YIELD CURVES DON’T LIE

Richard Bernstein’s Merrill Lynch note from 2006 is burned into my memory. I’ll never forget his recession call in the USA based on the inverting yield curve. The note said something to the extent: “a profit recession has occurred 100% of the time following an inverted curve”. Recessions, though not 100% accurate based on the yield curve, remain very high probability events when confronted with an inverted curve. And this makes a great deal of sense. An inverted curve is generally a sign that a credit binge is coming to an end and banks and investors are beginning to reign in their risk while also generally being accompanied by tighter government policy. An inverted curve is the equivalent of reaching the point where you’re slamming the breaks on the car trying to stop her. And it generally works!

In a recent note Richard Bernstein, no longer with Merrill Lynch and running his own shop, Richard Bernstein Advisors, highlighted some recent trends in global yield curves:


“One of our favorite indicators is the slope of the yield curve. Yield curves have historically been very good predictors of future profits growth and of future trends in equity market volatility. Steep curves (i.e., a wide, positive spread between 10-year and 2-year notes) have generally been followed by periods of stronger growth and lower volatility, whereas inverted yield curves (i.e., the 2-year rate is higher than the 10-year rate) have generally been followed by profits recessions (i.e., periods with negative year-over-year trailing EPS growth) and higher volatility.

The United States currently has the steepest yield curve in the world. As Chart 2 shows, the spread between US 10-year and 2-year notes was about 259 basis points at the end of May. Interestingly, this is not only the steepest yield curve in the world at present, but the US yield curve is close to its steepest since the mid-70s (the steepest was the 291 basis-point spread on February 4, 2011).

If history is any guide, the very steep US yield curve argues that current expectations regarding future US corporate profits growth and equity market volatility trends are too bearish. However, some yield curves around the world are starting to suggest increased caution may be warranted.

Chart 2 also reflects that yield curves are inverted or very flat in a number of countries, including some of the BRICs. Most investors are probably not surprised that Greece, Portugal and Ireland currently have the world’s most inverted yield curves, but our guess is that investors have no idea that Brazil’s yield curve is a mere 1 basis point from inversion, or that India’s is only 2 basis points from inversion.”

“Many US investors are very concerned about the Fed’s future monetary policy and the looming end of QE2, but aren’t the least bit aware that yield curves in the BRIC countries might soon invert. This seems critically important to us because history shows well that bull markets typically end not at the beginning of a central bank’s tightening cycle, but rather when the central bank has tightened too much, and inverted yield curves typically indicate that a central bank has tightened too much.

The US currently has the steepest yield curve in the world, and investors are very concerned about the longevity of the US bull market. BRIC yield curves are close to inverting, but investors don’t seem the least bit concerned.

This is a whopping disconnect, in our view, and presents a significant, actionable investment opportunity.”

I am not one to question this analysis, but it’s important to note that a slow-down in the BRIC countries would most certainly spill-over into developed countries. Particularly given the current environment in which developed nations are mired in near persistent recession and largely relying on emerging markets for growth. That said, a developed country such as the USA whose yield curve is quite steep, might outperform, but performance is relative in our global economy. And in this case, relative likely means “better than horrible”.

S&P 500: Bargains R Us

Rising earnings, falling stock prices mark deals

S&P 500 SPX-I stocks are looking cheap, as profits rise and share prices fall, according to an analysis by Bloomberg News [http://www.bloomberg.com/news/2011-06-19/stocks-cheapest-in-two-decades-as-s-p-500-falls-with-earnings-climbing-18-.html].

Standard & Poor's 500 Index companies will earn 18 per cent more this year than in 2010, according to the average estimate of more than 9,000 analysts polled by Bloomberg. Declines since April have pushed the price of the S&P 500 to 14.5 times the past year's earnings, compared with the average of 20.5 since June 1991.
The index is valued at 8.7 times cash flow, cheaper than it has been 81 per cent of the time since 1998.
"Even if companies posted no growth, price-earnings ratios would be lower than on 96 per cent of days in the past two decades," the article points out.

S&P 500 earnings may rise to $99.61 (U.S.) a share in 2011 from $84.58 last year and $61.52 in 2009, according to data compiled by Bloomberg. That's an increase from the forecast of $95.37 on Jan. 3 and $98.70 on April 29.

