june 2017 market commentary - Amazon Simple Storage Service (S3)
COMMENTARY
JUNE 2017 MARKET COMMENTARY MARKET REVIEW Fed Drafts Another Rate Hike
KEY TAKEAWAYS • As expected, the Fed raised rates to a range of 1 to 1.25 percent.
• A weaker batch of economic data,
lower readings on headline inflation and a fall in the price of oil pushed Treasury yields lower—until the last week of the month.
• Municipal bond yields followed
Treasury yields higher for the month.
• IG corporates continue to benefit from
low volatility and foreign demand from Europe and Asia.
Picks made in the 2017 NBA draft will have ripple effects for years to come in the world of professional basketball. In the fixed income space, global central banks had their own important choices to make in June, and their actions will likely continue to have important ramifications for investors. In mid-June, the Fed hiked its target Fed Funds rates by a quarter point to a range of 1 to 1.25 percent. This was largely expected by markets, despite falling inflation that remains below the Fed’s 2 percent target. The 10yr/10yr break-even inflation rate1 ended the month around 1.75 percent, indicating that market participants expect inflation to stay low (Figure 1). Low inflation expectations have helped cap longer-maturity yields. On the other hand, hawkish posturing from global central banks put pressure across the curve at the end of the month. ECB President Mario Draghi stated that the EU economy is strengthening and the risks of deflation are abating, and comments from two Bank of Canada policymakers increased expectations for a rate hike there. Overall, Treasury yields rose by roughly 10bps from two- to 10-year maturities, while the yield on the 30-year bond was slightly lower.
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One-Month PCE Inflation, Annual Rate (%)
Figure 1: Inflation Remains Below the Fed’s Target Figure 1: Inflation Remains Below the Fed’s Target
PCE (lhs) 10-Yr Breakeven Inflation Rate (rhs) Fed Target Source: Federal Reserve Banks of Dallas and St. Louis, as of June 2017.
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In addition to inflation, many other macro trends impacted investment-grade (IG) bonds in June. Oil prices remained below $50 for the month,2 and retail sales posted 1
JUNE 2017 MARKET COMMENTARY
Figure 2: Longer Bonds Fared Relatively Figure 2: Longer Bonds Fared Relatively Better in June Better in June
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a monthly decline in May as department stores and other high-end retailers continue to grapple with slowing foot traffic, weakening profit margins and store closings.3 These trends pushed Treasury yields lower. On the other hand, the testimony of former FBI director James Comey and the completion of the U.K. elections reduced some uncertainty in markets, causing price declines in Treasuries and other safe haven assets. Overall for the month, stock returns fared best on low volatility; investment-grade corporates had positive total returns; high-yield returns were challenged by low energy prices; and Treasury and municipal returns were negative.
TAX-EFFICIENT MARKET REVIEW Muni Investors Look for the Right Picks In June, the municipal curve also flattened, with the front end selling off in sympathy with Treasury bonds and long-end yields rising relatively less (Figure 2). Ratios were higher in June, as municipals underperformed Treasuries. While the muni
underperformance pushed ratios higher, municipal ratios still look low relative to historical levels. The three-, five-, 10- and 30-year ratios ended June at 74.0 percent, 71.8 percent, 86.5 percent and 98.2 percent, respectively. Municipal yields increased across the curve, ending the month at 1.4 percent, 2.0 percent and 2.8 percent for the five-, 10- and 30year maturities, respectively. Supply in June was down 24 percent versus the same month in 2016. New money issuance fell 11 percent, while refunding issuance declined 48 percent. However, muni supply was the second highest in any month yet this year. Demand remains solid, and many deals in June were oversubscribed. Aggregate inflows have reached $5.3 billion year-to-date.4 July is typically a slow month for issuance and we will continue to observe supply and demand dynamics. Overall, municipal fundamentals remain stable, but there are many idiosyncratic risks, especially in the state sector (see “Top 5 Muni Trends
on Our Radar for 2H17”). In particular, states like New Jersey, Illinois and Connecticut continue to struggle with pension and budgetary issues. On June 1, Moody’s Investors Service and S&P Global Ratings downgraded Illinois’ general obligation (GO) bond ratings to one notch above junk, to Baa3/(NEG) and BBB-(*-), respectively, from Baa2(NEG)/BBB(NEG). Investors have paid close attention to the ratings trajectory of the state, as Illinois would be the first state ever to be downgraded to high yield. However, late t in June, Illinois House Speaker Michael Madigan asked ratings agencies for more days to negotiate a budget before being downgraded. In our view, Illinois still wants to avoid the “taint” of highyield because the state still has an ability to pay—if not a willingness—and it wants to maintain market access. This contrasts with Puerto Rico, which is less worried about market access since it does not have the ability to pay investors. We note that a downgrade is still possible in the coming months if the state does not take steps to address its pension shortfall, even if the state passes a 2018 budget. For more details on the Illinois budget crisis, see our white paper, A Credit View of Illinois’ Past and Future.
