2013 Fixed Income Strategy
Content
JANuARy 2013
FIxEd INCOmE mARKET STRATEgy
“Won’t get Fooled again”…and more of my Favorite Theme (songs) for 2013
Highlights
} Won’t Get Fooled Again…and More of My Favorite Theme (Songs) for 2013. In the first of our “greatest hits” themes for 2013, over the long run today’s low interest rates lock in negative returns after inflation, “fooling” investors expecting fair returns in fixed income. However, the short-run return outlook depends critically on the next phase of debt ceiling-induced uncertainty. Whether that outcome derails the economic recovery will determine whether rates end up higher or lower by year’s end, and whether our expectations for modest increases in interest rates in 2013—targeting 2.25% for the 10-year Treasury—means we end up fooled again. } Like a Rolling Loan. “How does it feel?” The double-digit returns of the high yield market over the past year felt pretty good. But lower starting yields means lowering asset class return projections in 2013 to mid to high single digits. We stay “overweight” high yield as those returns, while lower than in past years, are still attractive for the default risk that ample global liquidity keeps at bay in 2013. } The Way We Were. “What’s too painful to remember, we simply choose to forget…” At the root of the last credit crisis stood overly accommodative monetary policy fueling asset price bubbles. Have policymakers learned any lessons? Persistent accommodative monetary policy remains the key determinant of risk asset price performance in 2013. That should make risk assets–stocks and the most credit-sensitive bonds–the best performing asset classes in 2013. } Movin’ Out. Of the basement, that is; representing our housing recovery theme and a source of optimism to the economic outlook in 2013. The trouble is that optimism is shared by everyone else. Housing recovery-themed investment strategies already outperformed in 2012; we look for lower returns in 2013 and underperformance of homebuilder vs. bank stocks as banks remain a standout beneficiary not fully priced. We also look for outperformance from bank bonds and mortgage credit, albeit to a lower degree than last year. } How Will I Know? “Just trust your feelings…” When it comes to the impact China has on the global economic outlook, probably better to dig deeper. The longerrun China outlook depends critically on the ability of the new leadership to implement key structural reforms. For 2013 however, China likely supports the global growth outlook, fueling continued strong emerging market performance. } Turning Japanese. Or should we say “Turning Bernankese?” Japan takes a page out of the Fed playbook and may finally successfully reflate. Though now consensus viewpoints, a weaker yen fuels a stronger Japan equity market in 2013.
* As of 12/31/2012, Securitized Asset breakdown: ABS (YTD 3.66%, 2013 Forecast 1.35%, Neutral), CMBS (YTD 9.66%, 2013 Forecast 3.50%, Overweight), Non Agency RMBS (YTD 37.34%, 2013 Forecast 8%–9%, Overweight). † Emerging Market breakdown: External Debt (YTD 17.44%, 2013 Forecast 5%–9%, Overweight), Local Debt (YTD 16.76%, 2013 Forecast 8%–12% Overweight), Corporate (YTD 16.74%, 2013 Forecast 6%–9%, Overweight). ‡ Yield to worst. § Yield to maturity. 1 We continue to view TIPS favorably as an alternative to nominal Treasury exposure in a portfolio. The respective indexes are listed at the back of this report. Inflation protected position represents outright positioning.
Jeffrey rosenberg, managing director, is BlackRock’s Chief Investment Strategist for Fixed Income
BOnd markeT summary
2013 2012 yTm§ F’cast Total as of Total return 12/31/12 return (%) (%) positioning (%) 15.81 10.51 2.94 2.59 9.82 4.09 17.44 6.98 1.99 6.13 5.59 2.13 2.22 2.72 1.64 4.38 1.51 0.86 5–8 4.50 2–3.5 1.75 2–2.5 2.80 5–9 0.75 -0.75– 1.8
sector High yield
Overweight Overweight Bank Loans Securitized Overweight Assets* Agency mortgages Corporates Non-US dollar Emerging markets† Underweight Neutral — Neutral — Overweight
Inflation Underweight1 Protection Treasury/ Agency Underweight
reFerence indices (decemBer)
2012 Total return (%) 4.21 6.78 yTm § as of 12/31/12 (%) 1.74 2.17 2013 F’cast Total return (%) 1–2 2.25‡
sector US Aggregate municipal Bond
“Won’t get Fooled again”…and more of my Favorite Theme (songs) for 2013
This year’s outlook piece of greatest hits summarizes the investment outlook for 2013. Our lead theme highlights the short and long run aspects of the interest rate outlook. Over the long run, today’s low interest rates lock in negative returns after inflation, “fooling” investors expecting fair returns in fixed income. However, the short-run return outlook depends critically on the next phase of fiscal policy uncertainty and economic resilience. Having achieved the last minute deal to avoid the worst case scenario, the fiscal cliff outcome postpones most of the difficult decisions into the debt ceiling debate. Whether those outcomes derail the economic recovery will determine whether rates end up higher or lower by year’s end and whether our expectations for modest increases in interest rates in 2013— targeting 2.25% for the 10 year—means we end up fooled again. Figure 1 summarizes our “greatest hits” of investment themes for 2013.
The “Old era” of Fixed income investing is Over
Fixed income returns benefited from everything going right in 2012. The atypical situation of declining interest rates and declining credit risks led to an index return for “core” fixed income of 4.2% but provided the average bond fund manager the opportunity to nearly double that return to just over 8%.1 Unlike past years, however, achieving those returns required significant drift from the benchmark, underweighting interest rate risk and overweighting credit risk. While the average bond fund delivered those near–historic average “core” fixed income returns in 2012, achieving similar results in 2013 will be much harder. Investors should adjust their fixed income return expectations lower for 2013 – much lower. For 2013, we expect “core” fixed income benchmark returns only in the region of 1-2% and similar manager drift from the benchmark in 2013 implies returns only in the 2-3% region for the average bond fund. But significant opportunities still exist for investors that throw off the “old era” of fixed income—investments tied to the benchmark and to underperforming interest rate risk sensitive asset classes and embrace “New World” investment strategies that utilize a more flexible approach. The Bond market Summary highlights our cross–sector fixed income return projections along with our longer–term recommendations for 2013 as well as last year’s performance and current yields. “Old era” strategies in fixed income typically contain too much duration exposure through overconcentration in Treasury, Agency and mBS sectors—sectors that likely underperform in 2013. In contrast, overweighting credit segments of fixed income in areas such as high yield, bank loans, emerging markets, municipals and credit portions of the mortgage market (“non-Agency mBS”) offer the scope for better returns in 2013.
Figure 1: 2013 inVesTmenT THemes and recOmmendaTiOns
Theme “Won’t get Fooled Again” recommendation Reduce interest rate-sensitive segments of fixed income (long duration, treasury, agency/agency mBS) in favor of higher credit risk segments of fixed income: corporate, high yield, municipal debt, emerging markets and the credit segments of the mortgage markets. Stay “overweight” high yield for income, but increase bank loan allocations. Stocks beat bonds, and credit beats interest rate risks. Increase credit risk and reduce interest rate risk in bond portfolios. A housing recovery theme favors bank bonds in investment grade and credit areas of the mortgage market, though outperformance of both is limited relative to past years. going further down the capital structure in banks also makes sense as bank equities have significantly lagged other housing recovery themed sectors (e.g. homebuilder stocks) suggesting banks can outperform homebuilders in 2013. Stabilizing China growth in 2013 supports the outlook for emerging markets. Overweight emerging market bonds (hard currency sovereign and credit as well as local currency) as positive fundamentals and strong investor demand for yield continues to lead to outperformance in the sector. Reflation policy in Japan leads to a lower yen in 2013. Bond yields however likely remain constrained as policy intervention takes on a more “repressive” nature limiting the scope of yield increases. Successful yen devaluation likely benefits stocks as well, though look for underperformance in Q1 on consolidation of recent gains.
