Global Asset Allocation Update

hy spreads

 

Long term momentum continues to favor IEF over HYG:

ief hyg

 

It is interesting to me that it is European and US high yield spreads that remain elevated. EM spreads, in Latin America and Asia, have narrowed much more than the US. That would seem to imply that the widening of US spreads was much more about shale concerns than EM concerns. As for Europe, even ECB direct buying of corporate bonds hasn’t been able to close the spreads in the HY market. The ECB may be the only entity in Europe willing to take risk right now.

Europe spreads

 

A lot of the rally in emerging markets is based on commodity prices coming back from the dead so that makes some sense. On the other hand, as I said earlier, global growth prospects do not seem to be improving, something that would seem necessary to sustain the commodity rally. Is it possible that a weaker dollar has healed the global economy’s wounds? Seems unlikely but thinking about it from a different perspective may yield a different conclusion. If a weakening dollar means capital inflows to EM, that is certainly a positive for those economies. Will it be enough if the US economy continues to weaken? I have my doubts but…

The dollar does seem to be trying to stabilize at these lower levels. One must consider the possibility that dollar stability at these levels is exactly what the doctor ordered and a major positive for the global economy. In all the talk about a strong dollar and a weak dollar we often lose sight of the fact that the best outcome, by far, would be a stable dollar. Is the Fed paying more attention to foreign exchange and the impact of dollar movements on the global economy (not just the US)? If so, it should not be unexpected; I predicted as much when Stanley Fischer was nominated as Vice Chair. He emphasized the value of the Shekel while at the Bank of Israel and his role at the Fed is to monitor the impact of Fed policy on international markets. But dollar stability is at this point a short term phenomenon and not something on which to base long term investment decisions. 

Yield Curve/Bonds

While credit spreads have been arguing for a hike in our risk allocation, the rest of the bond market is screaming the opposite. It is the movement of the yield curve and long term Treasuries that kept me from adding to our risk positions. The yield curve resumed its flattening trend over the last month and is now the flattest it has been since November of 2007 when it was going in the opposite direction, anticipating Fed rate cuts. That the yield curve continues to flatten even as the Fed is forced to back off rate hikes is probably not a positive sign. Getting the yield curve to steepen would probably require the market to start anticipating more easing from the Fed rather than just a lack of tightening. 

10:2 spread

 

Inflation expectations also resumed their fall as the dollar rallied for most of the last month. Falling inflation expectations are not by themselves a negative. Deflation is the natural consequence of capitalism and should not be feared as much as it is by the mainstream. But a rising dollar that pushes down prices is not the same thing and that appears to be what’s driving inflation expectations.

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