GOVERNMENT CREDIT MARKET REVIEW Corporates Focus on Outside Player Investment-grade corporate spreads remained tight in June, with the Bloomberg Barclays Investment Grade Corporate Index falling about 4bps to 109bps, generating 50bps of excess returns. The best-performing sectors were higher-beta sectors, including Communications, Metals & Mining and Health Care. Communications (Media/ 2
JUNE 2017 MARKET COMMENTARY
Figure 3: The Spread Differential between and Higher-Quality Figure 3: The SpreadBBBs Differential between Ratings Has Compressed BBBs and Higher-Quality Ratings Has Compressed
Amazon.com Inc. announced an allcash acquisition of Whole Foods Market Inc. for $14 billion that will be debtfinanced.7 In general, IG companies are putting cash outlays toward dividends and share buybacks rather than capital expenditure or debt repayment. Net debt/EBITDA has risen above its 10year average in S&P industrial sectors, S&P data shows.
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BBB versus A BBB versus AA Source: Source: Barclays, based on the Bloomberg Barclays U.S. Corporate Index, as of July 5, 2017.
Cable/Telecom) continued to retrace the spread widening seen in 1Q17, as M&A headlines slowed while health care-related credits reacted positively to the U.S. Senate’s proposed health care bill. The month’s worst performers were in the Oil & Gas sector, with oil prices hitting year-to-date lows in June. Supermarket credits also underperformed after Amazon announced an acquisition of Whole Foods which could shake up the industry. Year-to-date, IG corporate spreads have tightened 13bps, outperforming duration-matched Treasuries by 148bps. BBB has been the best-performing quality sector both month-to-date and year-to-date, per Barclays. Strength in BBB’s has caused the spread differential between BBB and higher-quality ratings to continue to compress (Figure 3). Corporate bonds continue to benefit from low volatility and foreign demand from Europe and Asia. Foreign investors currently hold over one-third of U.S. corporate bond assets, and as of 1Q17 foreign investors have added
STRATEGY AND OUTLOOK The Game Plan
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over $261 billion to their U.S. corporate bond holdings since 1Q16.5 However, the pace of increased foreign purchases has declined. Given recent hawkish comments from Draghi, concern has emerged that the higher rate benefit of buying U.S. corporates will be minimized if inflation in Europe grows faster than expected. IG funds have reported about $120 billion of inflows year-to-date.6 Demand remains strong, as new issues have been well received. The average new issue concession declined to 0.7bps in June from 2.5bps in May, per Bank of America Merrill Lynch (BAML). On the supply side, issuance slowed to $94 billion in June from a record $161 billion in May, per BAML, partly due to seasonality. Supply was slightly higher than $86 billion in June 2016, a month heavily impacted by Brexit volatility. For the first half of 2017, IG supply has reached $741 billion, up from $706 billion for the first half of 2016. M&A-related supply has ticked higher over the past two months, causing a decline in the remaining IG pipeline. In large M&A announcements for June,
Our outlook continues to reflect significant uncertainty in fiscal policy, which will likely influence the direction of U.S. Treasuries. We are monitoring the Treasury curve, as significant flattening has already occurred and may start to moderate, in our view. We are also focused on inflation and its impact on Fed action, and the Fed’s plans to wind down its balance sheet—possibly in lieu of raising rates at future meetings. The June meeting notes from the Federal Reserve included a plan to slowly reduce their pace of reinvestment. Some FOMC members have indicated they would start the process of unwinding the balance sheet as soon as September. The unwind could cause widening in mortgage-backed security spreads and/or a steeper Treasury yield curve. In our tax-efficient strategies, we remain duration neutral. We did not change our credit or sector allocation, but we are closely watching states that grapple with budget problems. States mostly reported higher tax receipts for the first quarter, but we expect tax growth to remain tepid for some time given low oil prices.8 We remain upin-quality as stress at the state level has been spilling over to local credits. 3
JUNE 2017 MARKET COMMENTARY
Medicaid cuts could negatively impact the budgets of large states such as California and New York. In our government credit strategies, we remain duration neutral and upin-quality, given that we continue to
see aggressive dividends and share buybacks and we think that the credit cycle is bottoming. We continue to believe that the stimulative policies of the Trump administration will occur to some degree, but that the implementation may be protracted.
