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Investing Commentary published on November 30, 2016

November 2016 Commentary

Summary

  • Municipal and Treasury rates rose in November, largely due to a risk-on sentiment.
  • OPEC agreed to cap production levels, boosting oil prices and further stimulating risk-on posturing.
  • The Fed stood pat in its November meeting.
  • Municipal outflows have been one of the biggest stories of November.

Market Review

Cheapening Up

At the end of every November, U.S. consumers flock to shopping malls for their first round of holiday gift-buying, hunting for some of the best bargains they'll find all year. Investment-grade (IG) bondholders, particularly municipal buyers, also look for deals, having become accustomed to searching for bargains among bonds mostly deemed as expensive. Just as Black Friday shopping can surprise shoppers with rock-bottom prices that impress even the thriftiest investors, November saw the highest yields of 10-year Treasury and AAA general obligation (GO) municipal bonds so far this year. However, all major fixed income asset classes turned in negative total returns in November, with the worst showing in Treasury and high-grade bonds, while high-yield bonds and equities did better.

Municipal and Treasury rates rose in November largely due to a risk-on sentiment that drove investors into riskier assets. Meanwhile, the Dow Jones industrial average soared to its third consecutive record close on December 8 and the Barclays Intermediate Corporate option-adjusted spread held up well, falling about 2 basis points (bps) to 107bps in November.

At the beginning of the month, oil concerns and election uncertainty prompted a risk-off stance in markets. However, many market and political trends in November prompted sentiment to turn risk-on. Early in the month, the election of Donald Trump and the conciliatory tone struck by him in his acceptance speech led to a significant increase in Treasury yields. Treasury bonds rose across the curve in November, with the largest increase occurring in the belly of the curve. On November 9, the Treasury Department auctioned $23 billion of 10-year notes at a yield of 2 percent, facing the weakest demand since March 2009.[1]

The Treasury curve had already steepened significantly prior to the election due to concerns about falling central bank support of longer-maturity bonds. However, due to Trumps stated plans of trade protection and higher spending on infrastructure, inflation expectations have risen further, prompting further steepening (see Figure 1).

Events at the end of November also stimulated risk-on sentiment. OPEC members came to an agreement to cap production levels, which reaffirms that Saudi Arabia has the ability to sway opinion at a certain pressure point. The deal, which is contingent on the cooperation of some key non-OPEC countries as well, sent oil prices higher; WTI ratcheted up to over $50 in early December versus $46.67 on November 1, per Bloomberg. Also, Trump’s nominee for Treasury Secretary, Steven Mnuchin, made comments in support of extended maturity issuance from the U.S. Treasury, and upbeat economic data fed the Treasury selloff. ADP reported growth of 216,000 in November payrolls, above an expected 170,000, per the Wall Street Journal.

In Fed news, the Fed stood pat in its November meeting, as expected. In a speech on November 17, Chair Janet Yellen pointed out that the neutral rate was low by historical standards, and said that she expects growth to continue at a “moderate pace” sufficient to strengthen labor markets and boost inflation to the 2 percent target in the next couple years. The Fed is now more dovish entering 2017, with two hawks leaving the board and two doves joining. Additionally, Fed language has shifted to acknowledge a modicum of progress on inflation. On the hawkish side, the Fed still has two dissenting votes for hiking rates in December, although this is one fewer dissenting vote than it had in September. The market currently places a 100 percent probability on a December rate hike, per Bloomberg.

In economic news, the unemployment rate decreased by 0.3 percentage point to 4.6 percent in November, and the number of unemployed declined by 387,000 to 7.4 million. These reports helped confirm a FOMC December hike for markets, although the employment report also said that the participation rate, at 62.7 percent in November, was 10bps lower than Octobers number.[2] Real gross domestic product was revised upward to a 3.2 percent annual growth rate for the third quarter. In the second quarter, real GDP increased 1.4 percent.[3]

Tax-Efficient Market Review

Muni/Treasury Comparison Shopping

Municipals started the month strong due to an expected drop in future issuance that led to strong showings from new deals in the market. Ratios dipped, and the municipal market posted inflows of $1.6 billion for the week ending November 9.

