The markets turned volatile again in early December as developments in China and the energy markets have added stress to both high yield bond markets and equities. As of December 15th, large cap U.S. Equity indices had narrowly entered negative territory year to date (before dividends) while broad measures of riskier parts of the markets such as small caps, junk bonds and international equities are down approximately 3-8% for 2015.
Energy’s abrupt decline has disrupted many capital markets worldwide. Last Friday, oil declined to $35.62/barrel – its lowest level in 6 years, and natural gas plunged to a 14 year low as the warmest weather on record has sapped demand in the face of high OPEC production. While energy’s weakness has historically provided a dividend to consumers in the form of lower prices at the gas pump (gasoline at $2.12/gallon is 62 cents cheaper than the prior year), much of the debt financed energy sector expansion over the last few years is now threatened. Like leveraged U.S. energy companies, the declines in energy and commodities in general are having an outsized impact on the currencies of oil exporters like Brazil and Russia.
Separately, the lead-up to the increase in interest rates by the Fed has blunted China’s efforts to rekindle its economic growth. Two weeks ago, China devalued the yuan, removed its dollar peg and transitioned its controlled value to a basket of currencies. The surprising fall of yuan to a 4.5-year low at 6.45 to the dollar is providing additional stress to the equity markets as U.S. exporter competitiveness is further harmed.
While generally stable credit conditions and low default rates have kept high grade corporate and mortgage securities yield spreads to U.S. Treasuries near historic median levels – the decline in energy and commodity prices has caused havoc in the lower quality segment of high yield market. Option adjusted spreads on CAA and unrated bonds have spiked up one or more standard deviations past historical levels. Declining prices and higher volatility typically elevates uncertainty and with it widens bid-ask spreads. This weak price discovery has become most pronounced in the lowest quality areas of the fixed income market and valuing portfolio assets has become quite difficult. In response, Third Avenue Asset Management – in an effort to treat redeeming and non-redeeming shareholders equally – halted redemptions on their high yield Third Avenue Focused Credit Fund. As investors were fleeing at a faster rate than the fund could responsibly sell assets, prices of the unsold remaining fund assets would be jeopardized. Rather than sell at distressed prices, the firm halted redemptions to liquidate the fund in an orderly manner over the next year. We believe troubles with this fund are not new and not indicative of the high yield asset class in general, but rather limited to the small sub-set of unrated or lowest rated securities. The fund, which at one point was $2.5 billion, had shrunk to $785 million through redemptions and loss on investments. The fund had the most exposure to illiquid assets of any fund in its class, with 85% of its holdings in distressed debt. We believe the real liquidity risk in high yield debt is within traditional mutual funds, not ETFs.
Historically, December has been a strong month and many investors come to expect the “Santa Claus Rally.” Seasonally, the typical December trading pattern shows weakness early (likely coincident with tax-selling) and a low around the 10th trading day of the month. Subsequently, stocks traditionally rally into year-end.
Importantly, the Federal Reserve met last week and increased the Fed Funds rate by 0.25%. In our opinion, the Fed missed the opportunity to initiate rate normalization earlier this year. Now confronted with weaker earnings, low inflation and a deteriorating high yield market, the Fed seems to have painted themselves into a corner. The initiation of normalization/tightening policies to combat mildly improving labor markets appears divergent from the easing policies of our important trading partners – Europe, Japan and China. Although the Fed followed through with their telegraphed rate hike from a credibility perspective, the factors cited above will likely restrict their ability to meaningfully raise rates in 2016.
Although we acknowledge that disruptions in the high yield market often portend difficult periods in the economy and/or equity markets, we believe the intermediate and long term out-look for high quality U.S. and International equity returns re- mains favorable and exceeds the returns present from currently low yielding fixed income securities. Given current levels of low interest rates and likely long term equity growth rates, we believe broad classes of equities are priced fairly — with high current relative earnings yields — and should deliver returns similar to their long term historical averages. The change in Fed policy does not dissuade us as we believe intermediate term future policy is intended to just remove the now-unnecessary extraordinary accommodative policies initiated during the 2008-2009 recession. In our view, equities remain the beneficiaries of moderate economic growth, fair prices, low inflation and continuing low levels of interest rates.
Sean Clark is the Chief Investment Officer and Anthony Soslow is a Senior Portfolio Manager, both at Clark Capital Management, which is a participant in the ETF Strategist Channel