SH: 2013: A year in US fixed income

David Harris, Head of US Multi-Sector Fixed Income

Yields on treasuries and cash are set to remain at depressed levels. As a result, demand among investors for yield will remain high and this will lead to further spread tightening in non-treasury sectors. However, given the tighter starting point for spreads as we enter 2013, a full repeat of the market performance of 2012 is unlikely.

Fiscal cliff

The outlook for 2013 hinges to a great extent on the outcome of the ongoing US fiscal negotiations. Economic growth prospects are highly dependent on the composition of spending cuts, tax increases and the secondary effects of any such actions. It remains unclear whether a resolution will be found, and nearly every outcome will result in some economic drag. Another deferral of tough decisions would prolong uncertainty and risks a US credit downgrade and a loss of confidence in the US. The chances of improving competitiveness through a major tax and regulatory overhaul are low.

Base case

Our base case is for a compromise which eliminates tax increases for most and removes the obligatory spending cuts to key sectors like defence. Tax increases on high income earners are likely, possibly through caps on total deductions, and the payroll tax cut will probably be eliminated. The prospect of large scale entitlement reform is remote.

The result of such a scenario is for private sector growth to continue in 2013 at a rate of around 2%, while fiscal austerity (through either tax increases or spending cuts) will subtract between 1-2% of GDP. While there could be some release of pent-up demand for hiring or investment spending once the uncertainty passes, it will not be enough to fully offset the fiscal drag.

Alternative scenarios

There are clearly alternative fiscal scenarios that are less favourable. An impasse could be devastating for growth if the full fiscal cliff were allowed to hit, subtracting roughly 4% from growth – and possibly more as business investment is retracted. Likewise, a deferral prolongs the uncertainty and curtails new investment, while another ratings downgrade also could disrupt markets. A major overhaul on the tax and regulatory front is the most optimistic outcome, though the odds are extremely low.

Low growth environment

US economic activity is still being restrained by tight overall credit conditions and widespread efforts to reduce debt. A return to the pre-2007 growth rate of 3-4% is not possible without broad increases in credit creation.

Housing appears to have bottomed and will be a small contributor to growth. However, due to tight restrictions on cash-out financing the ability for homeowners to monetise gains is severely restricted.

In this low growth environment, job creation will remain positive but low enough so that the unemployment rate only falls gradually. And inflation pressures will be non-existent in most sectors.

There are otherwise few areas that could cause a lasting positive surprise to growth. Consumer balance sheets remain in repair mode. Accumulated savings and asset wealth gains are as yet insufficient to sustain a consumption-led recovery. However, corporate deleveraging has been significant and borrowing at a state and municipal level has stabilised.

Business spending could pick up quickly if we see a resolution of the fiscal cliff. On the other hand, the siege mentality of cost control and restrained spending is likely to remain as long as the regulatory climate remains unfavourable and concerns about the consumer persist.

Differences to 2012

The main bond market themes look a lot like those of a year ago, with the major exceptions that: systemic risks surrounding European financial contagion have fallen; political risks in the US have been replaced by near-term fiscal uncertainty; overall risk premiums have fallen, offering less compensation for the remaining market risks.

Fed actions

The Federal Reserve (Fed) will respond to the slow growth and fiscal austerity with continued bond market purchases which will inhibit yield increases for treasuries and mortgage backed securities (MBS. Indeed, the Fed should continue its programme of purchasing $40 billion a month in MBS – plus reinvestment of principal and interest – and another $45 billion per month in long-dated treasuries through all of 2013.

Interest rates will remain exceptionally low throughout the year with cash yields holding near zero as the Fed follows through on its promise to hold rates low until 2015. The 10-year treasury yield is likely to stay around the 1.75% mark, perhaps fluctuating by .375% in either direction.

Investor demand

Persistently low cash and treasury yields will promote intense demand for yield among investors. Flows from cash into corporate bonds, high yield and emerging markets will put continued pressure on yield spreads and cause them to gradually narrow. Moreover, with high growth uncertainty, and profitability already near record levels, fixed income markets are unlikely to suffer from a widespread rotation into equities.

Lower returns than 2012

Given the tighter starting point, declines in risk premiums will be far less pronounced than last year, so overall excess returns from non-treasury assets will be much lower.

Allocations to non-Treasury sectors will remain a driver of outperformance in US fixed income, but security and industry selection will make a much larger contribution to returns. All in all, the combination of treasury yields holding steady and modestly positive excess returns means that total returns should be positive and well ahead of cash investments.

Investment strategy

We are faced with several challenges in 2013. First is the low overall yield environment, where long exposure to interest rates is unattractive compared to any past period, but where positive interest rate exposure can continue to be an efficient hedge against weaker growth and rising risk premiums.

The second challenge is in the low level of risk premiums themselves. Many of the highest quality corporate bond issuers have little intention of further improving their balance sheet and their bonds fully reflect fundamentals. Lower-rated companies offer more yield yet are much more sensitive to below consensus growth, or a fiscal impasse. Other sectors, such as MBS, are less exposed to economic conditions but are more sensitive to regulatory change – which may become a focus during fiscal negotiations.

In light of the fiscal uncertainties and the above challenges, we are entering 2013 cautiously positioned with positive yield and with low economic sensitivity. Holdings are focused on securitised investments collateralised by assets that generate strong cash flows under most economic outcomes. We are keeping our corporate bond holdings low and our holdings of US treasuries even lower.

Source: BONDWorld – Schroders