✔ The economic outlook has grown less clear amid falling inflation and oil prices.
✔ Valuations of municipal bonds and high-yield bonds have risen, relative to Treasuries.
✔ Corporate bonds in financials and construction may offer opportunities.
After months of improving economic conditions, several factors are contributing to a murkier view of the economy's health. Oil prices have drifted lower and inflation is struggling to move higher. In this environment, it is unclear how the Fed is likely to proceed, following its latest interest rate hike in June, says Tom DeMarco, CFA®, a market strategist in Fidelity Capital Markets’ fixed-income division.
Viewpoints spoke to DeMarco about his perspective on the challenging economic outlook and whether falling oil prices are likely to affect the broader credit market. He also discussed the recent strength in the municipal bond market, and whether investors need to respond to mounting budget issues in states such as Illinois.
What is the environment like for bond investors?
DEMARCO: Investors came into 2017 with high expectations for the Trump administration’s pro-growth agenda. As we moved into the spring, however, investors had doubts about the administration’s ability to implement its agenda—including items like tax and health care reform. Meanwhile, inflation numbers peaked and have been moving downward, which is the wrong direction from the perspective of the financial markets and for the Federal Reserve.
With inflation moving down and the Fed insistent on raising interest rates, there’s the potential for a mistake by the Fed if it hits the brakes too quickly.
Markets are still barely pricing in another rate hike for this year, and not until December, mostly due to weak inflation. Inflation, as measured by core personal consumption expenditures (PCE), has fallen by about 35 basis points this year. But I think even if inflation moves sideways from here, the Fed may continue to raise rates in an attempt to normalize policy. So interest rate volatility may increase over the summer from levels close to 30-year lows, as measured by the Merrill Lynch Move Index.
How are investors responding to this situation?
DEMARCO: Since the Fed’s March rate hike, the yield curve had been flattening. That suggested the market had some doubts about the Fed’s interest rate policy, though recent comments from central bankers caused that trend to reverse to some degree. If anything, the flatter yield curve is showing that the reflation trade, which counts on President Trump’s policies boosting growth, seems to be on weakening legs. In particular, I’ve been looking at the spread between the yield on the 5-year Treasury and the 30-year Treasury, which recently broke below 100 basis points—a key threshold that’s been in place since 2008. I think the spread could move toward 75 basis points, and potentially move as flat as 50 basis points.
I’m beginning to hear some rumblings that the flattening yield curve is a harbinger of a recession. That seems premature at this point, given robust consumer confidence levels and manufacturing activity indices, as well as relatively easy credit conditions. However, I believe it bears monitoring, as the yield curve has been a pretty good indicator of economic growth and recession risk over the years.
How are falling oil prices affecting the bond market?
DEMARCO: During the week of June 19, oil entered bear-market territory despite attempts from OPEC to stop prices from falling. The impact on the corporate bond market has been fairly limited outside of the energy sector. That is not to say there was no impact, though. For instance, we saw Charter Communications recently back out of a $1.5 billion high-yield bond sale as falling oil prices put pressure on market conditions. When oil prices appeared to recover in the last week of June, the company came back to the market with a bond offering split between investment grade and high yield.
Speculator short positioning in oil looks somewhat extreme, so a short-covering rally cannot be ruled out. That said, should oil resume its decline and drop below $40 a barrel, then I think we could start to see a broader impact on corporate credit. But I'm not expecting a significant selloff. As I indicated earlier, the broader market hasn’t been terribly affected by the weakness in oil prices. (See chart.)
The correlation between crude prices and bond prices is significantly weaker now. I believe that the prior bear market in oil prices was so severe that it shook many of the weaker oil companies out of the investment grade market and into the high yield market. And in the high yield market, a number of the weakest companies didn’t survive. In short, there’s a stable of stronger companies in the energy sector now than during the previous downturn. In addition, I believe many players were well hedged for what has transpired so far in 2017.
Are investors more interested in investment-grade bonds than in high-yield bonds?
DEMARCO: I think we’ve seen the best returns we’re going to see in the high-yield markets for a while. I am only looking for low-single-digit type returns for the remainder of the year, as valuations appear full to me. But as long as GDP growth continues to plod along, consumer confidence remains high, and the job market remains strong, then high-yield spreads should still have room to grind lower.
Are there credit sectors you find appealing?
DEMARCO: I like the financials sector, including big banks and brokers, and the life insurance sector looks interesting as equities in the sector continue to move higher. I am a little cautious over the deregulation push in the banking sector because depending on how far it swings it can be somewhat credit negative in the long-term, even though it could be more advantageous for the banking sector’s equity securities. Separately, the construction sector is benefiting from a healthy housing market.
I’m cautious on the health care sector, given what’s going on in Washington right now with health care reform. I’m also avoiding the retail sector for the most part, given the numerous negative headlines around that sector over the past year, as well as the uncertainty surrounding potential winners and losers from Amazon’s moves deeper into traditional retail. Considering the elevated valuations overall, I view this as a credit-by-credit market and not necessarily an overall sector call.
We are near historical tight spreads and the economic cycle is getting long in the tooth, so I tend to use these periods as a time to assess risk and reward and look to move up in quality where it makes sense.
What are you seeing in the municipal market?
DEMARCO: The muni market has been performing quite well. We’re in the sweet spot of seasonal factors in the muni market when a lot of redemption money flows back to bond holders, and supply is running somewhat below expectations. One measure of relative value in the municipal market is looking at muni yields as a percentage of Treasury yields. By that measure, muni bonds appear to be richly valued across the yield curve, in large part because of the favorable supply/demand picture. Those muni valuations may become more attractive as the supply and demand balance weakens through the summer.
The health care reform efforts in Washington do have some implications on the muni sector, as changes in health care rules could pressure state budgets—particularly among Medicaid expansion states. It appears that the credit cycle has peaked in the municipal market; total revenues for states have been trending downward, and a number of states are having budget issues. (See chart.) It’s not just Illinois. We’re seeing budget issues in Minnesota, West Virginia, Alaska, Connecticut, New Jersey, Massachusetts, and Maine, just to name a few. These pressures have led to recent downgrades of Alaska, Connecticut, Massachusetts, and New Jersey.
Even if Illinois lawmakers do manage to cobble a spending plan together and override the Governor’s veto, the state will remain on the cusp of having below-investment grade ratings. Investors may want to consider taking advantage of the strength in the muni market to improve the credit quality of their portfolios and make sure they are adequately diversified.