Market Review and Outlook 4th Quarter 2013
The year 2013 opened with considerable uncertainty, yet concluded with the highest degree of market confidence in the US economy that we have seen in some time. Rising interest rates were mostly offset by the income generated by intermediate high grade bond portfolios, with total returns essentially flat or modestly down this year. However, this increase gave us the opportunity to selectively buy bonds throughout the year, which we believe has enhanced performance prospects for 2014.
The year was marked by a large dispersion of returns across the yield curve, as evidenced by the significant difference between the Barclay’s 5 Year Municipal Index’s 0.81% return and the Barclays 1 to 10 Year Index’s -0.32%. While the 5 Year Index had a positive return, the 7 Year Index – only 2 years longer – was down 0.97%. This is an unusually large performance difference between bonds whose maturities are in such close proximity and it highlights the challenging nature of bond investing in 2013, but, in our opinion, it also suggests some opportunities for 2014.
2013 in Review
The year opened with the threat of the “fiscal cliff”, a combination of expiring tax cuts and required government spending cuts which together were expected to destabilize an already precarious economy. Last minute legislation, passed on January 1, 2013, provided temporary relief and gave the markets breathing room to adjust to the actual implementation of the spending sequester later in the year.
Anxiety about the fiscal cliff gave way to concerns about a new term that entered the market’s lexicon: “Fed tapering,” which described the systematic reduction of some $85 billion of monthly bond purchases in the program known as Quantitative Easing (QE). Bond market participants had mixed opinions on tapering, as did various Fed officials. Some were concerned that the tapering would come too soon and the economy would weaken, while others were alarmed by continued Fed buying and the ever-increasing size of its balance sheet. Many concluded that the beneficial effects of continued buying were diminishing and a change in the Fed’s policy was inevitable.
The municipal market experienced its share of headline turbulence as well, led by Detroit’s bankruptcy filing and the real possibility of Puerto Rico’s downgrade to non-investment status. Ultimately, these factors had relatively little impact on the broader municipal market. On the positive side, the market also took note of Illinois’ bi-partisan effort to finally address, at least in a preliminary manner, its large unfunded pension liabilities.
Municipal bond issuance in 2013 totaled $330 billion, which represents a significant drop from 2012’s $380 billion. Most of the fall off is attributable to a decline in refundings as interest rates rose, which had been a disproportionately large share of issuance in recent years. It is still unclear whether there will be a material increase in 2014’s municipal bond issuance, but demand for municipals remains strong despite the mutual fund outflows that occurred in 2013.
Domestically, the consumer began to save a little less and spend a bit more, although renewed sluggishness in job creation at the end of the year probably dampened some of the enthusiasm. An improved consumer balance sheet, in the form of better housing prices and higher investment portfolio values that benefitted from a powerful stock market rally, played a role.
The debt-ceiling and sequestration squabbles in Congress weighed on bonds for much of the year. In October, the government was forced to shut down, however briefly, but the markets seemed to take it all in stride. Interestingly, the crescendo in political acrimony seems to have peaked with the shutdown and, although there is a new debt ceiling vote expected again in February, this issue is not generating the level of concern that prior votes did.
The bond markets spent the second half of 2013 anxiously anticipating a Fed tapering. The Fed’s September announcement indicated that the Central Bank needed more proof that developing improvements were sustainable, and cautioned that an increase in interest rates might threaten the recovery. In all likelihood, the Fed was also concerned about the impact of the impending government shutdown that occurred a few weeks later. The September announcement also saw the Fed lower its forecast of U.S. economic growth from 2.3% to 2.0% for 2013. Just months earlier, its growth forecast had been 2.6%. Clearly, the Fed’s growth expectations were not being met and it intended to remain in a conservative posture until stronger growth was more evident.
However, in December, the tapering that the bond markets had been expecting was finally announced. Perhaps because it had been so publically debated for the better part of a year, its actual arrival was not as destabilizing as the fear of it had been earlier in the year.
4th Quarter Review
The fourth quarter opened with the government shutdown that many had feared. It lasted 16 days and ended just hours before the U.S. government was set to breach its spending limit, avoiding the uncertain consequences of a default. The negative impact on U.S. GDP was estimated to be between 0.5% and 1.0%. When one considers that GDP for the entire year 2013 was only around 2.0%, the drag was substantial.