“Like a Rolling Loan” “The Way We Were” “movin’ Out”
The end of an era
Two key features defined the “old era” of fixed income investing: yield and duration. Figure 2 on the next page, however, highlights how these two key features of this era no longer exist: (i) yields today stand below the level of inflation and (ii) interest rates today have less room to drop. The key features of the “old era” – yields above the level of inflation and secularly declining interest rates created returns that over the past 30 years averaged 8%—near equity like average returns— with half the volatility of the stock market.
“How Will I Know?”
“Turning Japanese”
1 Asset-weighted average return of Morningstar Intermediate bond fund universe.
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Figure 2: Treasury yields Vs. realized inFlaTiOn raTes
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10 RATIO
And while we readily acknowledge that such a shift increases the amount of equity risk present in the fixed income portfolio, as we highlighted earlier, most typical “core” managers are already utilizing such a strategy so that most “old era” allocations already exhibit more equity correlation than they have in the past. Allocating away from these traditional strategies towards one of explicit asset allocation can better manage the equity risk lurking in the fixed income portfolio. As we detail more below, in increasing credit risk exposures, consider floating rate bank loans as a diversifier from high yield strategies that have worked well in the past but show more limited prospects in 2013. Consider adding emerging market alternatives and not just in sovereigns but corporate exposures as well. And consider flexible fixed income—but where the strategy has ability to better manage those risks through its flexible approach and broader risk mitigation tool kit. Such “flexible,” “unconstrained,” or “opportunistic” strategies manage the credit and interest rate risks with management styles that are not tied to the benchmark— or to the past strategies that increasingly won’t work in tomorrow’s fixed income environment.
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Source: Bloomberg.
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10-Year Treasury Yield
Realized Inflation
Welcome to the “new World” of Financial repression
Today’s “New World” of fixed income offers nowhere near that potential for return in 2013. The Federal Reserve’s zero interest rate policy in place since the 2008 crisis has led to a dramatic collapse in the ability to generate income from “old era” fixed income investment approaches. And the expansion of the Fed’s balance sheet to purchase Treasury and mBS securities introduced a degree of “financial repression” to the financial markets not seen since the 1940s. yields so low that they no longer compensate for inflation is the hallmark of such an implicit policy choice. But the outcome for fixed income investors is never good: the prospect of rising inflation from such policies as occurred in the 40s and 50s leads to negative fixed income returns after inflation (-3.5% in the 40s and -1% in the 50s). Furthermore, the prospect for limited interest rate declines but much larger increases introduces a larger downside return profile than upside potential. But here’s the “real” kicker: even if interest rates do nothing at all in 2013, traditional “old era” fixed income investments—that is, investments that concentrate allocation to interest rate sensitive fixed income sectors— will suffer negative returns after inflation.2
Figure 3: mOVing FrOm “Old era” TO “neW WOrld” inVesTing
“OLD ERA” ALLOCATION “NEW WORLD” ALLOCATION
INTEREST RATE RISK
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CREDIT RISK
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adJusTing duraTiOn/yield mismaTcH Reduce Duration | Floating Rate, Long/Short, Flexible/Strategic Increase yield | High yield, Floating Rate, Flexible/Strategic
Interest Rate Risk Credit Risk
The 2013 interest rate Outlook or “Won’t get Fooled again?”
Our outlook for interest rates in 2013 pivots on the outcome of the looming debt ceiling debate, in which we continue to anticipate an avoidance of at least the worst case scenario that replays the 2011 debacle. This outcome would support a gradual rise in rates through the coming year to 2.25% for the 10-year US Treasury. Along the way, the looming debt
so what do i do with my money? ™
At the portfolio level, investors need to look beyond the era of traditional core fixed income investing. Where a typical “old era” fixed income portfolio held two-thirds interest rate risk and only one-third credit risk, tomorrow’s “New World” strategy should reverse those weightings, holding two-thirds credit risk and only one-third interest rate risk.
2 Precisely, under unchanged interest rate scenario, the aggregate index returns approximately 1.75%, 25 basis points below our expectation for 2% realized inflation in 2013, leading to a 25 basis point loss after inflation.
“ WOn’ T ge T FOOled ag ain”… and mOre OF m y FaVOriTe THeme (sOngs) FOr 2013
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CITIGROUP ECONOMIC SURPRISE INDEX
ceiling debate along with the host of uncertainties will mean a considerable range in rates potentially as large as 50 basis points on either side of that 2.25% forecast. Continued Fed policy accommodation likely limits the scope for more increases than that in 2013. However, were policymakers to fail to come to an agreement on the postponed spending cuts necessary to strike agreement on raising the debt ceiling, it is likely that interest rates would remain low for longer amid the extended economic uncertainty. On the other hand, the outlook for inflation appears more clearly benign, excluding the volatile food and energy components. We expect inflation will hold steady at least for now given the lack of wage and benefit pressures and the subdued growth environment. Ultimately, we believe the fiscal policy negotiations will be conducted without permanently damaging near term economic confidence but remain doubtful on meaningful fiscal policy reform to address the long run issues, leaving our base case as 2% economic growth but with risks to the upside. Combined with the reduction in risks of eurozone breakup and a China economic “hard landing,” the flightto-safety into Treasuries should subside in 2013, leading to our view of modest increases in interest rates. However, amid the continuing subpar recovery and weak job market, the Federal Reserve will maintain its latest form of “open ended” quantitative easing that supports financial market asset inflation and continued low interest rates. Finally, we highlight the risk to our outlook for modestly increasing rates. For the past several years, expectations for rising rates have been dashed as external risks led to heightened economic uncertainty, increased demand for Treasuries, and more Federal Reserve bond buying. To be sure, our forecast for higher rates in 2013 is more modest than in the past reflecting these concerns. yet rates could end up even lower in 2013 under the alternative scenarios of self-inflicted fiscal policy damage, or if yet another bout of external risk whether from Europe, the middle or Far East or other “hotspots” were to again arise.
