Unlocking Value Across the Economic Cycle
The U.S. economy has been growing for eight years now and currently finds itself in the third-longest cycle in post-war history (in a few months, it will be the second longest). This status presents meaningful implications for investors, as they consider opportunities across many different market segments.
Allocating assets globally and across multiple asset classes, the MacKay Shields Global Fixed Income (GFI) Team invests based on its belief that monetary policy, as dictated by central bank actions, is the single largest contributor to credit creation, and thus, an important driver of the inflection points in the market cycle. Following this approach, the team determines where various economies are in the business cycle, which sets the stage for a portfolio management process that is strategic in nature.
If the economic outlook forms one critical part of the investment equation, then fundamental analysis would form another. Taken together, these elements drive the exposures to the multitude of investment segments covered by the GFI Team.
The U.S. and Europe: Room to Grow vs. Room to Run
For brevity’s sake, it’s helpful for us to focus on the U.S. and Europe in this article, given the outsized influences the two regions are currently playing in the overall portfolio allocation. Our view of their respective positions in the economic cycle, and the potential market impacts, can be summarized in Figure 1.
Figure 1: Top-Down Macro Analysis for an Unconstrained Approach
|Central Bank Policy||
Low interest rates
Wide credit spreads
↑ Interest rates
↓ Credit spreads
High interest rates,
Narrow credit spreads,
↓ Interest rates
↑ Credit spreads
Can the U.S. Economy Continue to Unlock Growth?
When assessing a particular economy, there are many factors that must be taken into account, but we would highlight three factors that are particularly important when we think about the U.S. and its position in the latter stages of the cycle:
- Labor capacity has tightened – The supply of labor has tightened, and we see this theme across a number of industries.
- Credit growth has slowed – Credit growth remains positive, but commercial and industrial loan growth has slowed. Credit is a necessary fuel for helping smooth the way towards stronger growth, and as it slows down, you will tend to see the opposite effects.
- The Fed is in tightening mode – For us, this may be the most important indicator of all, as the Fed has now been tightening for over a year. Admittedly, this has occurred at a snail’s pace, but we view it as another indicator that we’re at the latter stage of the cycle.
Figure 2: Fed Funds Target Rate (6/30/09 – 8/22/17)
Sources: Haver Analytics, MacKay Shields.
Figure 3: Real Fed Funds Effective Rate (6/30/09 – 8/22/17)
Sources: Haver Analytics, MacKay Shields.
We recognize that as our outlook has taken on a muted tone, economic growth has picked up more recently. We also recognize that growth does not move in a straight line, and the question is if the recent spike is sustainable.
Fancy Seeing You Here, Europe!
We have come a long way since mid-2012 when European Central Bank (ECB) President, Mario Draghi, sought to placate market fears by stating that he “would do whatever it takes to preserve the euro.” Despite a number of fits and starts since that time, the region’s economic prospects have continued to improve. When juxtaposed with the U.S., the Euro zone presents several differentiating features:
- There is plenty of labor supply.
- Credit growth has strengthened and still has room to improve.
- While it has proven effective, the ECB is much earlier on in its monetary phase.
Portfolio Impact: Shift from High Yield to Investment-Grade Credit
Looking at the U.S., the primary impact to positioning has been a general upgrade in credit quality. While we had built up a meaningful overweight to high yield earlier on in the cycle, that has come down significantly, albeit gradually, over the past year.
High-yield spreads are now inside of 400 basis points (bps) relative to Treasurys, and based on the nature of the risk we’re seeing and where we are in the market cycle, there’s just not enough compensation commensurate with the riskier segments of the market.
To be clear, we haven’t exited high yield by any means. We are just making adjustments based on the aforementioned combination of the economic cycle and price. That said, in light of the strong rally for U.S. high-yield corporates, the GFI Team has been reducing overall unsecured high-yield exposure in favor of higher-quality, secured opportunities. Along these lines, the team has found select opportunities in investment-grade credit, with a focus on BBB- and A-rated credits, particularly from financials and consumer-oriented industries.
Portfolio Impact: Increasing Exposure to European Equities
One area where we’ve taken on a slight overweight is in Europe. In addition to the general economic improvements within the region, equity valuations are still compelling in many cases, presenting attractive upside potential when considering tailwinds, such as economic growth and continued support from the ECB’s monetary policy.
Figure 4: European Stocks Are Cheap Relative to the U.S. on Price/Book Multiples
Sources: Barclays Research, Datastream, MSCI, as of 9/25/17.
While economic dynamics are all but impossible to predict in the short term, the long-term trends, and the resulting impacts on investment opportunities, are more easily discernible to experienced managers. In these cases, applying a global, multi-asset perspective can provide access to attractive investment opportunities throughout the economic cycle, especially for those who are able to base decisions on a combination of top-down and bottom-up factors.
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Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.
There is no assurance that the investment objectives can be met. It is not possible to invest directly in an index. All investments are subject to market risk, including possible loss of principal. Diversification cannot assure a profit or protect against loss in a declining market. A portion of the municipal bond fund’s income may be subject to state and local taxes or the alternative minimum tax. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise.
High-yield securities carry higher risks and some of the Fund’s investments have speculative characteristics and present a greater risk of loss than higher-quality debt securities. These securities can also be subject to greater price volatility.
Credit rating agencies, such as Moody’s, Standard & Poor’s, and Fitch Ratings, have letter designations (such as AAA, B, CC) which represent the quality of a bond. Moody’s assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C, with WR and NR as withdrawn and not rated. Standard & Poor’s and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, and D. Past performance is no guarantee of future results, which will vary.
Basis points (bps) refer to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
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