CreditSights: Outlook For 2004
It may be too early in the game, but the trend currently seems to be one of "calendar creep." The biggest challenge you used to be presented with in December was juggling an over-packed calendar of holiday parties. But these days, it seems the traditional pastime among investors has shifted to handicapping the trends that will have the greatest impact on their holdings in the coming year.
Heading into 2004, we are facing an unusual period of consensus in terms of the economic outlook. Growth forecasts strong enough to put the wind up the skirts of bond investors are tempered by a Federal Reserve that is at pains to communicate to the market its willingness to maintain an accommodative interest rate stance in the face of low inflationary pressure. Strong growth that is benign to bonds may seem to be naively optimistic in one sense, particularly given the inflationary fiscal policies that are currently being pursued, but the view looks sound for many reasons.
Deflationary risks may have left the party, but enough disinflationary pressures are still hanging around the punch bowl to prevent the Fed from taking it away. Capacity utilization is rebounding from such a low level that a sustained period of growth can be experienced before any bottlenecks occur. A jobs market that remains the most inconsistent part of the recovery story is ensuring that there is minimal labor cost pressure. Long-term trends of rising productivity in the U.S. and the outsourcing of manufacturing jobs to countries like China and servicing jobs to countries like India make it quite possible that the employment cycle will substantially lag the gross domestic product cycle. Such an outcome, particularly in an election year, would only add to the rationale for interest rates to stay low.
Low is one thing however; unchanged is another. The wordsmiths at the Fed carefully craft each communiqué and it occurs to us that the assurance of rates remaining "accommodative" is not a guarantee of the Fed Funds rate remaining at 1.00% for any defined period of time. One could hardly describe a Fed Funds rate of 1.25% or even 1.50% as restrictive. In fact, one could easily describe 1.00% as being stimulative, now that the deflationary threat has receded. We don't have any particular reason to second guess the consensus view but, being contrarians by nature, we would advocate that investors devote some time to pondering the most likely timing of a change in Fed stance (and remember that previous trend changes in yields have often been triggered by the commentary released after a meeting in which there was no change in rates). The corollary to handicapping the first Fed move in 2004 is predicting the likely curve reaction. We favor a bear flattener with a constrained move higher in long rates.
Corporate bond investors will no doubt fret about valuation levels next year, but they should continue to enjoy a market that is technically strong and fundamentally improving. Issuance is likely to remain strong given current demand, the low interest-rate outlook and the expected pick-up in capital spending and mergers and acquisitions. But these latter factors will, in our view, not prove to be as detrimental to bondholders interests as they have been in the past. We believe that M&A activity is likely to be typified more by bolt-on acquisitions of specific product lines by companies facing constrained organic growth prospects than by the mega-mergers that were typical of past peaks in M&A volume. And while there is no denying that there is a trend already underway of directing a greater share of cash flow to equity holders, it too seems to be taking a more benign route of increased dividends (as opposed to debt-funded equity buybacks).
We go into 2004 overweight the corporate universe, with a bias toward the yieldy sectors, and advocate a long-duration stance. The greatest concern we have regarding the sector is the already tight pricing levels that have factored in much of the coming economic upside. So far however, few asset classes look to offer more attractive valuations and therefore the technical base remains intact. The only dismal note in our outlook for corporates in 2004 is that a confluence of favorable factors is likely to deliver only a modicum of excess return. It certainly won't be another year like this one.
Analysis by CreditSights, Inc., an independent online credit research platform. Call (212) 340-3888 or visit www.CreditSights.com for more information.