Figure 4: mind THe gap? relaTiOnsHip BeTWeen raTes and FundamenTals Breaks dOWn in a Qe WOrld
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Operation twist 66% Correlation— pre-Euro crisis, pre-twist, QE3
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Correlation to improving economic data breaks down 4
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US 10Y INTEREST RATE
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Citigroup Economic Surprise Index (LHS) 10-Year Interest Rate
Source: BlackRock, Bloomberg, Citigroup Research
towards signaling rising rates on any perceived temporary economic strengthening. On the other hand, it is aggressive at meeting expectations for ever-increasing amounts of policy accommodation. This policy reaction has led to a one-way correlation between rates and fundamentals: lower growth associated with declining rates but more limited increases in rates from higher growth. Similar to this time last year, the gap between low rates and rising economic growth suggests higher rates, yet persistent policy accommodation – in effect “soft” “financial repression” holds down those increases. The prospects for a meaningful shift in housing (as we detail below), and more caution from the Fed from furthering unconventional policy at today’s balance sheet size, suggests that 2013 could see an important shift in the prospects of future policy–signaling moving the US ever so gradually towards easing off the accommodation. The limits of a still highly leveraged economy (let alone a highly levered government sector) limit the scope of any such increases, and hence our forecast for modest increases in rates in 2013. On the risk side stands the prospect that yet again economic growth that appears to be strengthening at the end of one year only to disappoint in the beginning of the next. This year’s disappointment may yet lie in the fiscal debate just past as the impact of the expiring payroll tax provisions plus continued fiscal uncertainty raise the risk of dampening spending from both declining disposable income as well as declining confidence. Those scenarios remain a risk to our otherwise constructive outlook on gradual yet modest
Turning The Old rules on Their Head
In today’s “New World” of fixed income the old rules are turned upside down. Financial markets react more to the economy’s performance for its impact on monetary policy expectations than to monetary policy’s impact on the economy. Figure 4 above highlights how the relationship between economic fundamentals and interest rates has broken down during the latest iteration of Fed monetary policy. In the current monetary policy environment, Fed policy reacts in a skewed fashion: on the one hand, it is cautious
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January Fixed incOme marke T sTr aTegy
stability in US economic growth leading to modest increases in interest rates over the course of the year.
like a rolling loan
“How does it feel?” The double digit returns of the high yield market over the past year felt pretty good. But lower starting yields means lowering asset class return projections in 2013 to mid to high single digits. We stay “overweight” high yield as those returns, while lower than in past years are still attractive for the default risk that ample global liquidity keeps at bay in 2013. However we look to reduce risk in this income segment of the portfolio by shifting high yield bond allocations into bank loans that offer similar yields but with lower risk. Broadly, today’s tremendously accommodative monetary environment supports corporations’ access to debt markets and refinancing options. That helps keep default risk low, which offsets the risks of owning credit instruments. We expect default rates to remain low even in a weak growth environment. Corporate default risk is lessened as virtually all high yield borrowers have access to the market to refinance debt, reduce interest expense, extend maturities and better their terms. Furthermore, many of the weakest companies defaulted and restructured or liquidated in the 2008–2009 financial crisis, leaving behind a market with overall stronger balance sheets enabling them greater ability to weather an economic downturn. That doesn’t mean high yield won’t have its bouts of risk-off; less cushion in the form of lower yields in 2013 means a need to be more tactical with the asset class than in past years. Lower starting yields and higher starting prices means lowering asset class return projections in 2013 from the past few years of double digit returns into the mid to high single digits for 2013. As such, investors should consider diversifying their exposures in high yield to include loans and secured credit.
These offer yields at more compelling valuations than typical high yield bonds. Overall, while likely generating lower returns in 2013, the high yield, loan and secured bond asset classes still offer attractive yields in the context of ample global liquidity that keeps default risk at bay in 2013.
The Way We Were
“What’s too painful to remember, we simply choose to forget…” And yes, that is a Barbara Streisand reference. At the root of the last credit crisis stood overly accommodative monetary policy fueling asset price bubbles. Have policymakers learned any lessons? Persistent accommodative monetary policy remains the key determinant of risky asset price performance in 2013: more money printing means more asset price inflation. That makes risky assets – stocks and the most credit sensitive bonds – the best performing asset classes in 2013.
Figure 6: 2013 reTurn scenariOs in Fixed incOme
us 10 year treasury 1.75% 2.25% 2.75% Barclays aggregate 1.70% 0.72% -0.40%
Source: BlackRock.
Bond Bubble? no, Bonds are the “anti-Bubble” asset
An asset price bubble is when the expectation that the price can only go higher forms the only rationale for purchase. Residential real estate before the crash, internet stocks in the late 90s and gold today all depict such characteristics. But for fixed income, in answering the “bond bubble” question, the main motivation of investors for buying fixed income is the opposite of typical bubbles: the fear of losing money rather than the greed of potential profit has fueled the historic shift of assets into fixed income. That makes if anything bonds the “anti-bubble”: investors buy them because they expect that they cannot go down. The risk however for investors in 2013 is that even with our outlook for only modest increases in interest rates, returns available in core fixed income will not keep up with inflation we expect to range around 2% in 2013. And as the scenario table in Figure 6 highlights, rates at the higher end of our range may lead to negative returns even before considering the impact of inflation. In an asset price bubble, it is leverage —the willingness and ability to borrow money—that fuels the price increases and reinforces their ascent. Rising prices fuel greater expectations for rising prices. And that expectation creates more
Figure 5: Hy spreads Vs. deFaulTs
2000 SPREAD-TO-WORST (BPS) 16% TRAILING 12 MONTH DEFAULT RATE
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High Yield Spread-to-Worst High Yield Default Rate
Source: Moody’s, JP Morgan.
“ WOn’ T ge T FOOled ag ain”… and mOre OF m y FaVOriTe THeme (sOngs) FOr 2013
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willingness and ability to borrow against the rising value of the asset. Credit fueled bubbles are strongly reinforcing – until they ultimately collapse under the weight of their own debt. In broad terms, such a scenario characterized the lead up to the housing market fueled credit crisis of 2008. One key feature of that pre-crisis environment encouraging the use of leverage was monetary policy. In its response to the crash of the previous bubble – the tech stock bubble – the Fed first cut interest rates aggressively in 2001, then held the policy rate below the level of inflation from 2002 through 2005. Low interest rates create an incentive to borrow, but the size of the incentive is related to inflation: when inflation is higher than your interest rate inflation effectively helps to pay off the debt. Today’s policy environment of negative real interest rates resembles that prior environment of 2002 to 2005 only
but the amount of money creation – its rate of change, the length of time it will be being created and the creative forms in which its fact or promise takes place (the LTRO, the OmT, the FLS, etc)*—that determines financial market prices much more than the performance of the economy. The risk, of course, is to mistake the recovery in financial market prices for signaling the success of these policy interventions in the real economy and forget the distortions such financial market behavior can have on the real economy through the allocation of credit and the pricing of risk. In today’s unconventional monetary policy world, it’s the impact of the economy on monetary policy rather than the other way round that determines asset prices. And in the lyrics of the song, “But it’s the laughter, that we remember, when we remember, the way we were.”
Figure 7: mOneTary pOlicy Fuels asseT inFlaTiOn
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movin’ Out
Of the basement, that is; representing our housing recovery theme and a great source of optimism to the economic outlook in 2013. Of the key changes in the macro outlook for 2013, a definitive turn in the housing market stands as one of the most important potential reasons to expect better than expected growth in 2013. Housing and its collapse stood at the root of both the crisis and the slow growth aftermath going on over four years. And the failure of the Fed’s reflation policy as described above to migrate successfully into the housing market accounts for both the continued tepid recovery and the robust monetary policy response up to today’s unlimited promise of money creation termed “QE infinity.”
FED BALANCE SHEET ($BN)
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Figure 8: Banks lag HOmeBuilders On “HOusing recOVery”
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Source: Bloomberg, Federal Reserve
it’s gone global. Today every single major developed central bank runs negative real interest rates. And unlike in 2010 and 2011, in 2012 and 2013 emerging markets are also running more accommodative policy as opposed to tightening policy making the currency outlook more ambiguous than in prior periods of Fed quantitative easing. Together, this global policy accommodation fuels inflation of a different sort, inflation in asset prices. That feature explains the disconnect between financial asset price performance where US stocks increased double digits and risky portions of fixed income such as High yield returned nearly 16% while the economy barely grew above 2%. In a world of massive money creation from global central banks, the fundamental driver of asset prices is not fundamentals
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Source: Bloomberg. Note Banks represented by KBW Bank index; Homebuilders by S&P 500 Homebuilding Index.
