We continue to believe credit sectors offer value compared to government securities. With approximately 35% of the global treasury market trading at negative nominal yields and US Treasuries of 10 years and below trading at negative real yields (using core PCE as the inflation measure), government securities have never looked less attractive. We have never believed that it makes sense to pay a borrower for the privilege of lending them money.
Corporate credit continues to be moderately attractive. Corporate balance sheets are strong and profits may increase as economic growth improves, the value of the dollar moderates and energy prices stabilize. Second quarter earnings, although still weakened by the energy sector, have come in better than expected with 70% of companies reporting positive earnings surprises, compared to a long-term average of 63%. In addition, the US Bureau of Economic Analysis (BEA) increased its estimate of first quarter corporate earnings growth in its annual 2016 adjustment.
Corporate Fundamentals Are Normal
Earnings leverage ratios remain within normal ranges, and coverage ratios—benefiting from low rates—have risen to near all-time highs.
Although investment grade and high yield spreads have narrowed recently to levels below long-term averages, high yield default rates, excluding the energy sector, should remain well below long-term averages over the next few years. The par-value high yield default rate in June, excluding the energy and metals and mining sectors, was a mere 0.53%.1 We see particular value in bank loans, where BB and B yield to maturities are only modestly lower than the corresponding ratings in the high yield market, but without the duration risk.
Non-agency structured credit is attractive in light of the strong housing and commercial real estate markets in the US. We continue to find high quality non-agency mortgage-backed securities jumbo prime new issues attractive. Although supply remains limited, with banks retaining the bulk of this underwriting on their balance sheets, these credits trade approximately 2.5% behind like-coupon agency pass-through securities.
Select higher yielding emerging market sovereigns are attractive, with reasonable valuations and stabilized commodity prices. Most recently, emerging market issues have rallied, as investors have viewed these economies less vulnerable to the Brexit fallout than the UK and European markets.
A Moderating US Dollar
After its record appreciation in 2013-2015, we believe the US dollar should trade in a range, given less hawkish Federal Reserve policy. We believe the FOMC could raise rates this year. That said, the latest FOMC statement in July, while more positive, shows continued caution with respect to rate increases. Even post-Brexit, with anticipated easing among non-US central banks, the dollar has not retraced to its October highs.
We favor US equities over fixed income as valuations are relatively better. US earnings growth, while limited, is improving. However, after the strong performance of US equity over the last five years, absolute valuations are becoming higher while international equity is starting to become more attractive.
Adjusted for inflation, earnings yields are significantly more attractive than real bond yields. Even 10-year US Treasuries, when adjusted for inflation, offer a negative real yield.
Despite the recent uptick in value stocks, US growth should continue to outperform in this low growth environment.
Within value, we believe demand for income-oriented securities will continue as long as the low rate environment persists.
We favor large- over small-cap companies in the US, as we believe market leadership is shifting toward large cap after a 15-year run in small cap. There are also opportunities in mid-cap stocks, many of which have solid prospects and should do well in a slow growth environment.
For more detailed comments from Ken Taubes on the US economy, read his most recent Outlook.
1 JP Morgan Default Monitory, July 1 2016.