Ken Taubes is Chief Investment Officer, US.
We continue to believe credit sectors offer modest value compared to government securities. Although global yields have risen from their July lows, many short-term non-US developed market sovereign debt continues to trade at negative nominal yields, and 10-year bonds offer zero to modest positive yields. US Treasuries continue to offer negative or modest real yields, adjusted for CPI inflation.
We hold a neutral view with respect to the agency mortgage-backed securities (MBS) sector. While we believe housing fundamentals remain strong, the Federal Reserve’s (Fed’s) significant ownership of the asset class presents increased risk. Strong employment should continue to support the housing market. Although housing affordability has declined with rising rates and higher home prices, the index indicates steady levels of affordability.
Housing Affordability Has Declined, but Remains Strong
Source: Federal Reserve. Last data point 1/1/17.
However, Fed Chairman Janet Yellen recently confirmed that the Federal Open Market Committee (FOMC) has begun to discuss winding down the Fed’s balance sheet, and some believe such action might occur in late 2017 or in 2018. With the Fed owning 20% of outstanding agency MBS, any decision to stop reinvestment of coupons or paydowns could have a significant negative impact on the market.
We believe corporate credit offers moderate value, based on improving profits and the potential for tax reform. Profit and revenue growth turned positive in the third quarter of 2016 and should enjoy strong performance in 2017.
Both Earnings and Sales have Started to Grow
Earnings Season for 4th Quarter 2016 ended 2/15/17. Source: Bloomberg.
However, we have become more cautious on corporates in the past year, as spread levels have declined well below long-term averages and leverage has risen. The deterioration in credit quality is most pronounced in the investment-grade market, as is evident from the following chart. Corporations have financed share buybacks and increased dividends through issuance of debt at record low yields.
Credit Quality Decline Most Evident in Investment Grade Market
Source: Barclays. Last data point 12/31/16.
Relative to high yield, we believe that bank loans offer value. BB and B yield-to-maturities are only modestly lower than the corresponding bond yields in the high yield market, but without the duration risk. Investors should remain cognizant of repricing risk in loans, given that most loans carry minimal call protection and are pre-payable at any time.
Impact of Tax Reform on Corporate Credit
The potential for corporate tax cuts and cash repatriation under the Trump administration has provided a tail wind for equities following Trump’s election. The impact on corporate credit is more nuanced.
Proposed corporate tax cuts from 35% to 15% or 20%, could have a beneficial impact on corporate earnings, benefiting both debt and equity holders. Corporations with high effective tax rates, that conduct business primarily in the US, and that have minimal net operating losses and deferred taxes, would stand to benefit the most.
However, tax cuts and the potential elimination of interest deductibility would effectively increase the cost of debt financing, which could result in lower debt issuance going forward. Deductibility of existing debt may be grandfathered, while only newly issued debt would be subject to the new rule. As a partial offset to interest deductibility, Trump has proposed the expensing of capital investment for manufacturers, which may provide an incentive for further capital investment in the US.
There may be over $1 trillion of offshore cash held by approximately 30 to 40 multinational corporations, focused in technology and pharmaceuticals, many with payout ratios exceeding 100%. The proposal to repatriate these earnings at a 10% rate or less could deliver that net cash for use in the US, as well as $300 billion of additional value for non-financial firms. To the extent that repatriated earnings are used for share buybacks or increased dividends, this decision could result in significant leverage increases and downgrades among certain corporate issuers.
We believe US equities should be favored over fixed income, as valuations are relatively better. US earnings growth, while limited, is improving. However, after the strong performance of US equities over the last five years, absolute valuations are becoming higher, while international equity is starting to become more attractive.
Stocks vs. Bonds Valuation – Stocks More Attractive
Source: Bloomberg. Last data point 2/28/17.
At this stage of the economic cycle, we expect market volatility to increase. The US equity market has priced in a lot of good news, including the benefits of legislation yet to be passed. While cyclical stocks have recently surged on the prospects of higher growth, we believe that high-quality stocks should perform better if monetary policy tightens at a quicker pace, or if growth trends weaken. Two of last year’s lagging sectors, the consumer and healthcare sectors, may be poised for improved performance in 2017 due to their resilience in earnings growth throughout economic cycles and continued innovation and pricing power.
We also favor technology and financials. Technology may benefit from the shift to mobile and cloud computing, while financials should benefit from rising rates. Cyclical industries and sectors such as financials, basic materials and industrials could perform better. However, there have already been strong moves in these sectors ahead of any actual improvement in fundamentals. We are taking a cautious stance and focusing on more predictable and stable companies in consumer staples and healthcare.
Growth stocks typically outperform late in an economic cycle. Given the underperformance of growth stocks last year, valuations are also now attractive, trading at only a modest premium to value stocks.