* LTRO - Long-Term Refinancing Operations; OMT – Outright Monetary Transactions; FLS – Funding for Lending Scheme
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January Fixed incOme marke T sTr aTegy
To what end? To the recovery in the job market before fueling inflation hopes the Fed. The slow road to that recovery went through the inability of the mortgage market to transmit the policy accommodation into the housing market: unintended policy actions restrained the growth of credit while persistent weak hiring from a lack of business confidence restrained demand as the “kids in the basement” delayed household formation due to want of a job. Now it appears all of that may be about to change to the benefit of better than expected economic growth. While we share these views, the trouble is so too does everyone else. Housing recovery-themed investment strategies already outperformed last year. With so much hope for such a recovery priced into the market, the risk is disappointment in 2013, particularly in homebuilder stocks. However, other beneficiaries exist including bank bonds in the investment grade market and credit areas of the mortgage market though admittedly with more limited upside than last year given current prices. going further down the capital structure in banks also makes sense as bank equities have significantly lagged other housing recovery themed sectors (e.g. homebuilders as indicated in Figure 8) suggesting banks can outperform homebuilders in 2013.
of an economy, especially one in which the share of manufacturing is nearly 50%. Figure 9 shows the “Li Keqiang Index” relative to official gdP. given this index doesn’t capture much in service sectors, it is more volatile than gdP growth. As we can see, starting from beginning of 2012, the index started a broad decline before it rebounded in fourth quarter, helped by increase in fixed investment and easing monetary policy. These two policy levers represent the “traditional” policy accommodation levers used by China policy makers to stimulate (and restrain) the economy. Little by way of “transformational” policy has been accomplished in that most of the economy is still heavily geared towards production, investment and exports and a strikingly low (by historical and geographical comparison) level of domestic consumption. Figure 9 highlights that these traditional policy levers suggest better economic performance from China in 2013.
Figure 9: HOW Will i knOW? ask li keQiang
25% 20 REAL GDP GROWTH (%) 15 10 5 0 -5
How Will i know?
“Just trust your feelings…” When it comes to the impact China has on the global economic outlook, probably better to dig deeper. At the end of 2012, China’s growth slowdown appears to have stabilized on the successful application of its traditional policy tool of ramping up infrastructure investment and easing credit. However, the longer–run outlook depends critically on the ability of the new leadership to implement key structural reforms. That ability remains uncertain and with it a more uncertain longer run outlook for China’s growth. For 2013 however, China likely supports the global growth outlook, fueling continued strong emerging market performance.
2004 2005 2006 2007 2008 2009 2010 2011 2012
GDP Growth Rate Change in Li-Keqiang Index YoY (Electricity Consumption, Rail Cargo, Bank Loans)
Source: National Bureau of Statistics of China, Citi Research
ask (incoming premier) li keqiang
The potential for political considerations to impact the calculation of Chinese economic statistics leads to the questioning of the accuracy of China’s official economic releases. These concerns were validated quite unintentionally in a WikiLeaks memo from 2007. When he was party leader of northeastern Liao Ning province, China’s incoming premier Li Keqiang shared with then-U.S. Ambassodor to China Clark Randt that he didn’t rely on provincial gdP data because they were man-made and “for reference” only. Instead, he focused on just three data points to evaluate Liao Ning’s economy: electricity consumption, rail cargo volume and bank lending. These three data points summarized the input (electricity consumption), output (rail cargo) and credit (bank lending)
Longer term, the ability to sustain this level of growth hinges on the adoption and successful implementation of critical structural reforms. For example, according to the China Institute for Reform and development, rising rates of urbanization could account for increasing consumption share of gdP from current levels around 35-40% to 55% over the next decade. China’s successful transition to a consumptiondriven economy hinges on China’s ongoing reforms in the resident registration system, the financial system (interest rate liberalization, exchange rate liberalization and financial market liberalization), and factor price liberalization (removing price controls both subsidies and caps). Key to monitoring progress along these lines will be the National Peoples Congress and Consultative conferences in march and the 3rd Plenary
“ WOn’ T ge T FOOled ag ain”… and mOre OF m y FaVOriTe THeme (sOngs) FOr 2013
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session of the 18th Party Congress in the Fall of 2013. For the short term, we’ll watch both the official sector data and Li Keqiang’s recommended sectors to answer “How will I know?”
Figure 10: Japan OuTlOOk Hinges On reFlaTiOn OpTimism
12000 95 90 JPY/USD SPOT 85 10000 80 9000 75 70
Turning Japanese
NIKKEI INDEX
Or should we say “Turning Bernankese”? Japan takes a page out of the Fed playbook and may finally successfully reflate. Though now consensus viewpoints, a weaker yen fuels a stronger Japan equity market in 2013, however, we would look for some pull–back in the first quarter. While we would be cautious about extrapolating too much of the 2012 surprise story into 2013, the broader implications of a scenario of Japan reflation need to be considered for the outlook in 2013. For much of the past 20 years, global growth prospects have been held back by the lost decades in Japan: real growth rates that barely notched above 2%. Lost in the focus of developed market growth difficulties in the US and eurozone and emerging market growth optimism stands the lack of Japanese growth. There is a dichotomy between the share Japan represents of the world economy (just under 10%) and its share of the world’s economic growth (negative in 2011). Even a modest shift in Japan growth from more aggressive monetary policy holds the prospect for upside surprise in global growth in 2013. Whether the incoming Abe administration and the potential changes can meet the market’s expectations for currency
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weakness and reflationary domestic monetary policy remains to be seen. To be sure, prior bouts of Japan optimism have been met with disappointment. However, taking a page out of the other developed central bank policies of massive money creation suggests a more significant expansionary monetary policy in Japan may be on its way along with a contribution to global liquidity and asset inflation that the Fed and the ECB so far have led.
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The sector performance and yields listed are represented by, respectively: Barclays US High Yield Index, S&P Leveraged Loan Index, Barclays US Securitized Ex-MBS Index, Barclays US Mortgage Backed Securities Index, Barclays US Corporate Investment Grade Index, Barclays Global Aggregate ex-USD Index, JP Morgan EMBI Global Diversified Index, Barclays US Inflation Protected Securities Index and Barclays US Treasury Index. The reference indices are represented by the Barclays US Aggregate and the Barclays Municipal Bond Index. Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Investments in non-investment-grade debt securities (“high yield” or “junk” bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments in emerging/developing markets or smaller capital markets. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.
