But what might derail this positive momentum?
by Ron D’Vari, CEO, New Oak CapitalConnect with Ron by e-mail [email protected]
Early on we believed 2013 would be a pivotal and defining year. So far, events have confirmed our 2013 forecast. There has been no major deviation from forces we highlighted in our Q4 2012 Newsletter.
While the markets will continue pushing ahead driven by an unprecedented amount of liquidity, there remain critical domestic and global structural issues that could derail the positive momentum. Globally, central bankers remain determined to continue to battle the post-crisis challenges until the global economy gets back on a steady and sustainable growth path.
Despite these challenges and dysfunctional governments, central bankers are beginning to see positive results from their unprecedented aggressive monetary easing. The banks, however, are fully aware the battle is far from over and they may be only halfway through their high wire act.
The state of the economy
While the global economy is improving, it still has a way to go to shake off the fallout of the credit crisis. Thus long-term growth expectations will remain about half a percent lower than pre-crisis.
Among the key structural concerns are:
- Global institutional, regulatory and financial governance issues
- Evolving global financial system
- Impact of new regulations such as Dodd-Frank, Basel lll, MiFIDll and EMIR
- Credit bubble in China
- Infrastructure and political structural bottlenecks in emerging markets
- Geopolitical risks such as Japan/China territorial and currency disputes
- U.S. fiscal cliff and uncertainty about the outcome of the budget battle in DC
- Divided Congress and ineffective government
- Persistent high unemployment
- End of QE3 by the end of 2013
- European sovereign debt impasse
- Political stalemate and dysfunctional governments
- Negative public sentiment against austerity
- High and rising unemployment
- Dragged out recession
Positive Economic Drivers
On the positive side, the Federal Reserve is resolved to reduce unemployment to 6.5%, and this will be one of the key reasons for the markets’ optimism and gradual economic improvement.
U.S. housing is expected to continue to improve. This is partially driven by: a) low interest rates; b) gradual loosening of credit standards; c) private equity investments in single-family REO-to-Rent; and D) artificial housing supply management by the banks through delaying foreclosure.
Corporate cash levels are at all-time highs and corporations are now willing to speed up corporate investments as markets start to punish cash hoarders. The risks of spillover from Europe sovereign debt to the global economy have diminished. U.S. banks and major financial institutions are in their best shape since the credit crisis and are looking to grow their traditional lending. We also believe the impact of sequester budget cuts will be gradual and overtime will be overpowered by the low interest rates and improving economic conditions.
One factor that has quietly come up and that will gradually become more significant in time is the long-term availability of energy resources, such as oil and gas. The developments in shale gas will alter the domestic energy supply picture providing reasonably priced and relatively abundant new source of energy. This would eliminate one major constraint to U.S. growth and would boost growth expectations over time.
Due to continued productivity improvements and softened energy constraints, inflation will not be a risk despite the massive liquidity provided by monetary policy. In fact, the risk of inflation is shocking the system too abruptly and hurting the economy by withdrawing the liquidity too quickly.
Therefore, continued low interest rates, low inflation, abundant QE3 stimulus, improving housing, consumers’ growing confidence, accelerating corporate spending, and an ample supply of energy will gradually propel the economy despite government ineffectiveness, fiscal issues, and new regulations.
As the economic and unemployment picture improves, interest rates are bound to increase gradually over the next few years. However, fixed income assets are more exposed to higher expectations of real yields than rising inflation, as we view inflation to remain restrained. Hence, we prefer nominal bonds to Treasury Inflation Protected Securities (“TIPS”) as the base nominal yields are hedgeable. TIPS are neutral to inflation increases but are highly exposed to real rates rising (NewOak Insights) and are not directly hedgeable.
While corporate and structured product spreads are at their tightest post-crisis levels, there is still room for further compression due to demand-supply imbalance and the improving credit environment. The more ideal fixed income instrument under our outlook will be floating rate bonds with the potential of spread compression, as low interest rates will oblige investors to search for yield. We maintain our recommendation to consider the following sectors combined with a highly selective security selection to avoid downside risk.
- High quality structured products such as new issue ABS, CMBS and CLOs
- Leveraged corporate loans and asset-based loans
- High yield corporates and emerging markets positioned to benefit from global growth and improved liquidity
- Distressed and newly originated residential and CRE loans
- Distressed RMBS and CMBS and re-REMICS
- Private mezzanine corporate and CRE loans
- Well supported legacy and new esoteric securities such as timeshare, aircraft, and subprime auto
- Specialty finance (receivables and asset-based lending)
- Clean-energy securitization
Issuance in ABS, CMBS and CLOs are well underway to beat last year’s issuance and new issue in non-agency residential RMBS securitization is beginning to start upbut will be constrained for the time being.
Investors with appropriate infrastructure will invest directly in private corporate loans, whole-loan residential, and commercial loans (both distressed and new origination).
Corporate earnings as a percentage of GDP is at a record high since the 1950s and so are the corporate cash levels. Given the growth environment, the opportunities to invest this cash will continue to improve and result in good prospects for the top and bottom lines of companies to grow as well as the multiples to expand. While the equity values are now at record highs, based on our forward looking outlook, we remain constructive on equities and biased toward growth stocks.