by Neil Azous, Chief Investment Officer
- US dollar weakness is #1 theme for investors
- Interest rates to remain contained outside of fiscal success
- Emerging over developed markets; bias to local currency debt closed-end funds
- Municipal bond closed-end funds still offer the best value
- High yield credit closed-end funds offering more value on spread & discount widening
The biggest theme for investors is whether the broad US dollar continues to weaken. To date, the derivatives of that theme – emerging market debt and equity, European risky assets, precious metals, etc. – have all responded in kind.
Let’s Get Our Bearings – The US Dollar
From a global macro investing perspective, our working thesis is that the US dollar and crude oil are the ultimate drivers of asset prices and that everything else is just a byproduct of what those assets do next.
From a technical perspective, we view the 200-day moving average (DMAVG) as a short-term trend change, the 55-week moving average (WMAVG) as a medium-term trend change, and the 200-week moving average (WMAVG) as a cycle change.
Below is an illustration of the Bloomberg Dollar Spot Index (BBDXY) on a “weekly” basis, which also includes the August 2017 month-end. The BBDXY Index tracks the performance of a basket of ten leading global currencies versus the U.S. Dollar. Each currency in the basket and their weight is determined annually based on their share of international trade and FX liquidity.
Therefore, we pay close attention to a potential cycle change, or a break of the 200-week moving average (WMAVG) on a monthly closing basis, in the trade-weighted US dollar.
On August 31st, the BBDXY closed at 1152.94 relative to the 200-week moving average 1152.32, or a hair above it.
Geopolitically, market professionals believe that the Administration – President Donald Trump, Secretary of Treasury, Steven Mnuchin, National Economic Council Chair, Gary Cohn, and Commerce Secretary, Wilbur Ross – is aligned and prefer a weaker US dollar. For far too long, the rest of the world has benefitted from “weakening” their currencies. It is now the USA’s turn.
Fundamentally, from an interest rate differential standpoint, there is a clear bifurcation amongst the major central banks.
The Federal Reserve is set to become the first central bank in history to reduce the size of its balance sheet at the upcoming FOMC meeting. This follows three consecutive interest rate hikes.
Conversely, the European Central Bank (ECB), Bank of Japan (BoJ), Swedish Riksbank, and Swiss National Bank (SNB) have yet to embark on unwinding any of their extraordinary policies.
- At this week’s European Central Bank (ECB) meeting, the ECB is expected to tacitly acknowledge that they will be reducing the size or potentially stopping their asset purchases when the current program ends in December. Regardless, they are not going to ease policy from here and are starting from an extreme level of extraordinary policy on a relative basis.
- The Bank of Japan (BoJ) continues to explicitly advocate that their Comprehensive Easing (CE) and Yield Curve Control (YCC) policies will remain firmly intact without interruption even if the BoJ must buy the remaining 60% of bond issuance that they do not own.
- The smaller central banks resemble the ECB and BoJ. The Swedish Riksbank generally follows the ECB’s actions and the Swiss National Bank (SNB) continues its ultra-dovish stance to take advantage of its own interest rate differentials relative to the rest of Europe.
Let’s Get Our Bearings Cont. – US Fixed Income
Next, it is important to know what the market expects to happen in the future relative to our expectations. A prediction, or forecast, of the 10-year Treasury yield is meaningless unless we know what that expectation is relative to the market’s, and how realistic it is that the path may evolve between now and then.
Using our Federal Reserve model, we can “digitally” recreate every single scenario that is priced into the US interest rate market. The ability to recreate the expectations embedded in the US Treasury yield curve with precision is very powerful when it comes to asset allocation, and most importantly whether the risk is greater of higher or lower interest rates.
We are emotionally agnostic to whether the Fed does or does not raise interest rates ever again. However, there are many more likely scenarios where the Fed is done, or perhaps raises interest rates once or twice more before finishing with its tightening cycle.
For today, all we care about when analyzing the current path of Federal Reserve policy is the “end point.” That is, we have reached the point in the cycle where investors are no longer wondering “how many times the Federal Reserve will hike this year.”