The opinions expressed are those of BlackRock® as of January 11, 2013, and may change as subsequent conditions vary. Information and opinions are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable. The information contained in this report is not necessarily all-inclusive and is not guaranteed as to accuracy. Past performance does not guarantee future results. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Investment involves risk. Reliance upon information in this report is at the sole discretion of the reader. FOR MORE INFORMATION: www.blackrock.com ©2013 BlackRock, Inc. All Rights Reserved. BLACKROCK, BLACKROCK SOLUTIONS, iSHARES and SO WHAT DO I DO WITH MY MONEY are registered and unregistered trademarks of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners. Prepared by BlackRock Investments, LLC, member FINRA. Not FDIC Insured • May Lose Value • No Bank Guarantee Lit. No. ISG-0113 AC6470-0113 / USR-1354
FIxEd INCOmE mARKET STRATEgy
“Won’t get Fooled again”…and more of my Favorite Theme (songs) for 2013
Highlights
} Won’t Get Fooled Again…and More of My Favorite Theme (Songs) for 2013. In the first of our “greatest hits” themes for 2013, over the long run today’s low interest rates lock in negative returns after inflation, “fooling” investors expecting fair returns in fixed income. However, the short-run return outlook depends critically on the next phase of debt ceiling-induced uncertainty. Whether that outcome derails the economic recovery will determine whether rates end up higher or lower by year’s end, and whether our expectations for modest increases in interest rates in 2013—targeting 2.25% for the 10-year Treasury—means we end up fooled again. } Like a Rolling Loan. “How does it feel?” The double-digit returns of the high yield market over the past year felt pretty good. But lower starting yields means lowering asset class return projections in 2013 to mid to high single digits. We stay “overweight” high yield as those returns, while lower than in past years, are still attractive for the default risk that ample global liquidity keeps at bay in 2013. } The Way We Were. “What’s too painful to remember, we simply choose to forget…” At the root of the last credit crisis stood overly accommodative monetary policy fueling asset price bubbles. Have policymakers learned any lessons? Persistent accommodative monetary policy remains the key determinant of risk asset price performance in 2013. That should make risk assets–stocks and the most credit-sensitive bonds–the best performing asset classes in 2013. } Movin’ Out. Of the basement, that is; representing our housing recovery theme and a source of optimism to the economic outlook in 2013. The trouble is that optimism is shared by everyone else. Housing recovery-themed investment strategies already outperformed in 2012; we look for lower returns in 2013 and underperformance of homebuilder vs. bank stocks as banks remain a standout beneficiary not fully priced. We also look for outperformance from bank bonds and mortgage credit, albeit to a lower degree than last year. } How Will I Know? “Just trust your feelings…” When it comes to the impact China has on the global economic outlook, probably better to dig deeper. The longerrun China outlook depends critically on the ability of the new leadership to implement key structural reforms. For 2013 however, China likely supports the global growth outlook, fueling continued strong emerging market performance. } Turning Japanese. Or should we say “Turning Bernankese?” Japan takes a page out of the Fed playbook and may finally successfully reflate. Though now consensus viewpoints, a weaker yen fuels a stronger Japan equity market in 2013.
* As of 12/31/2012, Securitized Asset breakdown: ABS (YTD 3.66%, 2013 Forecast 1.35%, Neutral), CMBS (YTD 9.66%, 2013 Forecast 3.50%, Overweight), Non Agency RMBS (YTD 37.34%, 2013 Forecast 8%–9%, Overweight). † Emerging Market breakdown: External Debt (YTD 17.44%, 2013 Forecast 5%–9%, Overweight), Local Debt (YTD 16.76%, 2013 Forecast 8%–12% Overweight), Corporate (YTD 16.74%, 2013 Forecast 6%–9%, Overweight). ‡ Yield to worst. § Yield to maturity. 1 We continue to view TIPS favorably as an alternative to nominal Treasury exposure in a portfolio. The respective indexes are listed at the back of this report. Inflation protected position represents outright positioning.
Jeffrey rosenberg, managing director, is BlackRock’s Chief Investment Strategist for Fixed Income
BOnd markeT summary
2013 2012 yTm§ F’cast Total as of Total return 12/31/12 return (%) (%) positioning (%) 15.81 10.51 2.94 2.59 9.82 4.09 17.44 6.98 1.99 6.13 5.59 2.13 2.22 2.72 1.64 4.38 1.51 0.86 5–8 4.50 2–3.5 1.75 2–2.5 2.80 5–9 0.75 -0.75– 1.8
sector High yield
Overweight Overweight Bank Loans Securitized Overweight Assets* Agency mortgages Corporates Non-US dollar Emerging markets† Underweight Neutral — Neutral — Overweight
Inflation Underweight1 Protection Treasury/ Agency Underweight
reFerence indices (decemBer)
2012 Total return (%) 4.21 6.78 yTm § as of 12/31/12 (%) 1.74 2.17 2013 F’cast Total return (%) 1–2 2.25‡
sector US Aggregate municipal Bond
“Won’t get Fooled again”…and more of my Favorite Theme (songs) for 2013
This year’s outlook piece of greatest hits summarizes the investment outlook for 2013. Our lead theme highlights the short and long run aspects of the interest rate outlook. Over the long run, today’s low interest rates lock in negative returns after inflation, “fooling” investors expecting fair returns in fixed income. However, the short-run return outlook depends critically on the next phase of fiscal policy uncertainty and economic resilience. Having achieved the last minute deal to avoid the worst case scenario, the fiscal cliff outcome postpones most of the difficult decisions into the debt ceiling debate. Whether those outcomes derail the economic recovery will determine whether rates end up higher or lower by year’s end and whether our expectations for modest increases in interest rates in 2013— targeting 2.25% for the 10 year—means we end up fooled again. Figure 1 summarizes our “greatest hits” of investment themes for 2013.
The “Old era” of Fixed income investing is Over
Fixed income returns benefited from everything going right in 2012. The atypical situation of declining interest rates and declining credit risks led to an index return for “core” fixed income of 4.2% but provided the average bond fund manager the opportunity to nearly double that return to just over 8%.1 Unlike past years, however, achieving those returns required significant drift from the benchmark, underweighting interest rate risk and overweighting credit risk. While the average bond fund delivered those near–historic average “core” fixed income returns in 2012, achieving similar results in 2013 will be much harder. Investors should adjust their fixed income return expectations lower for 2013 – much lower. For 2013, we expect “core” fixed income benchmark returns only in the region of 1-2% and similar manager drift from the benchmark in 2013 implies returns only in the 2-3% region for the average bond fund. But significant opportunities still exist for investors that throw off the “old era” of fixed income—investments tied to the benchmark and to underperforming interest rate risk sensitive asset classes and embrace “New World” investment strategies that utilize a more flexible approach. The Bond market Summary highlights our cross–sector fixed income return projections along with our longer–term recommendations for 2013 as well as last year’s performance and current yields. “Old era” strategies in fixed income typically contain too much duration exposure through overconcentration in Treasury, Agency and mBS sectors—sectors that likely underperform in 2013. In contrast, overweighting credit segments of fixed income in areas such as high yield, bank loans, emerging markets, municipals and credit portions of the mortgage market (“non-Agency mBS”) offer the scope for better returns in 2013.
Figure 1: 2013 inVesTmenT THemes and recOmmendaTiOns
Theme “Won’t get Fooled Again” recommendation Reduce interest rate-sensitive segments of fixed income (long duration, treasury, agency/agency mBS) in favor of higher credit risk segments of fixed income: corporate, high yield, municipal debt, emerging markets and the credit segments of the mortgage markets. Stay “overweight” high yield for income, but increase bank loan allocations. Stocks beat bonds, and credit beats interest rate risks. Increase credit risk and reduce interest rate risk in bond portfolios. A housing recovery theme favors bank bonds in investment grade and credit areas of the mortgage market, though outperformance of both is limited relative to past years. going further down the capital structure in banks also makes sense as bank equities have significantly lagged other housing recovery themed sectors (e.g. homebuilder stocks) suggesting banks can outperform homebuilders in 2013. Stabilizing China growth in 2013 supports the outlook for emerging markets. Overweight emerging market bonds (hard currency sovereign and credit as well as local currency) as positive fundamentals and strong investor demand for yield continues to lead to outperformance in the sector. Reflation policy in Japan leads to a lower yen in 2013. Bond yields however likely remain constrained as policy intervention takes on a more “repressive” nature limiting the scope of yield increases. Successful yen devaluation likely benefits stocks as well, though look for underperformance in Q1 on consolidation of recent gains.
