The 10-year U.S. Treasury note traded at a 3.00% yield on Thursday, September 5. This level represents a significant increase from the 2013 trough yield of 1.66% on May 1. The good news is the majority of this increase is attributable to an increase in real yields and not inflation expectations. The bad news is that a multi-year "alignment of interests" among the U.S. Federal Reserve and the financial markets has been severed. The Fed's introduction of unconventional tools to combat the risk of deflation and the reality of deleveraging encouraged asset managers to launch a series of leveraged fixed income strategies designed to profit from a stable, low-yield environment. Although these strategies were likely viewed as supportive of the Fed's 2008 to early 2013 reflation mission, the prospective unwinding of these investment strategies, coupled with a pullback by retail and institutional investors from all types of "yield" instruments, has contributed to interest rate volatility and thus overall fixed income and equity market risk. We appear near the conclusion of the era of interest rate suppression created by no-end-in-sight Treasury and mortgage-backed securities purchases by the Federal Reserve.
While some investors may scrutinize "the trees" surrounding the potential degree of Fed tapering, expected to be announced at the conclusion of the September 17–18 Fed policy meeting, "the forest" is the redirection of U.S. monetary policy away from reflation to recovery. Yes, the Fed will continue for some time its bond purchases, or "quantitative easing," acquiring something less than $85 billion worth of bonds each month, but once unquestionable bids from the central bank will be no more. Reports of summertime liquidity hiccups in the supposedly liquid high-grade credit markets represent shadows of the future that need to be monitored carefully. A high percentage of non-exchange-traded or over-the counter fixed income assets reside with just a handful of industry players. Japanese and European reflation efforts that have lagged U.S. efforts also should prove important to global yield relationships and currency movements.
U.S. employment: Less than meets the eye
Amid a slew of recent positive economic news—robust U.S. auto sales, an improving U.S. housing market, and an upward trend in global purchasing manager indices—there is a pocket of weakness that should give equity bulls pause. The lead article in the September 7–8 weekend edition of The Wall Street Journal affirmed what alert economy-watchers have known for some time: there is trouble beneath the surface of the declining U.S. unemployment rate. Federal Reserve policymakers have suggested that its bond purchases would likely conclude around the time that the unemployment rate reaches 7.0%—it's now 7.3%—and that conversations about raising its target for short-term interest rates could begin when the unemployment rate falls to 6.5%. However, as the firm 13D Research reported on August 1 in its flagship publication, WHAT I LEARNED THIS WEEK:
"The unemployment rate has fallen primarily due to people dropping out of the labor force—a situation unheard of during an ‘economic recovery.' There has been little to no recovery in the overall percentage of the population that is employed which dropped from 63.3% in 2007 to 58.7% in October 2009 and remains near that level today. Nearly three times more people have left the workforce than have found a job in the current recovery. 73.9% of all new jobs this year have been in part-time positions. The current duration of lackluster full-time job growth is cause for concern and helps explain why real household income levels are not growing."
It is interesting to note that the Fed has hitched its quantitative-easing wagon to a data series that has enjoyed headline success while being less than meets the eye.
In Europe, signs of modest recovery and new political risks
Bottom-up stock analysts are expecting very strong (35%) growth in euro zone earnings over the next 12 months. Much of this expected earnings growth is attributable to highly favorable expectations for Italy (107% growth) and Spain (35% growth). Obviously, these high rates reflect expected growth from low current levels of profitability. By comparison, expected earnings growth for the largest euro zone economy, Germany, is only a paltry 2.5%.
Purchasing managers' indices (PMIs) for several euro zone countries, again most notably Italy and Spain, have recently moved slightly above 50, the highest levels since mid-2011. However, a PMI of 50 represents a country's or region's long-term average real rate of economic growth. For the euro zone countries, a PMI of 50 represents historical long-term growth of no more than 1%. Composites of leading economic indicators for various European countries paint a similar picture of very slight recent expansion, according to the Organisation for Economic Cooperation and Development. Essentially, European economic conditions have been returning to historically "normal" levels, but those are far from ideal.
Italy faces two near-term political risks to economic growth. The Italian Senate is considering a motion to unseat Silvio Berlusconi after his recent tax fraud conviction, which was recently upheld by the nation's high court. Members of Berlusconi's political party, the People of Freedom, may withdraw from the coalition government led by Enrico Letta of the Democratic Party, casting the country back into political limbo. Additionally, there has been some controversy over the European Union-supervised recapitalization of one of Italy's largest banks, Monte di Paschi, whose former management was caught in a corruption scandal. Already, the Italian 10-year sovereign bond yield has risen from 3.76% in early May, after the Letta government was formed, to 4.52% today.
Germany also presents a political risk to euro zone economic growth. It had been thought that Angela Merkel's Christian Democratic Party would comfortably win the September 22 parliamentary elections. However, there is now a possibility that the radical Left Party will join the Social Democratic Party (SDP) and Free Democratic Party (FDP) in a coalition that would gain a majority of the seats in the Bundestag and unseat Chancellor Angela Merkel. If the SDP and FDP accommodate the Left Party on some of its anti-capitalist policies, there could be repercussions across the euro zone.
Wilmington Trust® is a registered service mark of Wilmington Trust Corporation, a wholly owned subsidiary of M&T Bank Corporation. Investment management and fiduciary services are provided by Wilmington Trust Company, a Delaware trust company, and Wilmington Trust, N.A., a national bank. Loans, retail and business deposits, and other personal and business banking services and products are offered by Manufacturers and Traders Trust Company (M&T Bank), member FDIC. Wilmington Trust Investment Advisers, Inc., a subsidiary of M&T Bank, is a SEC-registered investment adviser providing investment management services to Wilmington Trust and M&T affiliates and clients.
The information in Market Notes has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates, and projections constitute the judgment of Wilmington Trust and are subject to change without notice. This commentary is for information purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or a recommendation or determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the investor's objectives, financial situation, and particular needs. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will be successful.
These materials are based on public information. Facts and views presented in this report have not been reviewed by, and may not reflect information known to, professionals in other business areas of Wilmington Trust or M&T Bank who may provide or seek to provide financial services to entities referred to in this report. M&T Bank and Wilmington Trust have established information barriers between their various business groups. As a result, M&T Bank and Wilmington Trust do not disclose certain client relationships with, or compensation received from, such entities in their reports.
Any investment products discussed in this commentary are not insured by the FDIC or any other governmental agency, are not deposits of or other obligations of or guaranteed by M&T Bank, Wilmington Trust, or any other bank or entity, and are subject to risks, including a possible loss of the principal amount invested. Some investment products may be available only to certain "qualified investors"—that is, investors who meet certain income and/or investable assets thresholds. Past performance is no guarantee of future results. Investing involves risk and you may incur a profit or a loss.
CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute. Other third-party marks and brands are the property of their respective owners.
Indices are not available for direct investment. Investment in a security or strategy designed to replicate the performance of an index will incur expenses, such as management fees and transaction costs that would reduce returns.