Below is how we come to that conclusion.
Federal Reserve Model
Below is a table showing the unconditional probability of an interest hike at each meeting until December 2018. The unconditional probability detailed below is the probability of an interest rate hike occurring at any specific meeting.
Here is what the model is saying:
- US fixed income is priced on the dovish side of expectations heading into the September 20th FOMC meeting.
- US fixed income is priced 4-to-1 against the Fed raising interest rates at the December FOMC meeting.
- It is highly unlikely that the Fed raises interest rates at any time between now and the end of 2018.
- The probability that the Fed never hikes again currently stands around 70%, making it more than four times more likely that they never hike again relative to hiking once at any point in the next 12 months.
- The market is priced such that the probability of the Fed hiking twice over the next 12 months is equal to the potential for an interest rate cut – that is, to say they are both at very low levels
As a way of explanation, the neutral rate is the interest rate where the Fed will no longer be easy or tight. By the Fed’s own official estimate, the real neutral rate is about zero. Meaning, that with a 2% inflation rate, you would assume that if the Fed funds rate ever got to 2%, they would be neutral. The inflation rate today stands at 1.7%. The Fed funds rate today is at 1.25%.
The fixed income market has reached the point where it is no longer a focus on whether or not the “Fed hikes at X meeting.” You are now making an explicit forecast on inflation and how that relates to the real neutral rate, which is around zero. Meaning, the end is now more important than the path it takes to get to the end.
For example, the 1-year forward 12-month core inflation rate discounted into the US Treasury market currently is at 1.6%. This is exactly equal to what the annual core CPI rate is expected to be after the September CPI report. If you use a real neutral rate of 0 (the last “official” Fed estimate is -22 bps), you would assume that the terminal rate in the Fed’s cycle is about 1.6%, or about one hike more from today.
Let’s Get Our Bearings Cont. – US Economic Data
The greater Houston area is the third largest contributor to GDP in the country. Additionally, the Houston area is the largest producer or refiner of petrochemicals in the country, not to mention a major shipping hub for many commodities from the Midwest. The Shipping Channel, if you have not seen pictures, is only now more than a week later becoming anywhere close to operational.
For the remainder of the year, and probably longer, the major economic data that we receive will be distorted by the after effects of Hurricane Harvey. Moreover, it will distort any annual figure through June of next year.
Let us paint you a picture for a frame of reference.
Over the last six months, core inflation has annualized at a rate of 0.6%. There are four more CPI reports between now and the end of the year. Those four reports last year annualized at a rate of 2.14%. So, mathematically speaking, to keep the annual rate of core inflation at the current rate, monthly inflation growth must be at least 0.3% for every month.
As a frame of reference, core CPI has never grown by 0.3% for consecutive months. Additionally, since 1990 it is extraordinarily rare for it to grow by 0.3% or more twice in the span of six months.
At the same time, while it is still very preliminary, gas prices in some parts of the country are up between 25-30%. If that is sustained, for the September CPI report released in mid-October, the headline month-on-month figure will be distorted higher by close to 1%.
You can extrapolate from there the effect on other pieces of economic data, but it will be extremely difficult to get an accurate read on the underlying strength of the economy or even metrics such as the demand for credit.
While we hesitate to go so far as to say the Fed is on a “permanent data hold” – if their excuse for the last two months has been to evaluate the incoming economic data before making any decisions, it just became exponentially more difficult to do that.
We will be on alert for their comments on this subject, but it will take a few weeks to get an accurate read on their sentiment. For example, on the contrary, the Fed could decide to do something very rash and ignore the data, and stick to the broken Phillips Curve model, or use easy financial conditions as an excuse to keep raising interest rates. We do not believe this is the base case.
Ultimately, we think the theme of “data distortion” could give investors another reason to stay long US fixed income and short the US dollar.
Armed with this knowledge, what can we say about prices moving forward, particularly when we account for factors related to closed-end funds?
Before reading further, we encourage you to review our previous update on July 19th – Closed-End Fund Outlook – Volume 2.