“Like a Rolling Loan” “The Way We Were” “movin’ Out”
The end of an era
Two key features defined the “old era” of fixed income investing: yield and duration. Figure 2 on the next page, however, highlights how these two key features of this era no longer exist: (i) yields today stand below the level of inflation and (ii) interest rates today have less room to drop. The key features of the “old era” – yields above the level of inflation and secularly declining interest rates created returns that over the past 30 years averaged 8%—near equity like average returns— with half the volatility of the stock market.
“How Will I Know?”
“Turning Japanese”
1 Asset-weighted average return of Morningstar Intermediate bond fund universe.
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January Fixed incOme marke T sTr aTegy
Figure 2: Treasury yields Vs. realized inFlaTiOn raTes
20%
15
10 RATIO
And while we readily acknowledge that such a shift increases the amount of equity risk present in the fixed income portfolio, as we highlighted earlier, most typical “core” managers are already utilizing such a strategy so that most “old era” allocations already exhibit more equity correlation than they have in the past. Allocating away from these traditional strategies towards one of explicit asset allocation can better manage the equity risk lurking in the fixed income portfolio. As we detail more below, in increasing credit risk exposures, consider floating rate bank loans as a diversifier from high yield strategies that have worked well in the past but show more limited prospects in 2013. Consider adding emerging market alternatives and not just in sovereigns but corporate exposures as well. And consider flexible fixed income—but where the strategy has ability to better manage those risks through its flexible approach and broader risk mitigation tool kit. Such “flexible,” “unconstrained,” or “opportunistic” strategies manage the credit and interest rate risks with management styles that are not tied to the benchmark— or to the past strategies that increasingly won’t work in tomorrow’s fixed income environment.
5
0 -5
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Source: Bloomberg.
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2012
10-Year Treasury Yield
Realized Inflation
Welcome to the “new World” of Financial repression
Today’s “New World” of fixed income offers nowhere near that potential for return in 2013. The Federal Reserve’s zero interest rate policy in place since the 2008 crisis has led to a dramatic collapse in the ability to generate income from “old era” fixed income investment approaches. And the expansion of the Fed’s balance sheet to purchase Treasury and mBS securities introduced a degree of “financial repression” to the financial markets not seen since the 1940s. yields so low that they no longer compensate for inflation is the hallmark of such an implicit policy choice. But the outcome for fixed income investors is never good: the prospect of rising inflation from such policies as occurred in the 40s and 50s leads to negative fixed income returns after inflation (-3.5% in the 40s and -1% in the 50s). Furthermore, the prospect for limited interest rate declines but much larger increases introduces a larger downside return profile than upside potential. But here’s the “real” kicker: even if interest rates do nothing at all in 2013, traditional “old era” fixed income investments—that is, investments that concentrate allocation to interest rate sensitive fixed income sectors— will suffer negative returns after inflation.2
Figure 3: mOVing FrOm “Old era” TO “neW WOrld” inVesTing
“OLD ERA” ALLOCATION “NEW WORLD” ALLOCATION
INTEREST RATE RISK
2/3
CREDIT RISK
2/3
adJusTing duraTiOn/yield mismaTcH Reduce Duration | Floating Rate, Long/Short, Flexible/Strategic Increase yield | High yield, Floating Rate, Flexible/Strategic
Interest Rate Risk Credit Risk
The 2013 interest rate Outlook or “Won’t get Fooled again?”
Our outlook for interest rates in 2013 pivots on the outcome of the looming debt ceiling debate, in which we continue to anticipate an avoidance of at least the worst case scenario that replays the 2011 debacle. This outcome would support a gradual rise in rates through the coming year to 2.25% for the 10-year US Treasury. Along the way, the looming debt
so what do i do with my money? ™
At the portfolio level, investors need to look beyond the era of traditional core fixed income investing. Where a typical “old era” fixed income portfolio held two-thirds interest rate risk and only one-third credit risk, tomorrow’s “New World” strategy should reverse those weightings, holding two-thirds credit risk and only one-third interest rate risk.
2 Precisely, under unchanged interest rate scenario, the aggregate index returns approximately 1.75%, 25 basis points below our expectation for 2% realized inflation in 2013, leading to a 25 basis point loss after inflation.
“ WOn’ T ge T FOOled ag ain”… and mOre OF m y FaVOriTe THeme (sOngs) FOr 2013
[3]
CITIGROUP ECONOMIC SURPRISE INDEX
ceiling debate along with the host of uncertainties will mean a considerable range in rates potentially as large as 50 basis points on either side of that 2.25% forecast. Continued Fed policy accommodation likely limits the scope for more increases than that in 2013. However, were policymakers to fail to come to an agreement on the postponed spending cuts necessary to strike agreement on raising the debt ceiling, it is likely that interest rates would remain low for longer amid the extended economic uncertainty. On the other hand, the outlook for inflation appears more clearly benign, excluding the volatile food and energy components. We expect inflation will hold steady at least for now given the lack of wage and benefit pressures and the subdued growth environment. Ultimately, we believe the fiscal policy negotiations will be conducted without permanently damaging near term economic confidence but remain doubtful on meaningful fiscal policy reform to address the long run issues, leaving our base case as 2% economic growth but with risks to the upside. Combined with the reduction in risks of eurozone breakup and a China economic “hard landing,” the flightto-safety into Treasuries should subside in 2013, leading to our view of modest increases in interest rates. However, amid the continuing subpar recovery and weak job market, the Federal Reserve will maintain its latest form of “open ended” quantitative easing that supports financial market asset inflation and continued low interest rates. Finally, we highlight the risk to our outlook for modestly increasing rates. For the past several years, expectations for rising rates have been dashed as external risks led to heightened economic uncertainty, increased demand for Treasuries, and more Federal Reserve bond buying. To be sure, our forecast for higher rates in 2013 is more modest than in the past reflecting these concerns. yet rates could end up even lower in 2013 under the alternative scenarios of self-inflicted fiscal policy damage, or if yet another bout of external risk whether from Europe, the middle or Far East or other “hotspots” were to again arise.
