Baird’s Mary Ellen Stanek Addresses Institutional Investors, Provides Bond Investing Outlook
MILWAUKEE, October 16, 2012
At her annual address at the Baird Advisors Institutional Investors Conference in Kohler, Wis., Managing Director and Chief Investment Officer Mary Ellen Stanek provided guidance for bond investors on the economy, inflation, interest rates and portfolio positioning. Following are highlights from her speech.
Slow Economic Growth Presents Continued Challenges, But Inflation Not Imminent
On the U.S. Economy
: “We see slow growth in the U.S. economy with continued headwinds. The U.S. GDP growth rate in 2012 was only 2.3%. This sluggish recovery limits job growth. We continue to have stubbornly high unemployment. September’s job report of 90,000 new jobs was disappointing; especially when you consider we need 125,000 just to replace those leaving the workforce. Underemployment is also an issue with as many as 1 in 6 not fully employed. Adding to the headwinds is heightened US Policy uncertainty due to the upcoming election, a Lame Duck Congress, and concerns about a fiscal cliff due to expiring of tax cuts and mandatory spending limits.”
On Global Uncertainty
: “The European debt crisis will continue to be a chronic issue, but not fatal. Concerns about a slowdown in China also loom.”
: “While we pay a lot of attention to the huge amount of liquidity that has been injected into the economy, we believe wage pressures remain benign with continued high unemployment and capacity in the labor markets. We believe there is more time before inflation kicks in, but we will watch for any wage pressure closely. Core inflation today remains near the Fed’s target with headline inflation below target allowing the Fed to continue their current policy.”
On Fed Policy
: “Fed policy will remain extraordinarily accommodative. The Fed is in unprecedented territory. Beginning in 2008, the Fed announced and maintained a near zero target interest rate. It then began QE1 with outright purchase of US Treasury securities. In 2011, the Fed reiterated their explicit language to maintain low levels for the Federal Funds rate through at least mid 2013. Next was Operation Twist, where the Fed sold shorter-term and purchased longer-term government securities in an effort to bring long term interest rates down. One could argue the Fed faced unprecedented challenges that led to these policies. They are not alone in implementing extraordinary monetary policies with the four most significant foreign central banks growing their balance sheet assets from $3.36 trillion in late 2006 to more than $9 trillion today.”
On Fiscal Policy
: Fiscal policy is at a crossroads, with deficit spending unsustainable. We are spending $1.54 for every $1 of revenue. We are concerned about policy choices and the long term impact on the economy. A credible deficit reduction plan is needed as we can’t keep “kicking the can” down the road. A real concern would arise if China, in a provocative move, would choose to reduce their purchases of our debt.”
Housing Market Stabilizing, But Consumer Student Loans May be Next Credit Bubble
On Signs of Hope
: “On the positive side, we see positive improvement on a number of economic measures from the recession lows including the unemployment rate, consumer confidence, vehicle sales, corporate profits, and the return on the S&P 500. Junk bond yields have tightened reflecting a lower risk premium. The rocky bottoming process in the housing market is finally stabilizing. We believe housing is very affordable now with low interest rates having a significant impact on monthly mortgage payments as a percentage of monthly median income. We’ve even seen some signs that housing inventory is shrinking. Stabilization in housing removes a huge negative impacting confidence.
“There are other signs of hope including a US manufacturing renaissance with some re-shoring of US jobs. The natural gas boom could be a game changer leading to new infrastructure investment, less dependence on foreign oil and lower energy costs. We also see a tech boom as Apple is now the largest ever US company.”
On Student Loans
: “While consumers have improved their balance sheets and are now in better shape, consumer student loans remain a problem and are potentially the next credit bubble. Student loans are up while consumer credit less student loans has fallen. This is a troubling trend.”
Bond Performance and Outlook
“So what does that mean for bond returns? 2012 has been surprisingly strong. US Treasury Yields are at 60-year lows. Yield spreads are tighter with valuation in some sectors, in our opinion, beyond fair value. As investors reach for yields, they are pushing valuations.
“We continue to believe yields will stay lower longer than people expect, defying consensus. In this environment, yield curve positioning and roll down, or the performance boost over time as securities shorten down a steep yield curve, continue to be important components of total return.”
On Portfolio Positioning
: “We are finding selected pockets of value in the corporate sector, especially financials. Net new supply in the corporate sector has slowed with most issuance replacing existing debt. Strong corporate profits have improved credit fundamentals. Balance sheets and liquidity are especially important in the financial sector where capital ratios have significantly improved while the supply has come down.
“We continue to underweight Treasuries. The bond indexes are still significantly exposed to sectors we believe are extremely overvalued. We continue to seek a yield advantage over the benchmark. We believe spread sectors remain fair to attractive despite narrowing yield spreads. We believe select securities are still trading below fundamental fair value.
“On the municipal side, demand outpaces supply with net new supply contracting by an estimated –$35 million in 2012. Lower quality and longer-term issues continue to outperform as investors stretch for yield. But credit challenges persist with downgrades outpacing upgrades by around 4 to 1 and chapter 9 bankruptcies increasing. A number of states have significant unfunded pension liabilities as well, a number we watch closely that could put additional pressure on munis.
“In this higher risk environment, we believe risk control continues to be important for both taxable and tax exempt portfolios.”
About Mary Ellen Stanek, CFA
Mary Ellen is Managing Director and Chief Investment Officer of Baird Advisors. She has more than 30 years of investment experience managing various types of fixed income portfolios. Prior to joining Baird Advisors, Mary Ellen was President and Chief Executive Officer of Firstar Investment Research and Management Company (FIRMCO) and was Director of Fixed Income. She is responsible for the formulation of fixed income strategy as well as the development and portfolio management of all fixed income services. Baird Advisors manages $16.8 billion in fixed-income assets.
Baird is an employee-owned, international wealth management, capital markets, private equity and asset management firm with offices in the United States, Europe and Asia. Established in 1919, Baird has more than 2,700 associates serving the needs of individual, corporate, institutional and municipal clients. Baird oversees and manages client assets of more than $94 billion. Committed to being a great place to work, Baird ranked No. 21 on FORTUNE’s 100 Best Companies to Work For in 2012 – its ninth consecutive year on the list. Baird’s principal operating subsidiaries are Robert W. Baird & Co. in the United States and Robert W. Baird Group Ltd. in Europe. Baird also has an operating subsidiary in Asia supporting Baird’s private equity operations. For more information, please visit Baird’s Web site at rwbaird.com
Yield curve roll-down is an additional price return component of a bond simply due to the passage of time. As a bond’s time to maturity shortens with the passage of time it will be valued at a lower yield/higher price given its now shorter maturity assuming a normal upward sloping yield curve which exists today.
In a rising interest rate environment, the value of fixed-income securities generally declines and conversely, in a falling interest rate environment, the value of fixed-income securities generally increases. High yield securities
may be subject to market, interest rate or credit risk and should not be purchased solely because of the stated yield or dividend rate. Investments in non-investment grade debt securities include risks such as increased credit risk and higher risk of default or bankruptcy.