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Credit Insights

Corporate Credit Bond Spreads Continue to Lag Equity Rally

GDP grows 3.5%, but is likely to moderate in the fourth quarter.

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While the stock market bounded higher last week, credit spreads in the corporate bond market languished by comparison and continued to lag the equity rally. The average spread of the Morningstar Corporate Bond Index tightened less than 1 basis point and ended the week at +124. In the high-yield sector, the Bank of America Merrill Lynch High Yield Master II Index tightened a measly 8 basis points to +430. While the S&P 500 rose 2.7% and is back to hitting new all-time highs, both investment-grade and high-yield spread levels are still well wide of their tights earlier this year. The tightest level our investment-grade bond index reached earlier this year was +101 on June 24, and the tightest the high-yield index reached was +335 on June 23. Considering that the high-yield market is typically much more correlated with movements in the equity market and $1.7 billion of funds flowed into high-yield mutual funds and exchange-traded funds last week, it was surprising that high yield did not perform better.

As expected, the Federal Open Market Committee decided to finish winding down its asset-purchase program and halted any further purchases. What was unexpected was that the FOMC took on a slightly more hawkish tone (meaning the committee members may be more inclined to begin tightening monetary conditions than loosen them) than in prior statements. For example, the FOMC changed the language in its statement to note that unemployment has improved substantially since the beginning of its current asset-purchase program and underutilization of labor resources is gradually diminishing. This is a change from last month's statement, in which it noted that there remained significant underutilization of labor resources. The FOMC did keep its language that the federal funds rate would remain near zero for a considerable time following the end of its asset-purchase program. Of particular note this month, the only dissenting vote was from Narayana Kocherlakota, who is generally regarded to be one of the biggest doves on the committee. Doves are generally known for preferring looser monetary conditions such as low interest rates. He suggested that the Federal Reserve should commit to keeping the federal funds rate near zero until the outlook for inflation returns to the Fed's 2% target and should continue the asset-purchase program. This is a turnaround from last month, when it was Richard Fisher and Charles Plosser, two monetary hawks, who dissented.

Last week, we cautioned that while the European Central Bank and Bank of Japan are continuing their respective quantitative easing programs, the global markets will have to learn to survive with decreasing amounts of monetary stimulus. However, the Bank of Japan quickly tore that assertion asunder as it announced last Friday that it will raise its annual target for expanding the Japanese monetary base by approximately 15%-30%. This will increase its quantitative easing program to JPY 80 trillion from its prior range of JPY 60 trillion-70. In context, JPY 80 trillion is roughly $730 billion, or 15% of Japan's GDP in 2013. Comparatively, when the Fed began its most recent quantitative easing program in December 2012, its annual run rate was approximately $1 trillion, or 6% of our GDP. In addition, shortly after the Bank of Japan made its announcement, the government's $1.2 trillion Government Pension Investment Fund announced that it was going to shift the allocation of its portfolio such that it would increase its stock allocation to 50% of the portfolio's assets, double its current exposure. The combination of these two programs will have global ramifications and resulted in a surge in asset prices worldwide on Friday.

Notable Earnings Takeaways
The ECB released the results of its most recent bank stress tests Oct. 26. While the stock prices of a few European banks fell slightly the day after, the results were largely a nonevent. The stress test results failed to change our view of the European banks; however, we moved our recommendation on Deutsche Bank's (DB) (rating: A-, narrow moat) bonds to underweight after digesting its most recent dismal earnings release. Elevated costs from higher compensation costs and additional provisions for litigation expenses were the primary culprits. Deutsche has built up EUR 3 billion of reserves for litigation, but given the size of the bank's outstanding legal and regulatory issues, we wouldn't be surprised to see additional charges over the next two years. We are most concerned about allegations that the bank's traders manipulated foreign exchange rates, a market in which Deutsche is a top three player. Basel III common equity Tier 1 capital finished the quarter at 11.5%, unchanged from the prior quarter. While this ratio compares favorably with that of many large European peers, we would prefer to see a higher ratio given the ongoing legal expenses, low profits, and dismal economic outlook for most of Deutsche Bank's markets. As such, we see better value among several other competitors in the European banking system. For example, we maintained our overweight recommendation on UBS (UBS) (rating: A, narrow moat) following its earnings release.

GDP Grows 3.5%, but Likely to Moderate in 4Q
The Bureau of Economic Analysis reported that third-quarter gross domestic product rose at an annual rate of 3.5%. This was near our 3.4% forecast and easily surpassed market expectations for 3.1%. The third-quarter growth rate is a decrease from the 4.6% annual growth rate reported for the second quarter, but still much better than the 2.1% decline the economy suffered in the first quarter. Robert Johnson, Morningstar's director of economic analysis, said, "The recent strength is probably more of a catch-up than a start of new, higher sustained growth rate of 3% or more." He currently forecasts "growth to drop back modestly to around 3% in the fourth quarter before dropping back to 2.0%-2.5% in 2015." Johnson expects GDP growth will moderate in the fourth quarter as a few of the strongest items that had contributed to growth will probably diminish. For example, the rate of government spending increased significantly in the third quarter but will probably not accelerate at the same pace in the fourth quarter. In addition, he pointed out that net exports looked higher than he had expected. Because of congestion among several U.S. ports, imports may have been temporarily slowed and are likely to rebound in September and October. For greater detail, please see Johnson's recent weekly column, "Central Banks Take Center Stage Again."

David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.