Figure 4: mind THe gap? relaTiOnsHip BeTWeen raTes and FundamenTals Breaks dOWn in a Qe WOrld
150
Operation twist 66% Correlation— pre-Euro crisis, pre-twist, QE3
4.5
Correlation to improving economic data breaks down 4
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50
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US 10Y INTEREST RATE
0 2.5 -50 2 1.5 1
-100
-150
1/09 6/09 1/10 6/10 1/11 6/11 1/12 6/12 12/12
Citigroup Economic Surprise Index (LHS) 10-Year Interest Rate
Source: BlackRock, Bloomberg, Citigroup Research
towards signaling rising rates on any perceived temporary economic strengthening. On the other hand, it is aggressive at meeting expectations for ever-increasing amounts of policy accommodation. This policy reaction has led to a one-way correlation between rates and fundamentals: lower growth associated with declining rates but more limited increases in rates from higher growth. Similar to this time last year, the gap between low rates and rising economic growth suggests higher rates, yet persistent policy accommodation – in effect “soft” “financial repression” holds down those increases. The prospects for a meaningful shift in housing (as we detail below), and more caution from the Fed from furthering unconventional policy at today’s balance sheet size, suggests that 2013 could see an important shift in the prospects of future policy–signaling moving the US ever so gradually towards easing off the accommodation. The limits of a still highly leveraged economy (let alone a highly levered government sector) limit the scope of any such increases, and hence our forecast for modest increases in rates in 2013. On the risk side stands the prospect that yet again economic growth that appears to be strengthening at the end of one year only to disappoint in the beginning of the next. This year’s disappointment may yet lie in the fiscal debate just past as the impact of the expiring payroll tax provisions plus continued fiscal uncertainty raise the risk of dampening spending from both declining disposable income as well as declining confidence. Those scenarios remain a risk to our otherwise constructive outlook on gradual yet modest
Turning The Old rules on Their Head
In today’s “New World” of fixed income the old rules are turned upside down. Financial markets react more to the economy’s performance for its impact on monetary policy expectations than to monetary policy’s impact on the economy. Figure 4 above highlights how the relationship between economic fundamentals and interest rates has broken down during the latest iteration of Fed monetary policy. In the current monetary policy environment, Fed policy reacts in a skewed fashion: on the one hand, it is cautious
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January Fixed incOme marke T sTr aTegy
stability in US economic growth leading to modest increases in interest rates over the course of the year.
like a rolling loan
“How does it feel?” The double digit returns of the high yield market over the past year felt pretty good. But lower starting yields means lowering asset class return projections in 2013 to mid to high single digits. We stay “overweight” high yield as those returns, while lower than in past years are still attractive for the default risk that ample global liquidity keeps at bay in 2013. However we look to reduce risk in this income segment of the portfolio by shifting high yield bond allocations into bank loans that offer similar yields but with lower risk. Broadly, today’s tremendously accommodative monetary environment supports corporations’ access to debt markets and refinancing options. That helps keep default risk low, which offsets the risks of owning credit instruments. We expect default rates to remain low even in a weak growth environment. Corporate default risk is lessened as virtually all high yield borrowers have access to the market to refinance debt, reduce interest expense, extend maturities and better their terms. Furthermore, many of the weakest companies defaulted and restructured or liquidated in the 2008–2009 financial crisis, leaving behind a market with overall stronger balance sheets enabling them greater ability to weather an economic downturn. That doesn’t mean high yield won’t have its bouts of risk-off; less cushion in the form of lower yields in 2013 means a need to be more tactical with the asset class than in past years. Lower starting yields and higher starting prices means lowering asset class return projections in 2013 from the past few years of double digit returns into the mid to high single digits for 2013. As such, investors should consider diversifying their exposures in high yield to include loans and secured credit.
These offer yields at more compelling valuations than typical high yield bonds. Overall, while likely generating lower returns in 2013, the high yield, loan and secured bond asset classes still offer attractive yields in the context of ample global liquidity that keeps default risk at bay in 2013.
The Way We Were
“What’s too painful to remember, we simply choose to forget…” And yes, that is a Barbara Streisand reference. At the root of the last credit crisis stood overly accommodative monetary policy fueling asset price bubbles. Have policymakers learned any lessons? Persistent accommodative monetary policy remains the key determinant of risky asset price performance in 2013: more money printing means more asset price inflation. That makes risky assets – stocks and the most credit sensitive bonds – the best performing asset classes in 2013.
Figure 6: 2013 reTurn scenariOs in Fixed incOme
us 10 year treasury 1.75% 2.25% 2.75% Barclays aggregate 1.70% 0.72% -0.40%
Source: BlackRock.
Bond Bubble? no, Bonds are the “anti-Bubble” asset
An asset price bubble is when the expectation that the price can only go higher forms the only rationale for purchase. Residential real estate before the crash, internet stocks in the late 90s and gold today all depict such characteristics. But for fixed income, in answering the “bond bubble” question, the main motivation of investors for buying fixed income is the opposite of typical bubbles: the fear of losing money rather than the greed of potential profit has fueled the historic shift of assets into fixed income. That makes if anything bonds the “anti-bubble”: investors buy them because they expect that they cannot go down. The risk however for investors in 2013 is that even with our outlook for only modest increases in interest rates, returns available in core fixed income will not keep up with inflation we expect to range around 2% in 2013. And as the scenario table in Figure 6 highlights, rates at the higher end of our range may lead to negative returns even before considering the impact of inflation. In an asset price bubble, it is leverage —the willingness and ability to borrow money—that fuels the price increases and reinforces their ascent. Rising prices fuel greater expectations for rising prices. And that expectation creates more
Figure 5: Hy spreads Vs. deFaulTs
2000 SPREAD-TO-WORST (BPS) 16% TRAILING 12 MONTH DEFAULT RATE
1500
12
1000
8
500 4
0
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1986 1990 1994 1998 2002 2006 2010 2012
High Yield Spread-to-Worst High Yield Default Rate
Source: Moody’s, JP Morgan.
“ WOn’ T ge T FOOled ag ain”… and mOre OF m y FaVOriTe THeme (sOngs) FOr 2013
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willingness and ability to borrow against the rising value of the asset. Credit fueled bubbles are strongly reinforcing – until they ultimately collapse under the weight of their own debt. In broad terms, such a scenario characterized the lead up to the housing market fueled credit crisis of 2008. One key feature of that pre-crisis environment encouraging the use of leverage was monetary policy. In its response to the crash of the previous bubble – the tech stock bubble – the Fed first cut interest rates aggressively in 2001, then held the policy rate below the level of inflation from 2002 through 2005. Low interest rates create an incentive to borrow, but the size of the incentive is related to inflation: when inflation is higher than your interest rate inflation effectively helps to pay off the debt. Today’s policy environment of negative real interest rates resembles that prior environment of 2002 to 2005 only
but the amount of money creation – its rate of change, the length of time it will be being created and the creative forms in which its fact or promise takes place (the LTRO, the OmT, the FLS, etc)*—that determines financial market prices much more than the performance of the economy. The risk, of course, is to mistake the recovery in financial market prices for signaling the success of these policy interventions in the real economy and forget the distortions such financial market behavior can have on the real economy through the allocation of credit and the pricing of risk. In today’s unconventional monetary policy world, it’s the impact of the economy on monetary policy rather than the other way round that determines asset prices. And in the lyrics of the song, “But it’s the laughter, that we remember, when we remember, the way we were.”
Figure 7: mOneTary pOlicy Fuels asseT inFlaTiOn
2000 3500
movin’ Out
Of the basement, that is; representing our housing recovery theme and a great source of optimism to the economic outlook in 2013. Of the key changes in the macro outlook for 2013, a definitive turn in the housing market stands as one of the most important potential reasons to expect better than expected growth in 2013. Housing and its collapse stood at the root of both the crisis and the slow growth aftermath going on over four years. And the failure of the Fed’s reflation policy as described above to migrate successfully into the housing market accounts for both the continued tepid recovery and the robust monetary policy response up to today’s unlimited promise of money creation termed “QE infinity.”