These policies could be particularly relevant to Banks in terms of deregulation, higher rates and general corporate earnings growth. See our recent piece, “Navigating Risks on Bank Capital Structures,” on the risks of going down in quality in the Banking sector.
1. Breakeven inflation is the yield difference between nominal Treasury bonds and Treasury inflationprotected securities (TIPS) of the same maturity. This difference indicates the level of inflation at which both nominal and real Treasuries would be equally profitable. It is a common measure of
inflation expectations. 2. Bloomberg, as of July 5, 2017. Based on WTI Crude (Nymex) closing prices. 3. Adjusted for seasonal variation and holiday and trading-day differences, but not for price changes. Source: U.S. Census, as of June 14, 2017.
4. Lipper and JP Morgan, as of June 28, 2017. 5. Fed Flow of Funds data, as of June 8, 2017. 6. Lipper, as of June 30, 2017. 7. Amazon.com Inc. and Whole Foods Market Inc., as of June 16, 2017. 8. U.S. Census, as of June 20, 2017.
DISCLAIMER: This material has been prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors, Inc. Information and opinions are current as of the date(s) indicated and are subject to change without notice. Any specific securities or portfolio characteristics are for illustrative purposes and example only. They may not reflect historical, current or future investments in any client portfolio. Nothing in this document should be construed or relied upon as tax, legal or financial advice. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. Breckinridge can make no assurances, warranties or representations that any strategies described will meet their investment objectives or incur any profits.This document may include projections or other forward-looking statements, which are based on Breckinridge’s research, analysis, and assumptions. There can be no assurances that such projections will occur and the actual results may differ materially. Other events that were not taken into account in formulating such projections may occur and may significantly affect the returns or performance of any account. Past performance is not indicative of future results. This document includes information from companies not affiliated with Breckinridge (“third party content”). Breckinridge reasonably believes the third party content is reliable but cannot guarantee its accuracy or completeness.
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JUNE 2017 MARKET COMMENTARY MARKET REVIEW Fed Drafts Another Rate Hike
KEY TAKEAWAYS • As expected, the Fed raised rates to a range of 1 to 1.25 percent.
• A weaker batch of economic data,
lower readings on headline inflation and a fall in the price of oil pushed Treasury yields lower—until the last week of the month.
• Municipal bond yields followed
Treasury yields higher for the month.
• IG corporates continue to benefit from
low volatility and foreign demand from Europe and Asia.
Picks made in the 2017 NBA draft will have ripple effects for years to come in the world of professional basketball. In the fixed income space, global central banks had their own important choices to make in June, and their actions will likely continue to have important ramifications for investors. In mid-June, the Fed hiked its target Fed Funds rates by a quarter point to a range of 1 to 1.25 percent. This was largely expected by markets, despite falling inflation that remains below the Fed’s 2 percent target. The 10yr/10yr break-even inflation rate1 ended the month around 1.75 percent, indicating that market participants expect inflation to stay low (Figure 1). Low inflation expectations have helped cap longer-maturity yields. On the other hand, hawkish posturing from global central banks put pressure across the curve at the end of the month. ECB President Mario Draghi stated that the EU economy is strengthening and the risks of deflation are abating, and comments from two Bank of Canada policymakers increased expectations for a rate hike there. Overall, Treasury yields rose by roughly 10bps from two- to 10-year maturities, while the yield on the 30-year bond was slightly lower.
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One-Month PCE Inflation, Annual Rate (%)
Figure 1: Inflation Remains Below the Fed’s Target Figure 1: Inflation Remains Below the Fed’s Target
PCE (lhs) 10-Yr Breakeven Inflation Rate (rhs) Fed Target Source: Federal Reserve Banks of Dallas and St. Louis, as of June 2017.
