by Neil Azous, Chief Investment Officer
- US bond market agnostic to whether Fed raises interest rates this year or doesn’t
- Emerging over developed markets; bias to local currency debt closed-end funds
- Municipal bond closed-end funds still offer the best value
- Leveraged Loan closed-end funds offering more value on spread & discount widening
Our intermediate-term outlook for the broad market and the closed-end fund universe is to favor carry-related instruments in a benign interest rate environment that lacks a catalyst for action.
To improve the risk-adjusted returns of passive closed-end fund investing or opportunistic trading, we continue to place greater emphasis on tactical asset allocation (TAA).
It remains prudent to add a concentration to the regions or sectors with the strongest profile and hold none-to-little exposure with the weakest outlook.
Interest Rate Differentials 101 At Their Best
So, what has changed since the beginning of June?
The dominant theme over the last six weeks is a shift away from easy central bank policy in Europe, the United Kingdom, Norway, Sweden, Canada, Australia, and South Korea.
Simply put, regarding extraordinary policy or interest rate normalization, these countries are coming from a much lower base relative to the United States. Therefore, the speed and degree of the initial adjustment can be violent as the market discounts the new path of each central bank. The initial adjustment is well underway, if not mature already.
Conversely, recent communications from various Federal Reserve policymakers have been very coordinated across the spectrum, suggesting that with the last 5 months core inflation annualizing at below 1%, the Fed could potentially be already at a “neutral” policy stance, negating the need for further tightening. They plan to run down the balance sheet this year, potentially starting as early as September or October, and it appears probable at this point that they will not raise interest rates again by the end of the year.
Regarding running down the Fed’s balance sheet. While we subjectively feel different about the effects of draining [up to] $50 billion per month from the financial system, it will likely not be until the early parts of 2018 before we could see any issues arise, though markets appear to already be discounting this draining of cash by flattening the U.S. yield curve.
As we stated in our last blog post – Why We Are Not Afraid Of Higher Yields – lacking a major catalyst, we do not see what event or evolution will move U.S. yields enough on an absolute basis to make us concerned in the intermediate term.
To reinforce that view and to help us analyze market expectations, we rely heavily on our Federal Reserve forecasting model. At Rareview Capital it is mandatory to compare your subjective opinion relative to market expectations and try to distil these quantitative expectations into a qualitative sequence of events.
Today, the cumulative market implied probability of the Fed raising interest rates one time by the December meeting is about 50% – or a coin flip. This means that if you were to directionally take either side of the bet, your payout would be only two times your money, but at the risk of losing it all – hardly favorable betting odds.
Now, let’s take a deeper look at what is tradeable in the interest rate market. If one were to purchase a straddle in the Eurodollar futures market – i.e. an options strategy where you buy an at-the-money call and put option – that captured either the Fed raising rates one time by the end of the year, or not at all, currently you would lose money on that bet. The only way you could potentially make money is if the Fed had cut interest rates, or raised them two times by the end of the year.
Thus, we can deduce on a cumulative basis, in expectations, if the Fed raises interest rates one more time by the end of the year – or not at all – that either outcome is expected, and would be profitable for holders of fixed income securities.
Next, add in the faltering domestic political agenda, including pushing back fiscal stimulus, and the net result is a weaker U.S. dollar.
This backdrop would be the portrait of interest rate differentials if you went to an Economics 101 class.
King Dollar Reminder
As the most significant driver of asset prices in the world, everything else is just a byproduct of the downward trend in the greenback.
For example, investing in U.S. exporters, tangible assets (foreigners who buy U.S. real estate or commodities) and appreciating currencies or stock markets provide the basis for profiting from the falling U.S. dollar.
While the inflows into the assets that benefit the most from a weaker U.S. dollar may not be linear and the price action may instead resemble a “foxtrot” market (i.e. two steps up, side-step, back-step), with other developed market central banks providing the rhythm for a change, we do not see a disruption in this theme, only a side- or back-step along the way, until the next major communication at the September FOMC meeting.
Armed with this knowledge, what can we say about prices moving forward, particularly when we account for factors related to closed-end funds?
Regionally, we favor emerging over developed markets.
Within emerging markets, because of their appreciating currencies and US nominal yields remaining contained, our desire is to be overweight fixed income relative to equities, especially closed-end funds with a gearing towards local currency debt.
For the last seven months, emerging markets benefited from the following tailwinds:
- Stability in China;
- A re-rating of corporate earnings higher;
- A weaker US dollar;
- Flatter yield curves around the world;
- A breakdown in correlation across asset classes;
- Extreme low volatility across asset classes;
- The dissipation of Trump-protectionism risk.
