February was a consolidation month for stock market levels. Following January’s market optimism, the US economy continued to power through February. Although market levels were tested and US Treasuries weakened, nothing collapsed. For economists and strategists, the largest pill to swallow was the realization that the Fed may not be as close to the end of rate hikes as economic observers previously thought.
- Chances are strong that the Fed will increase its target rate to 4.75% at its next meeting on March 28 and to 5% by July
- Interest-rate futures are even beginning to price in a hike to 5.25%
Inflation, which I mentioned in the October Commentary as the taboo subject is finally coming out of the conversational closet. As unemployment continues to decline, expect US worker productivity to deteriorate and labor costs to rise, thereby fueling inflation.
Expect a) The US economy to continue expanding; b) Interest rates to keep increasing at a measured pace; and c) The market to accept both as hand in hand progression.
Investment grade companies are paying low premiums to sell bonds. Rising corporate profits have boosted their credit quality outlook. The current spread (yield pickup) over U.S. Treasuries is even tighter than at year-end (88 basis points vs. 92). Narrow yield premiums make debt sales attractive for companies, especially with the benchmark 10-year Treasury’s yield at a low 4.55%, little changed since the Federal Reserve first began increasing interest rates in June 2004. Therefore, expect corporate bond issuance to jump over the near term.
A strong economic tide raises even weak US corporate debt. The effect of underlying economic strength has not been hidden from the High Yield (low quality) bond sector, which already has rallied a couple of percent this year amidst historically tight (expensive) spreads. We believe that over the short term, High Yield spreads may widen if heavy new issuance and new leveraged debt supply enters the market, but should be reasonably stable relative to underlying fundamentals. High profile bankruptcies probably will not spook this robust market; rather, it would take a fundamental turn in the economy to cause real damage.
US real estate market still confounds.
- Optimism: In another surprise, February’s reports of January housing starts rose 15% on optimism and because of record warm weather across the country, averaging 39.5 degrees, the highest in more than 110 years. Housing starts may actually continue to rise, even as new home sales drop from 2005’s record level, as developers work through last year’s backlog of orders.
- Pessimism: On the other hand, a January government report showed a 5% drop in the pace of new home sales from the December level – a surprise to analysts that were expecting little change – with 20% more homes on the market than the year before. The upswing in home inventories may not indicate a glut, but may point to a softening market. Additionally, home builders have recently reported an increased number of new home order cancellations.
- International: Also notable, an increasing number of US real estate dollars are traveling overseas for investment opportunities: Germany, South East Asia, Central America, and Croatia for example.
- Commercial: We expect commercial properties, REITs and loans to perform well.
The Long Bond returns! On February 9, the Fed sold $14 billion of 30-year bonds; its first sale of the long bond since August 9, 2001. Although the market was hungry for the bond, the long end of the curve was weak though the rest of the month. Anticipate the long end of the yield curve to succumb to strong market forces that drive prices down and yields up through the next month.
Municipal closed-end funds (CEFs) seem relatively expensive across several measures. Currently, most muni CEFs have historically tight discounts and dividends that are under pressure. New Jersey, New York, Florida, California, and national muni CEFs seem exceptionally pricey by both historical and predicted premium-discount measures. In addition, although current (after tax) dividend yields may seem okay, most muni CEFs are under earning their dividend and therefore are prone to dividend cuts; leveraged CEFs are particularly vulnerable. Overall we see limited value in the closed-end muni sector.
Greg P. Pellizzon
Michael Ashley Schulman, CFA
Hollencrest Capital Management