the short term. This brings our high yield allocation to a neutral stance in portfolios, and a strongly underweight position at the broader asset class level (high yield and emerging markets bonds). We expect the overweight cash position to be a temporary one, and will redeploy funds as assets are re-valued in light of rising interest rates.