Outlook
The outlook for 2015 is for good economic growth ranging from 2.5% - 3.0%, low inflation at 1.5%, and for the unemployment rate to be less than 5.5%. However, there are some indications at quarter end that the economic recovery might be losing some momentum. The Fed is expected to raise its target range for the federal funds rate in 2015 even if inflation remains below its 2% target.
Inflation appears to be low and may give the FOMC reason to be slow in raising rates. The Fed is expected to be slower in the pace and size of rate hikes than in previous periods such as the 2005-2007 hiking period. The final rate is also expected to be lower than historically.
Federal Reserve
US growth will maintain a modest, but above-trend, pace of growth for the remainder of 2015. Inflation should begin to rise gradually towards the Fed’s target of 2%, though potential currency and commodity influences will be closely monitored. The Fed is anxious to begin the process of unwinding its massive accommodation program but as of now, only one Fed rate hike is likely in 2015.
Christine Lagarde, IMF chief, made statements during the quarter that it would be best for the US Fed to postpone raising interest rates this year. Although the Fed responded that they were independent, it appears that the most recent dovish FOMC comments did recognize a concern for international financial events.
The Fed has now indicated that international considerations will also be an important factor in determining the timing, frequency and scale of its rate hikes. The Fed has now begun to focus on the recent Greek financial distress, China’s slower growth, and their potential impact on market volatility.
Trade also continues to be a primary focus for the Fed. Concern about economic growth, the strength of the USD and the effects of lower energy prices were prominently mentioned in the Fed minutes.
The Fed is positive about the underlying consumer spending over the medium-term, improvement in jobs, the wealth effect from improved housing and stock valuations, stronger consumer balance sheets, lower energy prices and higher consumer confidence. The Fed is tracking payroll gains and labor market slack with less emphasis on wage growth. The recent economic data indicates that the economic recovery is starting to lose momentum.
Interest Rate Hikes
The FOMC lowered their interest rate forecast by 50 bps in 2015. FOMC continues to be dovish, now signaling a September rate hike to be unlikely. Most market participants expect one modest rate hike by year-end 2015. The continued global disinflationary trend and the limited supply of conservative bonds will help keep interest rates low.
Inflation
The lack of inflationary pressures in the US will keep long-term rates low, however the longer the Fed delays raising short-term rates the greater the chance of rising inflation expectations.
Fixed Income Markets
Two-year Treasury yields ended June 9 basis points higher quarter over quarter at 0.65% after hitting a high of 0.73% in mid-June. The impasse between Greece and its European creditors led to a flight to quality as Treasury yields partially reversed their rise over the quarter. Yields ended the month 3-14 basis points higher across 2 year to 5 year maturities as the curve steepened by 12 basis points.
Yields climbed higher during the quarter, and the yield curve steepened. The US economy continues to improve, with the employment situation improving at a healthy pace. This is beginning to shorten investors’ expectations for the first Federal Reserve rate hike.
Credit spreads widened as market participants dealt with heavy new issue supply in the face of growing concerns over the liquidity available in the corporate bond market. Lower quality and off-the-run securities experienced the most spread widening.
Corporate yield spreads were wider in June as record issuance year to date, lower liquidity and ongoing developments in Greece are pressuring secondary markets. Demand for new issues remains robust. Short duration corporate yield spreads are back to the wide levels of early 2015.
Despite the higher yields and wider spreads, investment grade corporate bonds managed to generate a meager positive return for the quarter due to the higher coupon income offered over Treasury and agency securities.
Leverage continues to rise in industrials. Idiosyncratic risk is rising due to ongoing M&A activity and shareholder activism. Financial balance sheets are strong as asset quality continues to improve and capital levels and liquidity remain solid. New issue supply will be driven by M&A activity and banks issuing to reach required capital levels.
Liquidity
The cost of liquidity has risen with wider bid-offer spreads due to the lack of dealers willing to be market-makers. The amount of time needed to transact increases as traders seek liquidity sources. Investors can expect longer holding periods and less trading of their investment positions. Declining liquidity may also increase volatility. Smaller dealer balance sheets, an overall risk averse tone to the market and robust new issue supply all contributed to weak liquidity in the market during the quarter.
Bank Credit Ratings
Moody’s concluded their review of global investment banks with results better than expected. S&P results are still pending.
Moody’s updated bank rating methodology incorporates several solvency and liquidity factors. Their intent is to predict bank failures and determine how each creditor class may be treated when a bank fails. The new approach is based on their experience from the global financial crisis and changes in banking regulation.
Greece, Puerto Rico and China
Developments in Greece and Puerto Rico heightened the potential for event risk and volatility during the quarter. China’s domestic equity dramatic sell-off raised concerns.
All three areas were distractions to the markets during the quarter contributing to increased market volatility.
Greece and the Euro
The likelihood of Greece exiting the Eurozone increased dramatically as Greece missed a €1.6 billion payment to the IMF, stopped negotiations to call a national referendum on a bailout proposal, and imposed capital controls when the ECB halted expansion of Emergency Liquidity Assistance (ELA) funding for Greek banks. Greek voters rejected the bailout proposal which caused the crisis to worsen immediately. The Greek crisis has settled down with the recent 3-year bail-out agreements being hammered out.
A Greek exit might have triggered unexpected systemic risks and impacted Europe’s economic recovery which has been responding well to the ECB’s aggressive stimulus program.
Puerto Rico and the US Municipal Market
The market is now awaiting further news as to the fiscal situation in Puerto Rico which has adversely impacted some sectors of the municipal bond market. A study published in June recommended debt relief as part of a comprehensive package of economic and fiscal reforms for Puerto Rico. Governor Padilla later announced that Puerto Rico’s level of debt was unsustainable. This raised serious concerns about the Commonwealth’s ability to pay its debt. A default event could trigger wide volatility in US bond markets, specifically the municipal market.
China and China-A Shares
The coordinated aggressive Chinese banking, brokerage and government stimulus program now appears to be taking effect by stabilizing the domestic Chinese equity market’s dramatic sell-off. Fortunately, the sell-off was limited to Chinese domestic retail investors and did not impact foreign and US markets.