While the overall themes are largely intact, a few events have impacted the outlook for various sectors. Below we provide an update on each one that is relevant.
Within emerging markets, because of their appreciating currencies and US nominal yields remaining contained, our desire is to still be overweight fixed income relative to equities, especially closed-end funds with a gearing towards local currency debt.
We hesitate to say that the decline in the US dollar is over. As we sketched out above, there is no structural catalyst to own the US dollar from an interest rate perspective as the totality of the Fed’s potential interest rate hikes are already fully discounted. Conversely, other global central banks are coming from an extremely dovish level. While it may not be a straight line, we would caution you on believing the US dollar could not depreciate substantially more.
Therefore, until the U.S. dollar no longer remains in a weakening trend, collecting carry in emerging market fixed income remains our preferred approach.
From a valuation standpoint, in the closed-end fund market, municipal bonds remain the cheapest across all our 10 asset classes.
In fact, following the North Korea scare in August, municipal closed-end funds moved out to their widest discount this cycle and have yet to narrow-back materially.
Collectively, there is a favorable total return outlook for the sector if you pair the interest rate outlook with a cheap closed-end fund valuation. That leads us to believe this sector could continue to perform well in the intermediate-term.
Note, that from an entry point, there may be a better tactical location because interest rates are priced for perfection. Put another way, we would like to add to this asset class if yields back up 15 basis points from the current extreme.
Lastly, we are on the lookout for any negative developments from Hurricane Harvey to municipal bonds in the State of Texas. Considering Texas is the second largest issuer of municipal bonds in the US, it makes up a notable chunk of any municipal bond closed-end fund’s allocation. Currently, there has been a negligible impact.
US-based investors are now faced with a conundrum when investing in European equities.
Since mid-June, the European equity market, especially exporting countries like Germany who make up the largest part of European indices, have been negatively impaired by continued strength in the euro exchange rate. For example, on a peak-to-trough basis, the German DAX Index fell by close to 10% from its June high to its August low.
However, for a US based investor, who was long on European equities in local currency terms (i.e. unhedged), they did not suffer any losses as the euro appreciated by a near equal amount, offsetting any principal losses for US investors.
Moving forward, if it is a reasonable expectation that the euro continues to appreciate relative to the US dollar and that it will continue to impair export-based European countries’ profits, causing losses in their stock markets. Unlike the 2014 depreciation in the euro when investors wanted to mitigate any losses from the currency as it was benefiting that country’s stock market, a stronger euro is not beneficial.
From a tactical investment standpoint, US based investors are faced with a tough decision.
Do I buy European equities on a currency-hedged basis and remove the potential upside if the euro continues to appreciate?
Do I buy European equities in local currency terms, or not at all, as I think a further appreciation in the euro will cause European equities to underperform relative to other parts of the world?
The conclusion is that European equity closed-end funds are too complicated in the short-term.
Coupled with the fact that US large cap equity-focused closed-end funds continue to not offer a compelling risk/reward as they have seen their discounts narrow to the tightest level in over three years, this is another example of why our bias is to be overweight emerging markets where the underlying assets benefit from an appreciating currency. For many developed equity markets that is not the case.
High Yield Credit
Thirdly, in our last Closed-End Fund Outlook – Volume 2, we stated that the leveraged loan sector had lost sponsorship in the closed-end fund market. As we mentioned, the discount widening this year has erased any positive total return from holding leveraged loan closed-end funds for the year-to-date.
Since that time, high yield credit spreads have widened by about 45 bps, offering a modestly better entry point for investors. While spreads are still close to 100 bps below normal, on a relative basis to equities, the value proposition has incrementally improved, especially if interest rate volatility remains low for the intermediate-term.
We believe the time has come to begin to modestly increase exposure from a large underweight. However, should discounts widen out by another two or three percentage points and spreads continue to widen, that would likely prompt us to increase exposure more aggressively to an equalweight.
After all, many of these high yield credit closed-end funds allow you to gain access to many of the same individual bonds or loans but at a discounted price with a modest amount of leverage, and they trade on an exchange.
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