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In addition to inflation, many other macro trends impacted investment-grade (IG) bonds in June. Oil prices remained below $50 for the month,2 and retail sales posted 1
JUNE 2017 MARKET COMMENTARY
Figure 2: Longer Bonds Fared Relatively Figure 2: Longer Bonds Fared Relatively Better in June Better in June
M/M Change in Yield (bps)
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Muni Treasury Source: Thomson Reuters, U.S. Treasury, as of June 30, 2017.
a monthly decline in May as department stores and other high-end retailers continue to grapple with slowing foot traffic, weakening profit margins and store closings.3 These trends pushed Treasury yields lower. On the other hand, the testimony of former FBI director James Comey and the completion of the U.K. elections reduced some uncertainty in markets, causing price declines in Treasuries and other safe haven assets. Overall for the month, stock returns fared best on low volatility; investment-grade corporates had positive total returns; high-yield returns were challenged by low energy prices; and Treasury and municipal returns were negative.
TAX-EFFICIENT MARKET REVIEW Muni Investors Look for the Right Picks In June, the municipal curve also flattened, with the front end selling off in sympathy with Treasury bonds and long-end yields rising relatively less (Figure 2). Ratios were higher in June, as municipals underperformed Treasuries. While the muni
underperformance pushed ratios higher, municipal ratios still look low relative to historical levels. The three-, five-, 10- and 30-year ratios ended June at 74.0 percent, 71.8 percent, 86.5 percent and 98.2 percent, respectively. Municipal yields increased across the curve, ending the month at 1.4 percent, 2.0 percent and 2.8 percent for the five-, 10- and 30year maturities, respectively. Supply in June was down 24 percent versus the same month in 2016. New money issuance fell 11 percent, while refunding issuance declined 48 percent. However, muni supply was the second highest in any month yet this year. Demand remains solid, and many deals in June were oversubscribed. Aggregate inflows have reached $5.3 billion year-to-date.4 July is typically a slow month for issuance and we will continue to observe supply and demand dynamics. Overall, municipal fundamentals remain stable, but there are many idiosyncratic risks, especially in the state sector (see “Top 5 Muni Trends
on Our Radar for 2H17”). In particular, states like New Jersey, Illinois and Connecticut continue to struggle with pension and budgetary issues. On June 1, Moody’s Investors Service and S&P Global Ratings downgraded Illinois’ general obligation (GO) bond ratings to one notch above junk, to Baa3/(NEG) and BBB-(*-), respectively, from Baa2(NEG)/BBB(NEG). Investors have paid close attention to the ratings trajectory of the state, as Illinois would be the first state ever to be downgraded to high yield. However, late t in June, Illinois House Speaker Michael Madigan asked ratings agencies for more days to negotiate a budget before being downgraded. In our view, Illinois still wants to avoid the “taint” of highyield because the state still has an ability to pay—if not a willingness—and it wants to maintain market access. This contrasts with Puerto Rico, which is less worried about market access since it does not have the ability to pay investors. We note that a downgrade is still possible in the coming months if the state does not take steps to address its pension shortfall, even if the state passes a 2018 budget. For more details on the Illinois budget crisis, see our white paper, A Credit View of Illinois’ Past and Future.
GOVERNMENT CREDIT MARKET REVIEW Corporates Focus on Outside Player Investment-grade corporate spreads remained tight in June, with the Bloomberg Barclays Investment Grade Corporate Index falling about 4bps to 109bps, generating 50bps of excess returns. The best-performing sectors were higher-beta sectors, including Communications, Metals & Mining and Health Care. Communications (Media/ 2
JUNE 2017 MARKET COMMENTARY
Figure 3: The Spread Differential between and Higher-Quality Figure 3: The SpreadBBBs Differential between Ratings Has Compressed BBBs and Higher-Quality Ratings Has Compressed
Amazon.com Inc. announced an allcash acquisition of Whole Foods Market Inc. for $14 billion that will be debtfinanced.7 In general, IG companies are putting cash outlays toward dividends and share buybacks rather than capital expenditure or debt repayment. Net debt/EBITDA has risen above its 10year average in S&P industrial sectors, S&P data shows.
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BBB versus A BBB versus AA Source: Source: Barclays, based on the Bloomberg Barclays U.S. Corporate Index, as of July 5, 2017.
