Time to buy corporate bonds approaching, says Kames Capital’s Milburn
Phil Milburn (pictured), fixed income manager at Kames Capital, says in a note that the sovereign crisis could get worse before it gets better, but that with bad news priced into corporate bonds already the time to buy is approaching.
The fund management industry is full of either colourful or understated adjectives to describe recent market events. Conservatively, I will choose understated and refer to August as “interesting”.
In a month that witnessed the downgrading of the US sovereign rating by S&P, weak economic data, huge equity and credit market volatility and an aggressive buying programme of Spanish and Italian debt by the ECB, the most significant event for market prices was actually a piece of broker research!
The global macroeconomic research was from a well respected broker which had significant downgrades to Western economic growth forecasts at its core. Risk markets reacted badly to this, an effect compounded by a particularly weak Philadelphia Fed survey result (though this is known to be a volatile data series). Other brokers have also been cutting their economic forecasts and the consensus is now for the US to grow just over 1% in 2011. All eyes then turned to Bernanke and his Jackson Hole address, where hints can be given but no policy can be decided.
The obvious conclusion was a delay for those hoping for something more significant, though an extra day was added to the Fed’s September meeting to consider the various monetary options available. In his speech, Bernanke did mention the need to stimulate aggregate demand, which is proving very difficult in this deleveraging cycle.
An appropriate yet slightly over-simplified analysis of the credit crunch is that the initial effect was a shorter-term supply shock followed by a longer-term demand shock. When Lehman Brothers defaulted, the short-term funding markets completely dried up. Companies no longer able to finance their working capital outlays (receivables and inventory) started rapidly destocking. The follow-on economic contraction – the Great Recession – has been well documented and only a record fiscal and monetary stimulus prevented the recession from being a depression.
The longer-term issue is the necessity for deleveraging. Western savings rates have increased as consumers look to reduce their debt burdens. Corporations have done a good job of raising equity and improving their liquidity profiles, i.e. their reliance on short-term funding is extremely low. Banks are still working through their balance sheet issues; debt problems remain but total leverage has fallen significantly. Finally, governments have started to realise that debt trajectories are unsustainable, though actions are different across jurisdictions. The combination of these forces is likely to continue to suppress growth for the next economic cycle. I think more people are coming around to this theme of too much debt and too little growth (generally credited to the famous economists Reinhart and Rogoff). Some take this further and raise the concern about the ‘paradox of thrift’ creating a vicious downward spiral. However, monetary policy has not lost all its strength and more innovative actions are always possible in a fiat economy.
Economic commentators are increasingly discussing a double-dip recession, although it is worth noting that the US economy has still not recovered its 2007 peak level of activity in real terms. Rather than concentrate on whether a GDP growth number drops below zero, I thought I would voice my opinion that any fall would be far lower than in the post-Lehman collapse. The main reason for this is the inventory cycle that I referred to above. With lower stocks and a lean cost base it is far less likely that corporations will have to significantly cut production.
Consumer demand growth is low (in the 1-2% region), but the volatility of headline growth around that number should be a lot less. The one factor that could prove me wrong is if the eurozone dissolves into a chaotic meltdown. Given the number of bureaucrats that are still living in a world of denial, this is a tail risk that cannot be dismissed lightly. The ongoing sovereign crisis will inevitably be a feature of many fund commentaries in the months to come so I will not cover old ground here.