New Year, Old Worries
January 2, 2012
2011 was a volatile year where the old guard of the global economy was plagued by weak economies, bloated debt levels, tight credit, and action against normally stellar credit ratings. Europe dominated the headlines, both in December and 2011 overall, and continues to struggle.
December provided a long list of action from the ratings agencies. In early December S&P placed 15 European countries and the EFSF on a negative creditwatch, indicating a 50% chance of a downgrade within 90 days. S&P cited high debt levels, rising sovereign debt yields, political gridlock, and a risk of recession. Portugal was downgraded below investment grade, from BBB- to BB+, by Fitch Ratings. Fitch also stated that it would consider cutting several European sovereigns, revised France‟s outlook to "negative", and predicted a "significant" economic downturn in Europe. Moody‟s downgraded Belgium two notches, from Aa1 to Aa3, and warned that Britain‟s triple-A rating could be threatened by its public finances and poor growth prospects.
European banks have also become a source of concern. A combination of high debt levels and exposure to sovereigns has added importance to the role of the ECB. In an effort to keep European banks on steady footing, an ECB lending program awarded €489 billion in three year loans to 523 euro-area banks, far exceeding most estimates. Also, €411 billion was deposited by the banks at the ECB ahead of Christmas. This record high reflects growing distrust between European banks that are becoming more reluctant to lend to each other.
Responding to talk about a possible breakup of the EU, the head of the IMF, Christine Lagarde, warned that an EU failure could trigger a 1930‟s style depression. ECB president Mario Draghi also ruled out significant intervention in the Italian and Spanish bond markets, stating that any "first response" should lie within the country. But somewhat successful short-term debt auctions at the end of the year by Spain and Italy helped lighten their debt burdens and gave renewed hope heading into 2012. Over €1 trillion of sovereign debt will need to be refinanced in 2012, with Italy (€300+ billion) and France (€250+ billion) leading the way. Additionally, European banks, which have traditionally been leveraged, will have over €750 billion in debt to refinance.
The U.S. best weathered the storm in 2011 and is poised to continue in 2012. Compare the 5.52% rise in the DJIA with double-digit percent losses on European indices. 10- and 30-year Treasury yields have also fallen to below 2% and 3%, respectively, while yields in the eurozone have ballooned. The economy and the employment picture continue to improve at a moderate pace. The Fed has kept a massive amount of liquidity in the economy and has remained committed to stimulus for an extended period. Many feel that the Fed will keep rates at historic levels into 2014.
Aside from Europe, the economy and public finances in the US will be shaped by the 2012 elections. Fitch Ratings warned that the US will lose its AAA rating by the end of 2013 if the incoming Congress and Administration does not "reduce the deficit and stabilize the federal debt burden". Questions surrounding taxes and the debt ceiling remain unanswered heading into the New Year.
Growth in employment continued in November as the Bureau of Labor Statistics reporting that nonfarm payrolls were higher by 120k, generally in line with expectations. With upward revisions in November, the economy has added over 100k jobs in each of the past five months. The household survey placed the unemployment rate at 8.6%, down from 9.0% in October. However, the drop in the unemployment rate was not all good news; approximately half of the decline was attributable to a 315k drop in the labor force. Economists expect similar job growth for December‟s figures with a small rise in the unemployment rate. A positive employment picture was affirmed by a continual drop in weekly jobless claims, which continue to trend downwards and fell as low as 364k, the best this figure has been since the 2008 financial crisis.
GDP was slightly disappointing, with a downward revision for Q3 growth from 2.0% annualized, to 1.8%. However, all eyes will be on the 1st estimate for Q4 GDP, which will be released January 27th. Economists are expecting improved growth rates over Q3. ISM Manufacturing showed improvement in the month of November, rising from 50.8 to 52.7. New orders and production showed strong growth.
Many of the regional indicators also showed evidence of an improving economy. Empire Manufacturing rose from 0.61 to 9.53, the Philly Fed Index rose from 3.6 to 10.3, and the Richmond index rose from 0 to 3 (zero is neutral for these indicators). The Chicago PMI remained firmly in expansionary territory (above 50) at 62.5, versus 62.6 in November. Dallas was the exception, falling from 3.2 to -3.0, although many of the component questions (which do not factor directly into the overall index) showed improvement.
