Economic Growth and Negligible Supply Lead to Corporate Credit Spread Tightening
Economic indicators released last week indicate that US economy is continuing to expand at a moderate pace.
Economic indicators released last week indicate that US economy is continuing to expand at a moderate pace. For example, housing data showed a noticeable improvement as both new home and existing home sales strengthened. In addition, the weaker housing readings last month were revised higher from the prior poor monthly data release. Markit's US Manufacturing Purchasing Managers Index (PMI) rebounded sharply to 55.8 (its highest reading since April 2010) from 55.8. Consumer price inflation also moderated, increasing only 0.1%, its second monthly sequential reading since peaking at 0.4% in May. Lower inflation and moderate unemployment claims allowed consumers to hit the stores, which supported continued strength in shopping center data.
As is typical in late August, only $2.5 billion of new issue corporate bonds were priced. We expect there will be few, if any, new issues priced this week as investment bankers and corporate treasury teams take the final week of summer off before the Labor day weekend. With economic indicators revealing continued economic growth and little new issuance to satiate demand, the average spread in the Morningstar Corporate Bond Index tightened three basis points to +108. In the high yield sector, the ML BofA High Yield Master II Index tightened another 18 basis points to an average spread of +379 basis points. While it's unusual for high yield spreads to move this much in late August, the spread tightening was exacerbated by a healthy $2.1 billion inflow into high yield mutual funds and ETF's, reversing some of the prior week's outflows. This inflow was the highest amount of weekly inflows registered since October 2013.
Estimated Weekly High-Yield Bond Fund Flows - source: David Sekera
While economic indicators in the US continued to show positive economic growth, metrics released in the Euro Zone and China were not as rosy. For example, Markit's Composite PMI for the Euro Zone fell to 52.8 from 53.8, and the manufacturing component reading declined to 50.8 from 51.8. The reading for China's Manufacturing PMI declined to 50.3—just slightly above the 50 demarcation that divides expansion from contraction—from 51.7. While these reading still indicate that their respective economies are expanding, the decline in the readings may indicate a deceleration in their economic growth. As such, global interest rates held steady. 10-year US Treasuries ended the week one basis point higher at 2.40%, Germany's 10-year bond remained under one percent at 0.98%, the yield on Spanish 10-year bonds once again has slipped under that of the US Treasury bond to 2.38%, and Italian 10-year bonds ended the week at 2.58%.
No New News From Economic Conference at Jackson Hole, But Fed May Revise Forward Guidance As Soon As September
There was no new news or analysis that emanated from Jackson Hole, the site of the annual Federal Reserve economic conference. Federal Reserve Chair Janet Yellen's speech was decidedly balanced, and in our view did not shed any new light upon her or the Fed's economic outlook or future plans. We continue to expect the Fed will further reduce its open market purchase program at the September meeting and the program will be completed this fall.
The Fed released its minutes from the July Federal Open Markets Committee meeting last week. Within the minutes, it was reveled that several participants were increasingly uncomfortable with the Committee's forward guidance and suggested that the language should be revised. We suspect that the Fed may change its forward guidance at the September meeting (16th & 17th) away from its assertion that it "will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends," to language that provides the Fed with more flexibility to begin raising the rates as soon as next Spring. We think the change may occur at the September meeting for two reasons. First, it appears that additional members are uncomfortable with the existing language as "labor market conditions and inflation had moved closer to the Committee's longer-run objectives in recent months, and most anticipated that progress toward those goals would continue." Second, following the September meeting, the FOMC will publish its updated Summary of Economic Projections and the Chair will hold a press conference. This will allow the Fed to publicly update its economic forecasts while also allowing Fed Chair Yellen the opportunity to explain why the Fed has made the change and guide investors to how they should interpret the change. If the Fed does not take the opportunity to make the change at the September meeting, then it will likely hold off on making such an important change until the December meeting, which will be the next meeting scheduled to release economic projections and hold a press conference.
China: GDP Rebounds, But Underlying Fundamentals Deteriorating
Dan Rohr, Morningstar's Strategist for the Basic Material's Sector, published a report last week entitled False Dawn. This publication supported his opinion that while the uptick in China's second quarter GDP has comforted many investors, it shouldn't have. Immediately following the release of China's second quarter GDP, many economic commentators have stated that the uptick in sequential GDP growth to 7.5% from 7.4% was an indication that the most recent government stimulus has reversed the trend of an economic slowdown; however, based on Dan's analysis, it appears that the underlying fundamentals have deteriorated.
China's economy has continued to overly-rely upon infrastructure spending. In the first half of 2014, gross capital formation added over 3.6 percentage points to GDP growth; whereas, household consumption only contributed 2.9% points. This is about the same ratio of GDP contribution from each over the past seven years and will not be sustainable over the long run. As physical capital has exceeded the country's needs, the debt required to fund gross capital formation has significantly outpaced the underlying economy. For example, from 2007 to 2013, China's total debt burden has grown 151%, more than double that of China's 68% increase in GDP over the same time frame. At the end of 2013, China's total debt/GDP has increased to more than twice that of other large emerging market economies such as Brazil, India, and Russia.
In addition, these economic commentators have attributed some of the slower growth in the first half of the year to a slowdown in the real estate market. This may appear intuitive based on a slowdown in new construction starts and a slowdown in sales, but real estate under construction continued to be higher than in the prior period. The growth in real estate under construction more than offset the slower starts and sales and thus provided a lift to second quarter GDP. In fact, it appears that real estate under construction will continue to provide growth in the third quarter, which should support a solid third quarter GDP growth rate. However, as supply is growing in spite of falling sales, new starts may remain in negative territory and floor space under construction will ebb as it's completed. As an indication of how much real estate added to GDP growth, if real estate investment did not provide any incremental growth (i.e. zero percent), Dan estimate's of China's second quarter GDP growth would have only increased by 6.7%. If the real estate market remains weak, or worsens further, he estimates a 10% decline in floor space under construction would have reduced GDP to 5.4%, holding all else equal. For an in-depth analysis, please see Dan's article published on August 15, 2014.