The “guns of August” remain silent. A century ago this week, the great European powers transitioned from political posturing to all-out conflict as the brutal reality of combat engulfed their respective militaries in World War I. Today the notion of late summer brinksmanship resonates on several levels. The Russian aid intervention in eastern Ukraine is an obvious example. President Vladimir Putin continues to force the camel’s nose into the tent. For investors, perhaps a more immediate focus of concerns on the horizon is overvaluation. In an editorial in The New York Times this past weekend, Yale professor Robert Shiller noted that U.S. equity valuations have reached a significant high from a long-term historical perspective, prompting concerns of a hard correction. Despite a brief interlude of fear earlier this month, global markets continue to exhibit no fear of correction or a return to historical average volatility levels. All is quiet — for now, at least.
Real estate prices in China come under pressure. New-home prices in China contracted in July for the third consecutive month, according to data released this morning by the China’s National Bureau of Statistics. With an average contraction of 0.9 percent from June across the 70 cities measured, the rate of growth for new housing inventory costs was 2.4 percent, compared to July 2013. Oversupply, driven by rapid development in the past five years, continues to be a concern. Private data provider China Real Estate Index System estimates an inventory overhang of more than three years in 31 cities that the company’s data tracks.
Ruble trading band expands. Bank of Russia officials expanded the fixed trading band for the nation’s currency versus a euro/U.S. dollar basket to a nine ruble differential from seven, with the elimination of intervention transactions within the band. Despite volatility driven by conflict in eastern Ukraine, the central bank in Moscow has continued to signal an intent to have ruble trade unfettered by year-end and to manage monetary policy exclusively through benchmark lending-rate adjustments.
Data show trading uptick in Europe. Euro zone trade data for June released today registered an expansion in both exports and imports, with shipments abroad expanding at a faster pace to drive a surplus of €16.8 billion ($22.5 billion). While shipments to primary trading partners in North America and Asia rose, exports to Russia contracted sharply in advance of sanctions.
Forex moves into risk-off mode. Data from the Commodity Futures Trading Commission shows that during the week ending August 12, short positions in the euro and Japanese yen versus the U.S. dollar were cut back by traders in aggregate. Long positions in so-called safety currencies, including Canadian and New Zealand dollars, were also trimmed, according to the CFTC report.
Israel slows down. Numbers from Israel’s Central Bureau of Statistics released yesterday showed the country’s second-quarter 2014 gross domestic product expansion lagging, as exports fell by nearly 18 percent from the same period last year.
Jackson Hole puts Federal Reserve in focus. The Jackson Hole economic symposium, sponsored by the Federal Reserve Bank of Kansas City, kicks off this week. Financial markets will be watching the event to glean policy leanings from policymakers speaking at the event, including, in her first speech at Jackson Hole as Fed chair Janet Yellen; Central Bank of Brazil Governor Alexandre Antonio Tombini and Bank of Japan Governor Haruhiko Kuroda.
Portfolio Perspective: A High-Yield Opportunity — Miranda Davis, BPV Core Diversification Fund
“High-yield bonds have certainly caught our attention. There is some evidence of reach for yield behavior.” — Janet Yellen, June 18
In the month following Fed Chair Janet Yellen’s June press conference, high-yield debt funds experienced as much as a 20 percent drawdown and high-yield spreads have been steadily increasing. Nevertheless, high-yield bonds have caught our attention as a potential investment opportunity.
Perhaps the most pressing question is whether we are in a junk bond bubble — at least, that’s what Yellen seemed to be implying when she made her remarks. But while the recent outflows in high-yield bond exchange-traded funds and mutual funds indicate that investors who are not normally in high-yield bonds are getting shaken out, this is not indicative of a fundamental flaw in the asset class. On the contrary, in a low-interest-rate environment with equities that no longer look cheap, we believe high-yield bonds may provide a strong return opportunity. What Yellen calls “reach for yield” is not a bad thing in and of itself. Prudent investors examine opportunities in the marketplace and deploy capital where the relative risk–return profile is most attractive.
Others might view the drawdown as part of a broader phenomenon. We see little indication of an impending crisis, however. First of all, the U.S. economy is picking up. Data have been coming in strong across the board, from employment to a strong GDP print. Second, we are in a healthy credit market, with default rates ticking down, recovery rates remaining elevated and corporate balance sheets improving. We may have seen some lower-quality debt issuance lately, but any concerns regarding defaults will not materialize for several years. Finally, credit markets tend to follow predictable patterns. The high-yield spread has historically continued to narrow as the economy shows growth, and then widens suddenly when the credit cycle ends. The overall economy is a key barometer of the credit market, and we see little reason to be concerned about recent events in the high-yield class.
Another concern is the issue of high-yield debt performance in a rising rate environment. If we examine several periods of rising interest rates in the last 30 years, however, the high-yield category has earned a positive return in nearly all of them. This goes back to the relationship between a strong economy and a strong credit market. Rates normally rise when the economy is growing at a healthy pace, which means corporate balance sheets are in good shape. Given the recent pullback, there may not be much room for yields to fall. That being said, spreads are not at historical lows. Strong data could lead to higher Treasury rates, but we believe that this will cause the high-yield spread to narrow and fall back to the 3.50 to 3.75 percent range.
As it stands, we believe interest rates are expected to remain low for the foreseeable future. As the cost of capital declines to reflect this new reality, investors must adapt to lower returns across asset classes. This fact, combined with the state of the overall economy, means that a 6 percent yield on high-yield debt may be a particularly attractive asset class for the next few years. We believe high-yield bonds still have a place in a diversified portfolio, and that the recent correction in this asset class is little more than a compelling buying opportunity.
Miranda Davis is the portfolio manager of the BPV Core Diversification Fund at Knoxville, Tennessee–based registered investment adviser BPV Capital Management.
