In this month's LDI market commentary:
April’s Bond Market Activity — the French Effect
By early April, all eyes turned to France. Mild inflation data and moderate economic data had set a strong tone for Treasuries and a weak one for equities which was exacerbated by nervousness over the French elections. When the result came in consistent with polling indications, markets reversed course. Equities rose, investment-grade spreads tightened and Treasuries sold off.
Treasury yields did not recoup the early April move, finishing 11 basis points lower with the 10-year yield dropping to 2.28% while 30-year Treasuries fell 6 bps to 2.95%. Investment-grade credit spreads tightened 2 bps.
Sector Outlook — Communications
We are cautious on the communications industry. Several headwinds limit growth and encourage inorganic transactions. In the wireless segment, competition is intense. It is difficult to model meaningful growth for Verizon and AT&T until at least 2020 when 5G solutions may begin to gain scale. 5G will deploy higher frequencies than those currently in use, and the limited physical propagation characteristics of higher frequencies enhance the value of fiber that connects small cells.
In addition, the video distribution ecosystem is in flux as streaming options such as Netflix compete against traditional linear pay TV. Although cable companies are also exposed to this threat, their broadband plant is generally superior and remains a necessity for the majority of households. In addition, we think the probability of leveraging transactions to fix transitioning business models has increased. We currently believe regulatory deal approvals seem more likely under the new administration. The combination of the regulatory environment and weak fundamentals leads us to be cautious.
Structural Issues — Evolution of Global Monetary Policy and its Implications
The Great Recession and its aftermath transformed monetary policy. As policy rates approached zero, one central bank after the other resorted to quantitative easing to help arrest economic decline and promote growth. Now, almost a decade since the onset of the crisis, growth has returned ― but not enough to recover stubbornly permanent losses in the level of output, investment and productivity. And in the meantime, central banks’ assets, formerly a tenth of global GDP, have ballooned to a quarter.
This development raises a number of important questions. How much should central banks unwind their balance sheets, and how can they do it in an orderly fashion? How can they respond if the next recession occurs too soon? Was QE a once-in-a-lifetime exigency, or will we see it deployed in future crises?
Of the major central banks, only the People’s Bank of China has allowed its balance sheet to shrink substantially. The Fed remains cautious about roiling markets, but the ECB and Bank of Japan are still in full QE mode. This action will continue to exert some gravitational pull on yields for years to come, though more and more unevenly now that central banks’ policies have decoupled.
There’s little doubt that if a recession or financial crisis occurs soon, central banks’ initial reaction will be further QE. They are familiar with it now, and believe that it worked ― and after other innovations such as negative interest rates yielded disappointing results, QE remains their best option, though it has already shown signs of diminishing returns.
In the meantime, its side effects persist. Corporate leverage has grown, firms have preferred debt-driven financial engineering to real investment, and some have exploited cheap funding to delay restructuring. Governments have taken advantage of low bond yields to increase debt ratios and to avoid implementing politically risky policies. Central banks’ balance sheets have made them more cautious and less flexible as well as more politicized. And increased wealth inequality has led to political tensions.
We are currently enjoying global synchronized growth, a rare and welcome state of affairs. The outlook for risky assets remains positive, as long as shocks don’t intervene. But if they do, we may lack the policy tools to engineer a recovery, and plan sponsors should think through what that scenario implies for asset prices and bond yields.
(Portfolio managers Andy Barth and David Lee, along with analyst Scott Sykes, contributed to this report.)