Although global stock markets could encounter some near-term setbacks, there is no evidence of impending major cyclical problems. Within the U.S., the very low interest-rate environment plus a cheapened dollar will foster an earnings rebound for corporations – especially when compared to last year’s dismal results – suggesting that the cyclical bull market in stocks will transform from a liquidity-driven stage to a profit-driven phase next year. Historically, the first two to three years after a recession is the best period for equity prices. During this period, central bank policy is usually firmly ahead of the deflation curve, thereby limiting downside risk. Expect reflation trades to continue to dominate global financial markets.
In the short term, U.S. Treasury yields may fall further as headline CPI falls and core CPI deflates. Very low inflation or even deflation creates room for bond yields to drift lower, even if the economy stages a strong recovery. But in the longer run, anticipate bond yields to rise steadily next year as the world economy recovers and expect a stable U.S. inflation rate around 1.5%. Thus, with inflation in check investors may stay long corporate bonds to exploit the final leg of the credit-market recovery, and fixed income closed-end funds (CEFs) should rally alongside.
Quickly improving corporate balance sheets are also moving corporate bond prices higher. A tight rein on spending along with reduced share buybacks and dividends has pushed the level of liquid assets as a percentage of sales on corporate balance sheets to record highs. In the meantime, measures of leverage, interest coverage and debt-servicing costs have also improved. All of this suggests that the credit default rate should soon peak, validating the recent sharp tightening in quality spreads.
Michael Ashley Schulman, CFA
Hollencrest Capital Management