Wealthy Nations Daily Update - Outlook Part 2

With the Fed having finally started raising rates, one of the major uncertainties is now behind us. The extent of future rate hikes by the Fed will depend on the evolution of economic data throughout 2016 with the median consensus forecast being 1.25%. Our own forecast is for a lower Fed funds rate with 1% being the most likely outcome given the significant downside risks to global growth.

Global growth is one of the key inputs in our credit analysis and helps us determine how much credit risk or beta, we wish to take. For modelling purposes we monitor OECD industrial production as a proxy for global growth. Rather than wait for the data to be published, we use a model to predict OECD industrial production with the latest forecast being MINUS 2.2%. This is already the lowest reading since the Global Financial Crisis with the estimate being made BEFORE today’s ISM reading of 48.2, lower than the 48.6 November reading, which will have a negative effect on the already poor outlook from the model. If you would like a copy of the updated chart, please let me know.

How does this affect our investment thinking? We know from research, and historical experience, that high grade bonds outperform in declining growth environments, hence our portfolios have a relatively high average rating of single A. The same analysis leads us to conclude that sub-investment grade bonds will continue to struggle until global growth stops slowing, which seems a long way off at present.

Which brings us back to our forecast for Fed Funds. Never before has the Fed started a tightening cycle with the ISM below 50 (the average of the past three is 57.2) which suggests to us that rate increases will be very modest. If we are wrong, then it is far more likely that US growth disappoints and rates end the year below 1%; we see very little risk of rates exceeding 1% by the end of 2016.

In that environment, with inflationary pressures virtually non-existent, it is our contention that investors will find investment grade bonds very appealing. As an example, with a yield a smidgen under 5%, and a spread of 203 basis points over Treasuries our fair value model estimates our holding in IPIC 2041’s to be undervalued by around 22%. The same analysis suggests that Turkey 2043’s (Turkey is rated Baa3 by Moody’s and BB+ by S&P) is overvalued by 11% with the spread at just 283 basis points over, currently. That is very little additional compensation for the lower rating of Turkey and the downside risks to global growth. 

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