Fixed Income
U.S. economic recovery in jeopardy
Toward a double-dip recession?
Although the economic recovery in the U.S. seemed to be following its course and talks of a double-dip recession were quieting down at the beginning of the year, a slew of disappointing economic news reports prompted a sell-off that rattled financial markets this summer as uncertainty returned.
"Times have been very tumultuous," said Colleen Denzler, Senior Vice President and Head of Fixed Income Strategy at Janus Capital Group. "The economy was growing and then we hit a lull. In addition, recent events and rhetoric in Washington added to investor unease, leading the markets to a crisis of confidence." The sell-off was driven by three main factors:
- Sovereign debt problems in the European Union intensified and began to spread from countries including Greece, Portugal and Ireland to the core of the Euro-zone, particularly Italy and Spain. The European Central Bank intervened in the markets and purchased Spanish and Italian sovereign debt stemming the rise in yields, which were pressuring the region. But policy responses thus far have been insufficient to provide a long-term solution.
- U.S. economic data began to weaken in the spring when second-quarter gross domestic product came in lower than expected at 1.3%, which was later revised to 1.0%. Even more surprising was the revision to first-quarter GDP from 1.9% to 0.4%, proof that the economic recovery wasn't as strong as originally thought.
- Congress' inability to come to a decisive agreement on the debt ceiling, instead using it as a tool to advance each party's respective fiscal policy, accelerated uncertainty in the government and in markets. Standard & Poor's downgrade of the U.S. debt to AA+ on Aug. 5 further damaged consumer and business confidence.
Crisis of confidence
"In the U.S., it's a crisis of confidence with politicians who need to show the world they can get their house in order," said Daniel Janis, Senior Portfolio Manager at Manulife Asset Management. "In Europe, it's more a structural issue of fixing problems with banks if there are write-downs with sovereigns."
This crisis of confidence is especially obvious in unemployment numbers. Businesses, which have been raising cash and paying down debt, are shunning new hires, contributing to an unemployment rate hovering around 9%. The advance figure for seasonally adjusted initial unemployment was 414,000 for the week ended Sept. 3, up 2,000 from the previous week's revised figure, according to the U.S. Department of Labor.
"On the employment side, we would like to see a trend of stabilization," said Janis. "People want to have some semblance of a policy that creates jobs."President Barack Obama's $447-billion American Jobs Act to create jobs through new spending and tax cuts was presented at the beginning of September but lawmakers and corporations didn't see it as a promising tool.
"Businesses aren't confident in their ability to plan because of the potential for higher taxes and a reduction in government spending," said Denzler. "It's not that businesses don't need to hire. Most of them are saying that they have the money to hire right now but they just don't have the confidence, so they want to wait another six months. They just don't have confidence in the road ahead." As a result of continued high unemployment and these recent events, experts have lowered their expectations for growth although few believe in a double-dip recession.
"The key question is 'are we going into a double-dip recession,' which wasn't a question in the spring," said Steven Huber, Portfolio Manager in the Fixed Income Division at T. Rowe Price. "We don't think we're going into a double-dip recession but we think the downside risk has increased," he said. Manulife expects growth between 1% and 2%, while its previous forecast was for growth of 1% to 3%. But the firm still believes it will be a good environment for credit products. Denzler at Janus also anticipates a positive growth under 2%. Cutwater Asset Management, a fixed income asset management firm with $39 billion under management, views GDP registering below trend growth of roughly 1.5% for 2011 and 2.0% for 2012.
"We have been calling for a sub-par, or 'check mark' shaped recovery since the start of the rebound two years ago," said Cliff Corso, Chief Executive and Chief Investment Officer at Cutwater.
One of the reasons that the economy may avoid a double-dip recession is that the health of corporations isn't as bad as prior to the 2008 crisis, which bodes well for fixed income products, especially corporate bonds. Companies have taken advantage of low yields to reduce leverage and extend maturities. In addition, despite some spread widening in most credit markets over the summer, these markets have remained open unlike in 2008. "In 2008, there was a major liquidity crisis around a product, subprime," explained Janis. "We don't have that degree of funding crisis currently."
Denzler said her firm continues to see "positive fundamental indicators at the individual company level as conservatism and capital structure prudence remain core tenets within corporate America."
Toward shorter economic cycles
Although most experts agree that the situation isn't as bad as prior to the 2008 recession, many of them believe the current economic cycle is unlike any others. "Typically, coming out of a recession, growth is much stronger," said T. Rowe's Huber. For Cutwater, the economy has entered a new environment it calls the "Abnormal Normal," which produces slower economic growth, increased volatility and shorter economic cycles. It differs greatly from the previous period often referred to as the "Great Moderation," which was characterized by longer economic cycles, lower interest rates and tighter credit spreads.
"One of the many reasons for this is that the Great Recession was not caused by a classic inventory shock but rather a debt shock," said Corso. For instance, the ratio of total debt-to-GDP in the U.S. skyrocketed to about 350% just prior to the crisis. To put this number in perspective, this ratio was approximately 250% during the Great Depression. "It will take a lot of time and sacrifice to bring this ratio down to a sustainable level, and if the recent debt debate in Washington is any indicator of how we will tackle this problem over the long term, we're in for a lot of pain," he said.
"Another reason we think the Abnormal Normal will persist for some time is that lack of monetary policy power in the system. We equate monetary policy to penicillin shots, and the more shots you receive, the less effective they become. With short-term rates effectively at zero and the first and second waves of quantitative easing well baked in, how effective would a third quantitative easing be?"
Corso believes volatility will continue for the next 12 months due to Europe bubbling, a fiscal issue and election in the U.S. and many emerging market central banks on a tightening campaign, a classic highly correlative recession driver.
Emerging markets: Cause for concern or growth driver?
Fixed income experts are also paying close attention to the health of emerging markets and whether they could join a potential global recession or whether they will continue to pull the rest of the world. This is an important discussion because many managers see emerging markets as offering new opportunities in the fixed income world but these opportunities will highly depend on where emerging markets are heading. The typical view is that there will be a continued growth from emerging markets, albeit lower than in previous years. This thought, which has almost become a universal truth, has many money managers nervous. "We continue to see global growth being driven by the emerging market countries with U.S. growth carried by business investment and global sales, helped along by a weaker dollar, a relative value proxy, and higher exports," said Corso. "But we are naturally becoming more concerned that the world is unprepared for slower growth out of the emerging regions if that were to occur. This could be caused by many things, for example, the vigilant Brazilian Central bank, might keep short rates too high for too long."
Denzler of Janus is concerned about slower growth in China as much of the Chinese economy is driven by consumers in the Western world, who are still trying to reduce debt and moderate their spending.
Janis of Manulife is more positive on China. "China is on a high single-digit growth path," he said. "It could slow down because of interest rate measures, but there's no recession on the horizon."
"Chinese growth is slowing," echoed Huber. "But we don't expect a hard landing. They have been taking additional steps to rein in credit." He added that across emerging markets, inflation has been a concern for much of the year, for example in Brazil. "But currently, with global growth concerns, we've seen Brazil cut rates." As the U.S. economy shifts and struggles to recover from one of the most painful crises in its history, macroeconomic events are becoming increasingly important to understand how to invest in fixed income and what the main risks are in the asset class. "I really do believe that the risk in fixed income markets has changed, now coming more from interest rates, sovereigns and from the fiscal side," concluded Denzler.
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