In December, the federal judge in the Detroit bankruptcy case ruled that the city’s bankruptcy filing could proceed, at the same time allowing for the possibility that the city’s pension payments could be reduced in the restructuring of the city’s $18 billion debt. In a pronouncement which would have far-reaching consequences if upheld, the judge ruled that beneficiaries of the city’s pension fund do not have any extraordinary protections above normal contract rights. If upheld, this would be a positive event for bondholders. As of this writing, Detroit’s pension funds are pushing for an expedited appeal of this ruling, while the city’s attorneys have argued that an expedited appeal would threaten the negotiations between the city and its other creditors.
The highly visible challenges arising from Detroit’s unfunded pension dilemma may have provided some of the motivation for Illinois to focus on its own unfunded pension obligations and those of its municipal subdivisions. In a bill that was quietly signed into law in early December, the Illinois legislature and Governor Quinn sought to curb cost-of-living increases for the state’s retirees and to require current workers to skip five annual cost of living increases when they retire. Illinois is also seeking to boost the retirement age for current workers by up to five years, in exchange for a one percent decrease in their pension contributions. It is hoped that this might save $160 billion over the next 30 years and would be a significant step towards restoring the state’s credit quality – now rated the lowest of the 50 states. As expected, the state’s public unions are filing suit against the legislation and the outcome will likely be decided in court.
As we look forward into 2014
Given the uncertainty with which the year opened and the turbulence which it experienced, the year ended on a surprisingly calm note. The new year begins with almost universal optimism for US and global growth, which contrasts markedly with 2013’s more somber start. And while we share the hope that in 2014 the world economy will finally put the Great Recession behind it, it is important to remember that bonds remain an effective means, for many investors, to diversify asset allocation with the potential benefits of income generation and low volatility compared to riskier asset classes.
In Washington, political friction has abated since the brinksmanship of the October government shutdown. The improved atmosphere also allowed for a smoother transition than expected at the Federal Reserve (although the vote was more divided than normal), with Janet Yellen replacing Ben Bernanke as Chairperson. We believe that she will continue the spirit of Bernanke’s policies and approach, but recognize that she has the experience and intellect to act and to make changes where required.
How the current labor environment will play into Fed policy remains to be seen. The unemployment rate now stands at 6.7%, only a fraction above the Fed’s target of 6.5%. Despite the falling unemployment rate, job has slowed and the labor participation rate is at a 30 year low, so reaching the 6.5% threshold may not actually suffice to trigger a shift in Fed policy.
How the approach of mid-term elections will affect the currently calm political environment is also uncertain. The implementation and evolution of the Affordable Care Act is likely to play some role in both the posturing and the election. Also unclear is the degree to which the Fed will continue its bond purchases, and under what conditions it would decide to taper further.
For the first time in many years, we begin a new year without much in the way of visible economic headwinds, and the financial press is almost unanimously positive in its outlook for economic growth. Accommodative monetary policy is now the global norm, which may be viewed as a testament to the Bernanke Fed’s success. Perhaps the main headwind could turn out to be too much market complacency.
Although interest rates ended the year higher, we remain in the historically low rate environment that has prevailed globally for the last several years. While it is possible that rates will edge up further as growth improves, they are unlikely to rise significantly without a substantial change in Fed policy. A policy change of that magnitude would probably require an upswing in economic activity that could move GDP growth meaningfully above its current 2% level, as well as an improvement in the slow job creation rate. While we see a lot of positives for growth and jobs, we see them occurring gradually.
Municipal yield curve slopes are near historic steepness per Exhibit 5. We continue to target a barbell portfolio structure, which we expect to perform more favorably in a flattening environment. Also, we remain invested with maturities and durations broadly in line with benchmark durations.
The opinions expressed herein are solely attributable to Samson and should not be construed as an offer to buy or a solicitation to sell any securities. Inherent in any investment is the risk of loss. All factual information and statistical data in this document were obtained or derived from public sources. Samson makes no representations that such information or statistical data is accurate or complete. No person to whom a copy of this document has been delivered should rely on any such factual information or statistical data as being accurate or complete and should not undertake any investment program based on such information contained in this document. Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Past performance is not indicative of future results. All estimates, opinions and analysis in this document constitute judgments made by Samson as of the date of this document and are subject to change without notice. Samson has no obligation or duty to inform any person to whom a copy of this document has been delivered of any change in any estimate, opinion or analysis in this document or to update the document on a going forward basis.