However, municipals sold off as Treasuries declined in the wake of election results. For the four trading days ending November 14, municipals closed out one of the worst performances in three years, with yields rising 18bps to 1.11 percent in the 3-year; nearly 30bps to 1.41 percent in the 5-year; 46bps to 2.16 in the 10-year; and 45bps to nearly 3 percent in the 30-year. From the end of the third quarter to November 30, yields have jumped nearly 100bps in some parts of the curve.

Municipal outflows were one of the biggest stories of November, as investors fled due to tax reform concern and rising yields. Municipal retail inflows were positive starting the month, but for the periods ending November 16, November 23 and November 30, funds showed outflows of $3.1 billion, $2.2 billion and $2.1 billion, respectively. Year-to-date inflows have been reduced to $41.7 billion, per Lipper, as of December 7.

Despite these dramatic moves, Treasury bonds had a more tempered reaction to the election. From November 9 to November 30, ratios increased across the curve. The 5-year rose more than 20bps to 101.5, the 10-year increased 17bps to 106.87 and the 30-year rose nearly 15bps to 108.2.[4]

The municipal market continued to reel post-election through month-end and the first week of December. Issuance slowed from its torrid pace in October. Several primary deals were placed on day-to-day status, including a $226 million GO bond offering from Mississippi (the state eventually priced $190 million in GOs in early December). However, while the market traded off in the latter part of the month, some deals still were able to entice buyers via higher yields and wider spreads. Overall, issuance was $23.87 billion in November, down 6 percent from November 2015.

Much of the primary market offered more value than the secondary market, as dealers were pricing new deals attractively while hanging onto existing inventory. Bids wanted have rocketed higher, remaining above $1 billion since November 9.[5]

While the presidential election was the focal point of the market, other elections also held municipal investors’ attention. In California, notable muni-related election results included voter approval of a $3.5 billion GO bond issuance to fund rehab costs for San Francisco Bay Area Rapid Transit (BART) and the approval of 92 percent of local school GO bond measures, totaling about $23 billion. In total, $70 billion in new debt was proposed in the U.S. and $55 billion was approved, led by California issuers.[6]

Looking forward, municipal investors will be monitoring Trump’s plans, including his infrastructure spending goals. In our view, it may be difficult to push through large trade deals in Republican states such as Louisiana, South Carolina, Texas and Kentucky, where the export activity is greater. Figure 2 shows who won the vote in those states.

Government Credit Market Review

IG Corporates Still on Investors’ Shopping Lists

Corporates started the month with a weaker tone due to concerns about the election and lower oil prices. However, corporates gradually improved in the risk-on environment following Trumps win.

For the week ending November 11, the Barclays Corporate Intermediate Index saw option-adjusted spreads tighten 3bps, with higher-beta sectors such as Banks, TMT and Energy performing best. As the month went on the story changed, with IG spreads giving back much of their tightening. For the month, that index tightened 2bps to finish a spread of 107bps. The Bloomberg Barclays Credit Index outperformed duration-matched Treasuries by 38bps.

The best-performing sectors included those that could benefit most from rate increases and those that could be helped by fiscal stimulus. Life Insurance, Metals and Mining, Railroads, Technology and Wirelines all had strong showings for November. The worst-performing sectors, per the Bloomberg Barclays Credit Index, were sovereigns, foreign agencies, Wireless, supranationals and leisure. Crossover credits fared the best across the investment-grade quality spectrum, while Aa-AAA credits fared the worst.[7] Longer-maturity corporates outperformed, with most credit curves flattening.

High-grade supply slowed to $77 billion in November versus $101 billion in October and $144 billion in September, per Bank of America Merrill Lynch. The slowdown was largely due to issuance being front-loaded following Brexit to take advantage of low rates, as well as election uncertainty and the Thanksgiving holiday. In addition, high-grade issuance related to M&A has been moderate since Brexit. M&A issuance perked up this month to $18 billion versus $9 billion in October, but the jump was largely due to one deal: Abbott Laboratories’ $15 billion offering to back its acquisition of St. Jude Medical, per Bank of America Merrill Lynch. Moving forward, no large M&A deals are expected to close before year-end and, given the holiday season, December activity is generally concentrated in the first two weeks of the month.

