Our economic outlook

An editorial opinion 
by Derek Vogler, CFA^® 
Vice President - Investments

May 16, 2013

Well, it’s official. As of 4/29/13, the great bond bull market ended – that is, according to Bill Gross, the legendary bond investor who manages the largest bond fund in the world. Mr. Gross made this comment roughly two weeks after the ten year U.S. Treasury hit the 1.67% mark. He does hedge his forecast by saying that a bear market (where rates would begin a steady rise) is still not in the cards until growth and inflation begin to rise. Since the great recession, the U.S. has been only able to manage slow to moderate growth. This, even as monetary policy has been extremely accommodative. With short-term rates essentially zero percent, and the massive quantitative easing program pouring $85B per month into bond purchases, the pedal has been on the metal for quite some time. The big question no one seems to be able to answer is when we will see a significant pickup.

Of course, timing is the hardest part of any forecast. While only Mr. Gross knows the exact variables on which he bases his forecast, perhaps he is taking cues from the corporate bond market. High-quality companies can now fund their businesses at what can only be described as ridiculously low rates. Recently, Apple decided to tap the credit markets for the first time, although the company was already flush with cash. They placed $17B in new issuance in record time, with investors eager for even more. Their six tranche offering ranged from three to thirty years, with the longest bearing a coupon of only 3.85%. The debt due in five years carried a coupon of only 1%.

While high-quality companies like Apple, with tons of cash, have always been able to sell their debt at reasonable rates, even much riskier companies have recently seen their funding costs decline dramatically. At the beginning of May, the Barclay’s High Yield Index, which is composed of below investment grade credits, dropped below 5% for the first time ever. For comparison, this number briefly touched 25% back in late 2008 at the heart of the credit crisis. Five percent is also interesting because this is where the 10-year U.S. Treasury traded back in 2007 before the crisis. While there is nothing magical about 5% and similar comments could have been made all the way down from the peak of the yield, we do find it interesting how little investors are now willing to accept on these risky assets. In many cases these companies have less than stellar balance sheets and clearly have yet to impress the major credit rating agencies. But investors are willing to pour their money into these assets due to the current rate environment. Maybe Mr. Gross was factoring in these paltry returns and decided “enough is enough” when he made his recent call.

Other than some short-term fluctuations, the general trend in rates has been down for a number of years. So the question now is what has changed? Has the recent uptick in employment and the U.S. housing market been enough to re-ignite the high-powered U.S. economy? Certainly some of the data has improved lately, but there are quite a few indicators that still point to very sluggish growth. Equity investors definitely appear to be believers, as they have pushed market indexes in the U.S. to all-time highs. Year-to-date, through mid-May, the S&P 500 index has soared by roughly 15%. Most other developed countries have also seen their markets lift dramatically, with double digit returns across the board. And who could forget Japan? Its market has been red hot since their new government targeted higher inflation. In the same time period, the Nikkei Index is up approximately 45%. Equity markets appear to be reflecting an economic recovery on the horizon, success in battling worldwide deflation, or maybe it’s just the reaction from investors being forced into riskier assets to find an acceptable return (even if it comes with higher risk).

Given Mr. Gross’s forecast, along with significantly higher stock prices, one could assume that we are close to a period of significant and sustained economic growth. While nothing is impossible, we remain concerned that some of the positives we are seeing today will quickly diminish once the Fed decides to exit its current quantitative easing program.

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