Overall consumer prices were flat (0.0%). Core prices, somewhat worryingly, rose 0.2%, indicating that prices pressures could be building despite the perceived slack in the economy. Import prices rose 0.7% in November, reversing three months of decline. Import prices are up 9.9% over the last year. Producer prices were up 0.3% in November, led largely by a 1.0% increase in the volatile food component. Producer prices without food and energy were 0.1% higher.
Despite missing expectations, consumer spending continues to climb. Retail sales (+0.2%), Q3 personal consumption (+1.7%), and personal spending (+0.1%) were not spectacular, but steady.
Consumer confidence continues to climb. The measure by the University of Michigan has climbed for the fourth consecutive month, reaching 69.9 in December, which is a six-month high. Confidence, as measured by the Conference Board, rose to 64.5, an eight-month high. The resolution (or not) of the tax situation by Congress could have an impact on the confidence figures moving forward.
Economists have been looking for signs of a turnaround in this market for quite some time. Recent indicators have only given hope that a stagnant market has been consolidating. Housing starts were much stronger than expected, driven by the multi-family component.
Existing home sales rose from levels that were revised significantly lower by the National Association of Realtors, who revised years worth of data due to an error in the methodology that resulted in double counting. New home sales were mixed, but remained steady at historically low levels while pending home sales rose for the third consecutive month.
Home prices remained stagnant as the S&P / Case-Shiller home price index fell by 1.2% in October and showed broad-based declines across the country.
Economic Calendar (January 2012)
US Treasury Market
The benchmark 10yr Treasury note fluctuated in a 29bp range in December from 1.82% to 2.11% and closed the year at 1.89%. The European credit turmoil that undermined the global economic recovery resulted in investors shunning risky assets and the continued flight-to-safety helped to mark the best year for bonds since the 2008 financial crisis.
When the S&P Rating agency stripped the US of its AAA rating in August, logic would imply less demand and higher yields for the government debt. But because US government debt remained to be seen as one of the very few global assets considered to be risk-free, the Barclays Capital Treasury Bond Index returned 9.81% in 2011. The year actually witnessed the most demand seen for Treasuries on record since the government began recording the data in 1992; on average $3.04 per each dollar of the $2.135 trillion in notes and bonds sold. The announcement by the Fed in September of Operation Twist proved to lift stocks and lower long term yields as it intended. The 25+ year segment of the Barclays Capital Treasury Bond Index returned a whopping 33.96% on the year.
Fitch Ratings Agency assigned a negative outlook to US Government debt in November after the congressional committee failed to agree on budget cuts and then declared in December they will cut the US‟s AAA rating by the end of 2013 unless a plan is formulated to reduce the budget deficit.
The minutes of the last Fed meeting reiterated that short term rates are likely to stay close to zero until mid-2013 while the futures market suggests rates won‟t increase until late 2013 or early 2014. The continued global financial crisis is expected to keep the benchmark 10yr yield down and some think it could go as low as 1.5% before rebounding. According to a Bloomberg survey of bank and securities companies, the average forecast has the 10yr yield at 2.67% by the close of 2012.
Corporate Bond Market
Volatility in December, albeit nonviolent, was driven by news from Europe and economic data locally. Anxiety over Europe was mostly stoked by threats of sovereign state downgrades from Fitch Ratings. The threat of downgrades coupled with the uncertainty surrounding the death of the North Korean leader Kim Jong-Il led to spreads closing on December 19th at a monthly high of 132.29bps, according to the Markit Investment Grade Index. Lack of additional negative news from Europe and improved employment numbers for the remainder of the month helped the index tighten, ending the month at 120bps, 7.6bps tighter.
The Barclays Capital U.S. Corporate Index returned 2.14% for the month of December, outperforming similar duration Treasuries by 0.99%. The firming up in Treasuries for the month of December helped the price component of the return to end up 1.724% after finishing November in negative territory. The long (10+years) reversed its performance from last month by retuning 4.17% compared to -3.49% in November while the short end (1-3 years) returned 0.25%. From the sector perspective, industrials returned 2.36%, financials 1.89% and utilities 1.78%. Performance from a quality perspective was tighter for December as the range from lowest 2.02% (AA) to highest 2.28% (BBB) was 26bps, the narrowest it has been for 15 months. AAA returned 2.09% while A returned 2.06%. For 2011 the Barclays Capital U.S. Corporate Index returned 8.15%, in positive territory for the third straight year after a negative return in 2008 due to the financial crisis.