Cable/Telecom) continued to retrace the spread widening seen in 1Q17, as M&A headlines slowed while health care-related credits reacted positively to the U.S. Senate’s proposed health care bill. The month’s worst performers were in the Oil & Gas sector, with oil prices hitting year-to-date lows in June. Supermarket credits also underperformed after Amazon announced an acquisition of Whole Foods which could shake up the industry. Year-to-date, IG corporate spreads have tightened 13bps, outperforming duration-matched Treasuries by 148bps. BBB has been the best-performing quality sector both month-to-date and year-to-date, per Barclays. Strength in BBB’s has caused the spread differential between BBB and higher-quality ratings to continue to compress (Figure 3). Corporate bonds continue to benefit from low volatility and foreign demand from Europe and Asia. Foreign investors currently hold over one-third of U.S. corporate bond assets, and as of 1Q17 foreign investors have added
STRATEGY AND OUTLOOK The Game Plan
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over $261 billion to their U.S. corporate bond holdings since 1Q16.5 However, the pace of increased foreign purchases has declined. Given recent hawkish comments from Draghi, concern has emerged that the higher rate benefit of buying U.S. corporates will be minimized if inflation in Europe grows faster than expected. IG funds have reported about $120 billion of inflows year-to-date.6 Demand remains strong, as new issues have been well received. The average new issue concession declined to 0.7bps in June from 2.5bps in May, per Bank of America Merrill Lynch (BAML). On the supply side, issuance slowed to $94 billion in June from a record $161 billion in May, per BAML, partly due to seasonality. Supply was slightly higher than $86 billion in June 2016, a month heavily impacted by Brexit volatility. For the first half of 2017, IG supply has reached $741 billion, up from $706 billion for the first half of 2016. M&A-related supply has ticked higher over the past two months, causing a decline in the remaining IG pipeline. In large M&A announcements for June,
Our outlook continues to reflect significant uncertainty in fiscal policy, which will likely influence the direction of U.S. Treasuries. We are monitoring the Treasury curve, as significant flattening has already occurred and may start to moderate, in our view. We are also focused on inflation and its impact on Fed action, and the Fed’s plans to wind down its balance sheet—possibly in lieu of raising rates at future meetings. The June meeting notes from the Federal Reserve included a plan to slowly reduce their pace of reinvestment. Some FOMC members have indicated they would start the process of unwinding the balance sheet as soon as September. The unwind could cause widening in mortgage-backed security spreads and/or a steeper Treasury yield curve. In our tax-efficient strategies, we remain duration neutral. We did not change our credit or sector allocation, but we are closely watching states that grapple with budget problems. States mostly reported higher tax receipts for the first quarter, but we expect tax growth to remain tepid for some time given low oil prices.8 We remain upin-quality as stress at the state level has been spilling over to local credits. 3
JUNE 2017 MARKET COMMENTARY
Medicaid cuts could negatively impact the budgets of large states such as California and New York. In our government credit strategies, we remain duration neutral and upin-quality, given that we continue to
see aggressive dividends and share buybacks and we think that the credit cycle is bottoming. We continue to believe that the stimulative policies of the Trump administration will occur to some degree, but that the implementation may be protracted.
These policies could be particularly relevant to Banks in terms of deregulation, higher rates and general corporate earnings growth. See our recent piece, “Navigating Risks on Bank Capital Structures,” on the risks of going down in quality in the Banking sector.
1. Breakeven inflation is the yield difference between nominal Treasury bonds and Treasury inflationprotected securities (TIPS) of the same maturity. This difference indicates the level of inflation at which both nominal and real Treasuries would be equally profitable. It is a common measure of
inflation expectations. 2. Bloomberg, as of July 5, 2017. Based on WTI Crude (Nymex) closing prices. 3. Adjusted for seasonal variation and holiday and trading-day differences, but not for price changes. Source: U.S. Census, as of June 14, 2017.
4. Lipper and JP Morgan, as of June 28, 2017. 5. Fed Flow of Funds data, as of June 8, 2017. 6. Lipper, as of June 30, 2017. 7. Amazon.com Inc. and Whole Foods Market Inc., as of June 16, 2017. 8. U.S. Census, as of June 20, 2017.
DISCLAIMER: This material has been prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors, Inc. Information and opinions are current as of the date(s) indicated and are subject to change without notice. Any specific securities or portfolio characteristics are for illustrative purposes and example only. They may not reflect historical, current or future investments in any client portfolio. Nothing in this document should be construed or relied upon as tax, legal or financial advice. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. Breckinridge can make no assurances, warranties or representations that any strategies described will meet their investment objectives or incur any profits.This document may include projections or other forward-looking statements, which are based on Breckinridge’s research, analysis, and assumptions. There can be no assurances that such projections will occur and the actual results may differ materially. Other events that were not taken into account in formulating such projections may occur and may significantly affect the returns or performance of any account. Past performance is not indicative of future results. This document includes information from companies not affiliated with Breckinridge (“third party content”). Breckinridge reasonably believes the third party content is reliable but cannot guarantee its accuracy or completeness.
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