In the second half of the year, while many of these tailwinds remain firm, we are on the lookout for any change in this profile that would make us rethink our overweight view, including:
- China showing tighter financial conditions;
- The U.S. dollar stops going down, or the pace of weakness abates dramatically on a relative basis;
- Higher US real yields, especially shock events;
- Implied volatility in the NASDAQ-100 Index (NDX) remaining elevated in the high teens for an extended period. As a way of background, the top 10 constituents of the index are “secular growers.” Any durable rotation into the growth from value style, or into cyclical sectors, would likely portend to a larger move higher in U.S. yields. Put another way, selling the NASDAQ-100 is synonymous with higher outright yields, or potentially a steeper yield curve;
- Protectionism risk creeping back into the market beyond the steel sector;
- New low prices in crude oil, or an outright breakdown in the OPEC production cut deal;
- The Federal Reserve no longer in a holding pattern, or a material pickup in inflation expectations.
As you know, the optimal combination for investing in emerging markets is moderate growth, accelerating earnings, easing monetary conditions, and contained inflation expectations.
That said, while monetary policy will be less accommodative moving forward it is too early to make the call that earnings momentum has begun to slow after the robust recovery from Q3 2016 and global growth momentum has started to wane, especially the global synchronization coming undone.
Also, until the U.S. dollar no longer remains in a weakening trend, collecting carry is our preferred approach.
Next, from a sector standpoint, in the closed-end fund market, municipal bonds remains the cheapest across all of our 10 asset classes. A favorable total return outlook for interest rates paired with a cheap closed-end fund valuation leads us to believe this sector could continue to perform well in the intermediate-term.
Thirdly, the leveraged loan sector has lost sponsorship in the closed-end fund market.
For example, in the month of June, the sector at one point, saw its discount widen by 3%. In many cases, this discount widening erased any positive total return from holding these closed-end funds for the year-to-date.
As a reminder, the discount widening in leveraged loan closed-end funds comes after the sector reached its tightest discount in more than five years back in February.
This is important to note. The migration of inflows into this asset class was very disproportional. Buyers emerged last summer on account of the market requiring floating interest rate exposure to hedge against the Fed embarking on a tightening cycle.
The key point here is that the lack of demand for floating rate instruments argues that investors are less fearful of further interest rate increases, or a cyclical change in yields.
For now, we will watch this sector closely and continue to hold a modest underweight. However, should discounts widen out by another two or three percentage points, that would likely prompt us to increase exposure. After all, leveraged loan closed-end funds allow you to gain access to many of the same individual leveraged loans but at a discounted price, and they trade on an exchange.
Part of this discount widening, we believe, is due to a decline in crude oil prices as high yield credit spreads, excluding the energy component, have remained unchanged for the last four months. Conversely, high yield energy spreads have widened by about 100 bps.
The price of crude oil remains a constant source of concern as the downside risks are asymmetric.
While cognizant of these asymmetric downside risks in the credit sector, we are pleased to see that the market is beginning to discount the risks of crude oil prices breaking below $40, which could become a material risk to energy company profitability. This is a positive development as we have been underweight the high yield sector as a whole, and with more risk premium becoming injected into the market, the value proposition grows incrementally.
Tying these variables together, we think that with high-yield closed-end fund discounts widening they may offer a more attractive opportunity in the near future, but that time is not now.
The same can be said about closed-end fund Master Limited Partnerships (MLP’s) with the caveat that their volatility is more than five times that of the municipal bonds, the least volatile closed-end fund sector. That keeps our exposure to this space measured until there is further stabilization in the crude oil outlook. That said, we would be quick to add exposure upon confirmation that the outlook is more symmetrical.
Finally, US large cap equity-focused closed-end funds continue to not offer a compelling risk/reward. This is not true for those that focus on the real-estate sector, however, which we believe offer compelling risk-adjusted returns in this benign interest rate and weaker U.S. dollar environment as foreign investors seek hard assets with their stronger currency.
In fact, US equity closed-end funds have seen their discounts narrow to the tightest level in over three years. Additionally, in some cases they now offer a less compelling value relative to owning ETF’s that utilize similar strategies, due to the relative risk of potential discount widening should the equity market experience a sell-off and investors become fearful.
As a reminder, retail investors are the largest holders of closed-end funds. Hence, the discounts of these funds are strongly driven by the human emotions fear and greed. When volatility across asset classes, especially equity volatility (i.e. the VIX), is persistently low, investors become greedy and push closed-end fund discounts beyond what is rational.
In conclusion, we advocate that investors seek out specialists that have a multidisciplinary approach – asset allocation, valuation modeling, risk overlay, etc. – to closed-end funds, including managers that have a strong fixed income background given that is where the opportunity set now resides.
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