FED BALANCE SHEET ($BN)
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Federal Reserve Balance Sheet ($BN, RHS)
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Figure 8: Banks lag HOmeBuilders On “HOusing recOVery”
600 500 HOMEBUILDERS (LHS) 120 100 80 60 40 20 0
Source: Bloomberg, Federal Reserve
it’s gone global. Today every single major developed central bank runs negative real interest rates. And unlike in 2010 and 2011, in 2012 and 2013 emerging markets are also running more accommodative policy as opposed to tightening policy making the currency outlook more ambiguous than in prior periods of Fed quantitative easing. Together, this global policy accommodation fuels inflation of a different sort, inflation in asset prices. That feature explains the disconnect between financial asset price performance where US stocks increased double digits and risky portions of fixed income such as High yield returned nearly 16% while the economy barely grew above 2%. In a world of massive money creation from global central banks, the fundamental driver of asset prices is not fundamentals
400 300 200 100 0
BANK (RHS)
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Banks (RHS)
Homebuilder (LHS)
Source: Bloomberg. Note Banks represented by KBW Bank index; Homebuilders by S&P 500 Homebuilding Index.
* LTRO - Long-Term Refinancing Operations; OMT – Outright Monetary Transactions; FLS – Funding for Lending Scheme
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January Fixed incOme marke T sTr aTegy
To what end? To the recovery in the job market before fueling inflation hopes the Fed. The slow road to that recovery went through the inability of the mortgage market to transmit the policy accommodation into the housing market: unintended policy actions restrained the growth of credit while persistent weak hiring from a lack of business confidence restrained demand as the “kids in the basement” delayed household formation due to want of a job. Now it appears all of that may be about to change to the benefit of better than expected economic growth. While we share these views, the trouble is so too does everyone else. Housing recovery-themed investment strategies already outperformed last year. With so much hope for such a recovery priced into the market, the risk is disappointment in 2013, particularly in homebuilder stocks. However, other beneficiaries exist including bank bonds in the investment grade market and credit areas of the mortgage market though admittedly with more limited upside than last year given current prices. going further down the capital structure in banks also makes sense as bank equities have significantly lagged other housing recovery themed sectors (e.g. homebuilders as indicated in Figure 8) suggesting banks can outperform homebuilders in 2013.
of an economy, especially one in which the share of manufacturing is nearly 50%. Figure 9 shows the “Li Keqiang Index” relative to official gdP. given this index doesn’t capture much in service sectors, it is more volatile than gdP growth. As we can see, starting from beginning of 2012, the index started a broad decline before it rebounded in fourth quarter, helped by increase in fixed investment and easing monetary policy. These two policy levers represent the “traditional” policy accommodation levers used by China policy makers to stimulate (and restrain) the economy. Little by way of “transformational” policy has been accomplished in that most of the economy is still heavily geared towards production, investment and exports and a strikingly low (by historical and geographical comparison) level of domestic consumption. Figure 9 highlights that these traditional policy levers suggest better economic performance from China in 2013.
Figure 9: HOW Will i knOW? ask li keQiang
25% 20 REAL GDP GROWTH (%) 15 10 5 0 -5
How Will i know?
“Just trust your feelings…” When it comes to the impact China has on the global economic outlook, probably better to dig deeper. At the end of 2012, China’s growth slowdown appears to have stabilized on the successful application of its traditional policy tool of ramping up infrastructure investment and easing credit. However, the longer–run outlook depends critically on the ability of the new leadership to implement key structural reforms. That ability remains uncertain and with it a more uncertain longer run outlook for China’s growth. For 2013 however, China likely supports the global growth outlook, fueling continued strong emerging market performance.
2004 2005 2006 2007 2008 2009 2010 2011 2012
GDP Growth Rate Change in Li-Keqiang Index YoY (Electricity Consumption, Rail Cargo, Bank Loans)
Source: National Bureau of Statistics of China, Citi Research
ask (incoming premier) li keqiang
The potential for political considerations to impact the calculation of Chinese economic statistics leads to the questioning of the accuracy of China’s official economic releases. These concerns were validated quite unintentionally in a WikiLeaks memo from 2007. When he was party leader of northeastern Liao Ning province, China’s incoming premier Li Keqiang shared with then-U.S. Ambassodor to China Clark Randt that he didn’t rely on provincial gdP data because they were man-made and “for reference” only. Instead, he focused on just three data points to evaluate Liao Ning’s economy: electricity consumption, rail cargo volume and bank lending. These three data points summarized the input (electricity consumption), output (rail cargo) and credit (bank lending)
Longer term, the ability to sustain this level of growth hinges on the adoption and successful implementation of critical structural reforms. For example, according to the China Institute for Reform and development, rising rates of urbanization could account for increasing consumption share of gdP from current levels around 35-40% to 55% over the next decade. China’s successful transition to a consumptiondriven economy hinges on China’s ongoing reforms in the resident registration system, the financial system (interest rate liberalization, exchange rate liberalization and financial market liberalization), and factor price liberalization (removing price controls both subsidies and caps). Key to monitoring progress along these lines will be the National Peoples Congress and Consultative conferences in march and the 3rd Plenary
“ WOn’ T ge T FOOled ag ain”… and mOre OF m y FaVOriTe THeme (sOngs) FOr 2013
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session of the 18th Party Congress in the Fall of 2013. For the short term, we’ll watch both the official sector data and Li Keqiang’s recommended sectors to answer “How will I know?”
Figure 10: Japan OuTlOOk Hinges On reFlaTiOn OpTimism
12000 95 90 JPY/USD SPOT 85 10000 80 9000 75 70
Turning Japanese
NIKKEI INDEX
Or should we say “Turning Bernankese”? Japan takes a page out of the Fed playbook and may finally successfully reflate. Though now consensus viewpoints, a weaker yen fuels a stronger Japan equity market in 2013, however, we would look for some pull–back in the first quarter. While we would be cautious about extrapolating too much of the 2012 surprise story into 2013, the broader implications of a scenario of Japan reflation need to be considered for the outlook in 2013. For much of the past 20 years, global growth prospects have been held back by the lost decades in Japan: real growth rates that barely notched above 2%. Lost in the focus of developed market growth difficulties in the US and eurozone and emerging market growth optimism stands the lack of Japanese growth. There is a dichotomy between the share Japan represents of the world economy (just under 10%) and its share of the world’s economic growth (negative in 2011). Even a modest shift in Japan growth from more aggressive monetary policy holds the prospect for upside surprise in global growth in 2013. Whether the incoming Abe administration and the potential changes can meet the market’s expectations for currency
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Source: Bloomberg
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JPY/USD (R)
weakness and reflationary domestic monetary policy remains to be seen. To be sure, prior bouts of Japan optimism have been met with disappointment. However, taking a page out of the other developed central bank policies of massive money creation suggests a more significant expansionary monetary policy in Japan may be on its way along with a contribution to global liquidity and asset inflation that the Fed and the ECB so far have led.
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The sector performance and yields listed are represented by, respectively: Barclays US High Yield Index, S&P Leveraged Loan Index, Barclays US Securitized Ex-MBS Index, Barclays US Mortgage Backed Securities Index, Barclays US Corporate Investment Grade Index, Barclays Global Aggregate ex-USD Index, JP Morgan EMBI Global Diversified Index, Barclays US Inflation Protected Securities Index and Barclays US Treasury Index. The reference indices are represented by the Barclays US Aggregate and the Barclays Municipal Bond Index. Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Investments in non-investment-grade debt securities (“high yield” or “junk” bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments in emerging/developing markets or smaller capital markets. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.
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