December was a calm month as the markets looked forward to the Christmas holidays and a new year. Most trading desks stopped taking new positions for the year and mostly concentrated on executing trades for customers. Companies issued approximately $1.2 trillion in debt for 2011 slightly less than the $1.3 trillion issued in 2010. AT&T succumbed to U.S Antitrust Challenge and dropped its proposed $39 billion dollar deal of T-Mobile USA. While it cost AT&T a $4 billion breakup fee to scuttle the T-Mobile deal, Moody‟s and Fitch removed their "watch for downgrade‟ on the issuer and affirmed its long-term ratings A2 and A, respectively.
Looking ahead to 2012, fourth quarter earnings kick-off on Monday January 9th with Alcoa leading the way and the bulk of firms beginning to report earnings the week of January 16th. U.S Banks are also due to submit their 2012 capital plans and stress tests to the Fed by January 9th with the results being released mid-March.
Municipal Bond Market
December proved to be a very solid performing month for munis with the 10yr AAA yield breaking new record lows throughout the month and closing the year at the lowest level of 1.83%, according to Municipal Market Data. The 10yr muni-to-Treasury ratio fell below 100% in December due to the relative outperformance in munis. Munis experienced strong demand from flight-to-quality and although yields are at multi-year lows, from a risk/return perspective the yields are attractive. With 30yr Treasury yields artificially deflated due to Operation Twist, long-term munis have been yielding 120% and more relative to Treasuries, but there is a structural lack of demand that far out on the curve in muniland.
Despite the dire predictions of massive amounts of defaults heading into the year, state and local governments managed to maneuver through the economic downturn quite well. The major defaults that did occur throughout the year were shrugged off by the market as they were years in the making and anticipated. Municipalities that missed debt payments in 2011 fell to $2.1 billion from $2.8 billion in 2010.
Not only did a muni default crisis not unfold, munis performed exceptionally well in 2011, outperforming stocks, corporate bonds and Treasuries. The Barclays Municipal Index recorded an annual return of 10.7% while the Barclays Taxable Municipal Index returned 20.42%. Supply and demand dynamics also helped push down yields as 2011 saw the lowest amount of issuance in a decade.
More of the same is expected in 2012 with municipalities continuing to tighten their belts and issuance at extremely low levels. Defaults are not expected to increase significantly and munis could prove to be a relatively safe investment with a relatively attractive yield. Fitch Ratings has a stable outlook on states this year, opposed to its negative outlook last year. It noted that budget gaps have been closed without undue reliance on one-time solutions and the shortfalls for this year are meaningfully lower. While there is potential for federal spending cuts, states should have ample time to react.
General Investment Disclosures
This publication has been prepared by BondWave LLC. This publication is provided for informational purposes only. Neither the information, nor opinion, nor prices in this publication constitute a solicitation to buy or sell any financial instrument. This publication is not intended to provide personal investment advice. The securities discussed in this publication may not be suitable for all investors. Investors should independently evaluate each issuer, security, or instrument discussed in this publication and consult with their investment advisor before making any investment decisions.
Information contained in this publication has been obtained from sources believed to be reliable, but BondWave Advisors does not represent or warrant that such information is accurate or complete. The information in this publication is not intended to predict actual results, which may differ substantially from those reflected. Past performance is not necessarily indicative of future results. Any opinions in this publication provided by BondWave LLC are as of the date of this publication and are subject to change. BondWave LLC has no obligation to update its opinions or the information in this publication.
BondWave disclaims liability arising out of the use of the information and opinions contained herein.
About BondWave Yield Curves
The yields shown in the charts specified as BondWave curves are based on the known and applicable MSRB/TRACE trades for that same date (as reported by MSRB for municipal securities and TRACE for corporate securities, as applicable). Trades must have a minimum par value of $50,000 to be included and the resulting curves are based on the par-weighted values of the yields.
Please be advised that the yields reflected are only presented to provide an indication of the bond market on the date specified and are not indicative of the expertise of BondWave or any recommendations provided by BondWave. Because the yields are based only upon the securities that traded over the applicable period, such yields may not be indicative of what is currently available in the marketplace or the yields of other municipal or corporate securities that did not trade on such dates. Municipal and corporate security yields are based in part on certain assumptions and as a result, an investment in such securities may not result in performance comparable to the quoted yields. Past performance is not necessarily indicative of future results.
© Copyright BondWave LLC (2012). All rights reserved. No part of this publication may be reproduced in any manner without the prior written permission of BondWave LLC.
(c) BondWave Advisors