Last week Federal Reserve Chair Janet Yellen delivered her semi-annual testimony to the House Financial Services Committee, sending the Dow and S&P to new all-time-highs, and provided a boost to global equity markets.
Markets seem to have focused on her reference to the recent improving economic data - drawing a consensus that a June (or even the possibility of March) rate rise may be on the table. However Yellen also stressed caution over the uncertain economic picture; notably the risks and ‘considerable uncertainty’ associated with the current administration’s plan to boost growth through further unsustainable fiscal stimulus. In contrast she stressed ‘the importance of improving the pace of longer-run economic growth’.
Little mention was made of the Fed’s agenda for eventually curtailing its QE reinvestment policy - which markets have been fixated on. However, given assurances that whenever this is initiated it will be done gradually and the significant proportion of the Fed’s balance sheet being in long maturity mortgage and Treasury bonds some argue, including Stephen Williamson Vice-President of the St. Louis Fed, that such a step towards policy normalisation would not be as harmful or contractionary as many expect.
There is still a worry that the 1950-1981 period, when Treasury yield surged from 2% to 15%, is a relevant parallel to now. However, the contrasts could not be starker. Indeed taking the past three centuries of UK and US yields it is the past 5 decades that are the aberration; for the other two and a half centuries - when economic and demographic growth prospects were much higher than today – yields were typically in-line with current levels rather than the blow out from the 50s and 60s which included 2 oil shocks and the Fed dragging their feet for 15 years before properly adjusting policy amongst many other things.
From a longer term perspective (both historical and future) of the US economy, current comments and decisions by the Fed are likely driven by the importance of being perceived as ahead of the curve, rather than the first steps towards surging yields and accelerating growth. Given that markets have consistently overestimated the pace of Fed Funds hikes in recent years and the scant tangible improvement in longer term economic growth prospects (perhaps even the opposite) it is possible that not only is much of the Fed policy path already priced in for Treasury and bond markets, but also that the short-term bullish sentiment (bearish for bonds) and reflective equity index highs will not last the test of time. With no significant surge in potential global growth and little achievement in global deleveraging we continue to favour high quality creditor bonds that offer above average yields and attractive risk adjusted returns.
In the credit markets, there have been a number of interesting corporate issues out of late, some of which have looked relatively attractive, while others have not offered enough in terms of spread cushion. The offering from Kuwait Projects (KIPCO) is a perfect example. Rated BBB- (one notch above junk) the 10-year issue, was launched at a yield of 4.75%; which would normally be a welcome holding in most portfolios. However, using our proprietary Relative Value Model, we calculate the expected return stands at a mere 2.6%; as it trades only 32bps wider than similar securities. Although we have been long term holders of the major investment holding company in the past, and the Kuwaiti ruling family indirectly owned a large stake in the company, this issue offers very little in terms of cushion, with less than one notch of credit protection.
Ahli Bank Qatar, another corporate new issue to the market priced at +163bps over UST, which is relatively attractive given similarly rated A2 bonds with a duration around 4.5 years trade at ~91bps. The expected return and yield is calculated at 6.6%, with 3.3 notches protection. Although this bond offers far more spread cushion than the KIPCO issue and a higher credit rating, we would not look to hold it as we have chosen to not hold GCC banks at the moment, and Ahli Bank is tiny at~3% market.
As regular readers will be aware, just as we are constantly looking to make attractive risk adjusted investments we are equally keen to avoid taking any unnecessary risks when building our portfolios by undertaking sufficient credit analysis and evading the ‘search for yield’ trap where downside “cushion” may not adequately compensate for when things don’t go quite to plan.