Podcast: April 2010 Market Recap

Hello, my name is Sean Simko. I am Managing Director of SEI Global Fixed Income management. Today’s discussion is a recap of the market activity and performance for the month of April.

Regulatory proposals made headlines domestically and abroad as concerns continued to swirl around impact to the financial sector. Risk started to be re-priced toward the end of the month as the battle waged on between improving fundamentals within the U.S. economy, spread markets and the European debt crisis. There was a global flight-to-quality bid in the Treasury market as investors flooded the sector buying everything from Treasury bills to the long bond. Concerns over Greece’s fiscal problems and the probability of the contagion spreading to Spain and Portugal trumped all positive data. We expect trading to remain volatile even after the issue is settled, as the battle between improving fundamentals and the ongoing fear of sovereign default will continue to weigh on investors.

Despite the gloomy headlines, our fixed-income sentiment model continues to show signs of improvement, albeit at a slower pace. Fundamentals are finally catching up to the markets and should continue to do so barring exogenous events. The debt crisis in the Eurozone remains as a dark cloud on the horizon. I intentionally don’t refer to the crisis as “the Greece crisis” because of the potential for contagion. Italy, Portugal and other regions are all at risk.

The Federal Open Market Committee (FOMC) concluded its scheduled two-day, closed-door meeting on Wednesday. Although it didn’t feel as if the FOMC was center stage, differing views still circulated regarding the potential outcome of the meeting and language that would be crafted in the statement. In the end, recent data allowed the Fed to remain in a holding pattern The fact that inflation expectations remain contained and inflationary trends continue to trend lower provided the fed the ability to remain in the wait-and-see mode until signs of sustainable improvement materialize.

The Committee left the lending rate unchanged, as expected, holding it in the range of 0 to 25 basis points and released a statement that was similar to its last one, maintaining the language around keeping the federal funds rate “exceptionally low” for an “extended period.” There were a few minor upgrades, one of which referenced the labor market. There were also discussions about the potential for additional members of the committee to cast dissenting vote. This did not materialize, as Kansas City Fed President Thomas Hoenig was again the sole dissenter again in recommending a change to the “extended period” language. Overall, the usual themes remain the same. Declining inflation trends and areas of economic weakness support the view that it is appropriate for the committee to hold rates low for the foreseeable future. Additionally, the market is looking for clues to any change in the language or any indication of when the changes will occur. Although there have been modest upgrades to the economic climate by various fed speakers throughout the year, we think it is too early for victory to be declared or to see a significant change to the committees’ overall game plan. Our expectation remains firm that the Fed will remain on hold until the fourth quarter of 2010 if not the first quarter of 2011. An increased amount of fedspeak in coming months will address changes to the statement language and timing on monetary tightening.

The Treasury curve flattened, fostering by the nervousness around Greece and the possibility of the sovereign debt contagion, with the long end of the curve leading the charge. Rating agencies not only took action against Greece, but Spain and Portugal were also hit with lower credit ratings. The results of the Fed meeting aided the Treasury rally. Keeping the language signaled to the market that the Fed is not concerned about inflation therefore there is no immediate reason to raise rates or for Treasuries to sell off. The 2-year note underperformed the curve rallying a mere 5 basis points. The long bond rallied by 19 with the 10-year close behind moving 17 basis points lower in yield. The U.S. Treasury component of the Barclays U.S. Government Index continued its positive run in 2010. The index returned 1.05% for the month while returning 2.18% year to date.

The Treasury Inflation Protected Securities (TIPS) market outperformed the nominal treasury market in April despite data supporting the trend toward lower inflation. The Barclays U.S. TIPS index returned 2.37% for the month, bringing its year-to-date return to 2.95%. This sector has held up extremely well even as inflation data continues to move lower. Inflation data trending lower is an enigma as commodities rallied throughout the month. Oil averaged over $84 a barrel, hitting an intra-month high of $86.84.

April marked an inflection point for the investment-grade credit market, as bullish sentiment gave way to uncertainty and fear. In effect, market focus shifted away from the improving nature of corporate fundamentals and the domestic economic recovery, and instead began to trade off of macroeconomic event risk and headline noise. To this point, the confluence of strong first-quarter corporate earnings and expansionary U.S. economic readings helped the market in the first half of April. Civil charges brought against Goldman Sachs and the uncertainty over financial regulation and the European credit crisis later came to the forefront, increasing volatility and setting a softer tone to the market.

Despite the late-stage weakness, aggregate investment-grade option adjusted spreads, as measured by the Barclays Capital Credit, ended April 4 basis points tighter, with the index generating 41 basis points of excess return. Within high-grade, broad sector utilities and industrials outperformed providing 78 basis points and 63 basis points of excess return, respectively. Broad sector financials underperformed the market generating 28 basis points of excess return. The credit derivative market underperformed the cash market with the CDXIG 14 widening 5 basis points.

Looking forward, the volatility is likely to continue. There is still a great deal of uncertainty regarding sovereign risk and regulatory reform. Until greater clarity is cast on these issues we expected the improving corporate fundamental backdrop to be eclipsed by macro risk.

The rating agencies were once again in the headlines. It seems second nature to hear the government investigating the actions of the agencies regarding the role they played in the subprime market, but combine this with the recalibration of municipal ratings and scenario just seems ironic. One of the most notable changes with the recalibration is centered around California. California General Obligation debt will be now rated A1, higher than its previous BAA1 credit rating. If this wasn’t enough for investors to try and get a handle on, they had to attempt to put money to work in a month that saw little to no new issues (even the Build America Bond calendar came in at approximately a quarter of what was expected). The Barclays Capital Municipal index returned 1.21% for the month while posting a 2.48% return year to date. As a result, yields in April rallied 13 basis points at the ten-year point of the AAA curve to finish the month at 3.14%. The 30-year point moved lower only by 2 basis points to finish the month at 4.44%. Municipal securities were supported by the lack of supply and minimal immediate default threat even as sovereign concerns weighed on spread products. High-grade municipals as a percentage of Treasuries ended the month in line with the levels seen at the start of the month. The 10-year AAA general-obligation debt percentage to Treasuries finished the month around 85% in line with historical averages. Even with the move lower, the yield curve remained very steep ending the month close to 375 basis points. Municipal issuance fell in April to total $27.1 billion for the month with tax exempt issuance making up the lion’s share. Tax exempt issuance totaled $18.3 billion with taxable contributing remaining $8.8 billion. Build America Bonds saw the lowest issuance since mid- summer 2009. The lack of issuance was in part due to the market sitting back in a holding pattern waiting for added clarity on the extension of the program.

The municipal market had a sustainable rally in April, however it did not compare to the flight-to-quality rally witnessed in the Treasury market. As a result, the market looks cheap compared to Treasuries which will help support the current levels as money will likely flow into the sector. Municipal yields are likely to move higher along with Treasury and other spread products as the economic recovery gains traction. The positive market technicals and overall demand for tax exempt paper should provide a backdrop for the sector to outperform.

Our view remains that in order to move forward, the market needs to see some resolve within the European Union. The Union needs to take control of the situation, and prepare a long term fix to the debt problem. If only a temporary fix occurs, the problem is likely to resurface time and time again creating a larger degree of turmoil with each occurrence. Until European debt problems are resolved, treasuries will have the tendency to remain in demand. We are optimistic on the municipal markets at the current levels. Yields are likely to move higher; however, technicals are set to support the current market baring no exogenous or systemic event. We remain cautiously optimistic on the economy as we are seeing signs that the various pockets of weakness for instance the labor market are turning the corner.

If you have any questions regarding this commentary, or questions surrounding the market, please contact your SEI representative. Thank you.