High-grade corporate deals were largely well-received. The average new issue concession fell to 4bps from 8bps in October, although September’s concession before that was above 1bp, per Bank of America Merrill Lynch. Average new-issue yields have declined overall this year, particularly for IG names further down in credit (Figure 3) as spreads have tightened. In terms of flows, U.S. high-grade fund flows continue to show strength despite the significant move in Treasury bonds after the election. IG funds posted an inflow $1.3 billion in November, per Thomson Reuters. This was the ninth consecutive monthly inflow into investment-grade funds. Year-to-date inflows total nearly $101 billion.

Earnings season for 3Q16 provided insight into the IG corporate fundamentals. Per Bank of America Merrill Lynch, 3Q16 earnings significantly surprised to the upside. Despite consensus expectations of a 1.8 percent decline, year-over-year earnings growth turned positive for the first time since 1Q15, tracking at 2.7 percent growth. This is improved from a 2.8 percent decline in 2Q16. On the revenue side, revenues were up 2.2 percent year-over-year in 3Q16, versus a 1.1 percent decline in 2Q16. Earnings showed that net debt was slowing and net leverage improved, but gross leverage increased to 2.19 times in 3Q from 2.14 times in 2Q.

Looking forward, markets will be watching the policies of the new president-elect to discover potential impact on corporates.

Breckinridge Strategy

December Hike in the Bag?

The election of Donald Trump and the Republican sweep of Congress raise the possibility of transformational policy change, and have pushed Treasury yields substantially higher in the weeks since the election. Equities have rallied on a new regime that is potentially friendly to corporations and fiscal stimulus. The election is a trenchant example of the populism trend pervasive across the globe.

Markets are now looking for insight as to whether the potential positives from President-elect Trumps stated policies could outweigh the negatives. Positives could include stronger growth from fiscal stimulus that boosts corporate profits, and deregulation/higher rates that help Banks. A large potential negative is that an increase in U.S.-led trade protectionism could start a trade war and significantly hurt emerging-market nations. Direct exports to the U.S. account for a notable proportion of GDP in a wide range of both emerging market and advanced economies.[8]

At this point, it's unclear which policy items will be prioritized and what the net effect the combination of some or all of these policies will be. In our view, it will likely take several months before any of these plans are enacted and even longer for their impact to be felt. In general, we think that the term premiums will continue to rise as a result of rising inflation expectations. In municipal bonds, we think market participants will continue to monitor outflows related to tax reform and higher rates.

In all of our Tax-Efficient strategies, we made no changes to duration targets during the month. Our duration targets and yield curve positioning remain neutral, and we continue to adjust portfolios to the recent increases in yield across the municipal curve. Additionally, as we generally do in our investment process, we are considering tax-loss harvesting when appropriate. We note that while yields have increased we are not overly cheap from a historical perspective, as we have reached ratios in this range in the recent past.

In our Government Credit strategies, we made no changes to our duration targets. We remain modestly shorter than the benchmark, and we continue to adjust and shift away from the shorter portions of the curve in favor of the longer maturities and a more-level structure. The Investment Committee also made no changes to asset allocation targets in Government Credit strategies this month. We continue to focus on high-quality credits that have meaningful leverage or credit rating targets.

 

[1] Bloomberg, as of November 30, 2016.

[2] U.S. Bureau of Labor Statistics, as of December 2, 2016.

[3] Bureau of Economic Analysis, as of November 29, 2016.

[4] Thomson Reuters, Municipal Market Monitor (TM3), as of December 8, 2016.

[5] MMA, as of December 8, 2016.

[6] Barclays, Breckinridge Capital Advisors, as of November 18, 2016.

[7] Barclays, as of December 1, 2016, based on the Bloomberg Barclays Credit Index.

[8] Citi, as of November 9, 2016.

 

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