September 30, 2014
After a second quarter marked by complacency in the capital markets, the third quarter saw more concerns from the market regarding the Fed’s exit from QE and their eventual expected overnight interest rate hike that most predict is finally on the way sometime next year. The S&P 500 had a total return of 0.62% for the quarter. The VIX, barely above 10 last time we wrote this following the second quarter, is over 29 as we write this today in the midst of an extremely volatile October in the equity markets. Spreads in more volatile sectors, which typically widen as the VIX increases, are out about 20 to 25 bps in some of the major financial credits. Accordingly, high yield and BBB credits have underperformed higher quality/lower Beta sectors of the credit markets. In terms of interest rate volatility, The Merrill Lynch Option Volatility Estimate (MOVE) index, which measures interest rate volatility as an index on interest rate options, has spiked to 74 from a low of 52 in August amidst a much more complacent capital markets environment. There has been a massive flight to quality and specifically to long duration US Treasuries, corresponding with comparatively lower global bond yields. For example, German Bunds yield just 75 bps, the French 10-year yields 1.13% and the Spanish 10-year bond yields 2.1%. For some perspective, in July of 2012, Spanish 10-year bonds yielded 7.51% in the heart of the Euro crisis while the US 10 year had a yield of 1.4% at the time. As we write this today, the US 10 year yield dipped below 2% all the way to 1.86%. The Ryan Labs on-the-run 10 year US Treasury Index yielded 2.51% at the end of the third quarter while the Ryan Labs on-the-run 30 year US Treasury Index had a yield of 3.21%.
Fundamentally, the U.S. economy has had mostly positive news as of late. Despite a poor month of August, the monthly Non Farms Payroll report bounced back in September with a net change of +248k jobs and an Unemployment rate of 5.9%. Outside of the August report of +180k jobs, every month since January has seen a NFP change of at least 200k. Manufacturing underwhelmed expectations but still came in at a respectable 56.6. New home sales were up an mpressive 18% in August, and are benefiting from a lower interest rate environment compared with the rising yield environment for most of the second half of 2013. Existing home sales were slightly weaker than expected last month but had been strong in prior months. On the negative side, September retail sales came in weaker than expectations at -0.3% month-over-month compared with expectations of -0.1%, and after a strong August number of 0.6% growth. As of late, global growth concerns have come into the forefront, especially in the Eurozone as well as in China. A sign of weaker global final demand has been weakness in commodities, most notably in oil. West Texas Intermediate crude oil prices have dropped sharply, dipping to $82 from a high of nearly $104 in June. Surprising weakness in German industrial production and a GDP increases just above zero are examples of weaker Eurozone activity. In light of this news, there has been recent chatter of the effects of the end of the Federal Reserves multi-year quantitative easing coming at a time of potential global slowdown. In terms of corporate profitability, we are in the midst of 3rd quarter earnings and results have been mixed. While earnings growth has come in at 11.59% so far with 82 companies of the S&P500 reporting, concerns over a strong dollar and the subsequent effect on demand for U.S. goods overseas have been a discussion point.
Bonds traded sideways in the third quarter but have rallied overall for the year after a historically bad 2013. The 10 year US Treasury yield finished the third quarter at 2.51%, from 2.53% to end the second quarter and from 3.03% at the end of 2013. The 10-year has rallied substantially in October and is at 2.20% as we write this after a very volatile week in both the stock and bond markets. Earlier this week, the 10-year dipped below 2% in the midst of a violent interday equity market selloff. Still, the 10 year yield is well above its low of 1.39% in July of 2012. The return on the Ryan Labs 10-year Treasury Index for the year through 9/30 was 6.8% after posting a -7.73% in 2013. With weaknesses in both commodities and Eurozone growth data, and a CPI of 1.6% and PPI of 1.6%, bonds have been bid to start the quarter.
The third quarter was relatively weaker in the credit markets, with higher quality triple A bonds outperforming BBBs. Within high-grade fixed income, credit spreads in the Barclays Aggregate Index ended 2011 at 217 bps, 2012 at 133 bps, tightened to 111 bps to end 2013, and finished the third quarter wider at 107 bps off Treasuries from 96 bps at the end of the second quarter. Spreads have widened more substantially recently with the spike in the VIX and in a stock market correction. Spreads on financial credit ended the third quarter at 107 bps from 96 bps at the end of the second quarter. Recently many of the major banks reported positive third quarter earnings including upside surprises from Morgan Stanley, Goldman Sachs, Wells Fargo, JPMorgan, and Citigroup while Bank of America missed earnings estimates. Industrials also finished the quarter wider, ending the third quarter at 115 bps from 102 bps to end the second quarter. The agency MBS sector has outperformed duration-neutral Treasuries by 40 bps for the year as of the end of the third quarter, despite the Federal Reserve winding down their Agency MBS asset purchase program. The excess returns of the agency MBS sector was 38 bps versus duration-matched Treasuries for the month of September. The option-adjusted spread at the end of the September was 30 bps.