Should stocks stay at current prices and the analyst predictions come true, the S&P 500 would trade at 12.8 times income on Dec. 31, the lowest level since 1985 except for the six months after Lehman Brothers Holdings Inc.'s bankruptcy in September 2008 and nine months in the late 1980s, according to Bloomberg data.

One point to bear in mind is that margins are extremely high, at about 10 per cent, after aggressive cost-cutting, and that may be unsustainable, according to Joe Weisenthal of Business Insider [http://www.businessinsider.com/sp-only-appears-cheap-2011-6].

How Much Will 'Floating Rate' Funds Really Float?

Investors who have been loading up on "floating rate" mutual funds this year to capitalize on rising interest rates might be in for a surprise—even if rates rise.

Floating-rate funds are unique among fixed-income vehicles, giving investors the potential to benefit from—rather than be hurt by—rising interest rates. They hold lower-quality corporate loans whose interest payments can reset every three months or so, enabling the funds' yields to ratchet up if short-term interest rates rise—unlike conventional bonds, which go down in value when rates go up.

 

With nearly everyone sensing that rates are bound to go up sooner or later, it isn't surprising that investors have become infatuated with floating-rate funds. So far this year, according to Morningstar, these funds, also known as "bank loan" portfolios, have taken in $21 billion in new money from investors. Their assets have grown by 50% in just five months and have more than doubled over the past year to some $70 billion.

So what is the problem? Floating-rate funds might not be quite as buoyant as investors expect.

The income generated by bank loans has long been based on Libor, or the London Interbank Offered Rate, a standard measure of what banks charge one another to borrow. This week, the three-month Libor rate was below 0.25%, near all-time lows.

But about two years ago, bank loans began to include "Libor floors," or minimum levels at which their income payments begin ratcheting upward if interest rates rise. According to Robert Polenberg of Standard & Poor's Leveraged Commentary & Data, 40% of existing bank loans have Libor floors, with the level averaging 1.59%. Virtually 100% of newly issued loans, says Mr. Polenberg, include them.

While this feature ensures a minimum yield, it also acts as an anchor. To see why, consider the $3 billion bank loan raised last month for Chrysler Group. Maturing in 2017, it pays 4.75% plus a 1.25% Libor floor. That means its current coupon, or income stream, is locked at 6% until short-term interest rates rise above 1.25%. The loan's coupon can be adjusted upward every 90 days, but that won't happen until Libor exceeds 1.25%—a full percentage point above where it stands today.

That feature makes newer bank loans more like conventional bonds. "The loan behaves like a fixed-rate instrument with a higher [sensitivity to interest rates] until Libor breaches the floor," says Gautam Kakodkar, a structured-credit analyst at Barclays Capital.

Thus an upward jolt in interest rates not only could leave floating-rate loans temporarily unable to float but might even knock their prices down—until Libor finally rises far enough.
"I don't think you would see a dramatic drop," says Robert Dial, manager of the $1.4 billion MainStay Floating Rate fund. "It's conceivable that the market might [fall] a point or two. But investors would probably say, 'In a month or two, I catch up."'

David Allison of Allison Investment Management in Columbia, S.C., points out that charts of past performance showing these funds performing well when rates went up are based on periods before Libor floors were common. Who knows how investors will react if loans that they expected to float higher with rising interest rates just sit there?

"I think a lot of retail investors might be expecting a more-rapid increase in income than the Libor floors may allow in the short term if interest rates rise," says Justin Gerbereux, co-manager of the $2 billion T. Rowe Price Institutional Floating Rate fund.

What these funds offer is a trade-off: You get generous current income but might not benefit fully from rising yields until interest rates rise a percentage point or more. Your protection against rising rates should still kick in, but only after they have shot up considerably.

Investors ought to care about the risk of larger interest-rate increases over longer periods of time, says Christine McConnell, manager of the $12.1 billion Fidelity Advisor Floating Rate High Income fund. "In that case you're still getting the floating-rate protection you ultimately want. It's not fine-tuned, but it's still there."
Investing in a floating-rate fund, then, is a bit like buying insurance with a high deductible: a perfectly sensible decision, so long as you realize you have protected yourself against large risks while exposing yourself to smaller ones.

Unfortunately, a yield that floats after interest rates rise a lot—but mightn't while they rise just a bit—probably isn't what many investors had in mind when they bought these funds.

The Long Run