Podcast: May 2010 Macro Summary View

SEI Global Fixed Income Management manages fixed-income strategies for SEI’s Managed Account Program (MAP) and Integrated Managed Account Program (IMAP).

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

I’m sure that I’m not the only one who was relieved when May came to an end. The 20 trading days in the month felt much longer, as volatility and uncertainty brought about skepticism regarding the U.S. economic rebound. Yes, the markets were beaten up, yet somehow continued to stand firm, wavering but not falling hard. Sovereign-debt troubles continued to surface, as doubts remained about the solvency of Greek debt and the potential for additional fallout to affect other European countries such as Spain, Portugal and Italy. Geopolitical tensions driven by Iran and the Koreas added fuel to the fire, creating more nervousness and volatility, which resulted in a massive global flight-to-quality trade as investors sought refuge in the U.S. Treasury market.

Macroeconomic data continues to point to a global economic expansion, albeit at a slower expected pace of “two steps forward, one step back.” Growth in a straight line is out of the question. The positive data points and moves forward are muted by negative global news and speculation about a double-dip recession for the global economy. China added to the volatility, first stating it was not going to abandon investing within the eurozone—helping stabilize a falling euro and equity markets—but then releasing weaker growth data, which put pressure on the markets once again. The euro and European regions are and will remain a concern for some time to come. The primary concern is that all measures taken to date don’t permanently solve this crisis; they’re just a near-trillion-dollar Band-Aid. Policymakers need to fix the heart of the matter, which is how the respective governments are actually run, and changes need to be enforced. Until this happens, the European debt crisis will remain in the headlines and on investors’ minds, creating more stress in the markets.

Our proprietary fixed-income sentiment model reflected the volatility and near-term gloom and doom within the markets. Gloom and doom may be a little too harsh at times, but market sentiment reflected this view throughout the month. The model broke through its 200-day moving average to the downside, showing that the market is cheapening, which creates potential buying opportunities. We would need to see a modest snapback with a strong follow-through before we view a reversal in trend as sustainable.

Even with conflicting signals from the sovereign debt crisis, and positive U.S. economic data, the Barclays Capital Aggregate Index was up 84 basis points, just over ¾ of a percent. Treasuries led the move, returning 1.71%, as investors reduced risk and fueled the flight-to-quality trade. Risk was re-priced within most spread sectors. For the month, the investment-grade corporate sector declined 55 basis points with - 2.60% of excess return versus Treasuries. Commercial mortgage-backed securities fell 1.67% with - 2.93% of excess return, and asset-backed securities fell 55 basis points with -42 basis points of excess return.

The Federal Open Market Committee (FOMC) didn’t hold a policy meeting in May, and minutes from its April meeting showed little change in opinions and views. The takeaway was that the Committee didn’t change its commitment to the language around low rates and the likelihood of asset sales from its balance sheet. The Committee commented on the labor market, sharing the view of a modest upgrade but questioning the sustainability of the move. Another notable item was the mixed view on inflation. Although modestly concerned with commodity prices, the Committee expressed the belief that slack within the economy will likely weigh down inflationary pressures.

We saw a continuation of the flattening trend to the shape of the yield curve, confirming our view. The curve flattened once again, driven by anxiety from the instability of the euro and recent geopolitical tensions. The 10-year led the move, rallying 36 basis points to end the month at 3.29%. The two-to ten-year curve flattened approximately 17 basis points during the month to 253 basis points, notably flatter than the 270 basis points at the turn of the year. A flatter curve for a prolonged amount of time will begin to have a negative effect on banks and financial institutions. We are nowhere near this inflection point, nor do we believe that the curve will have a massive flattening move from these levels, but it is something that needs to be monitored. The two-year note underperformed the curve, rallying only 19 basis points to end at 76 basis points. The 30-year bond rallied by 30 basis points, and the five-year’s price action was similar to the 10-year, rallying 32 basis points. The U.S. Treasury component of the Barclays U.S. Government Index continued its positive run in 2010, returning 1.71% for the month and 3.93% year to date.

The Treasury Inflation-Protected Securities (TIPS) market was pummeled in May, as TIPS were not able to keep pace with the nominal Treasury market and flight-to-quality bid. Lower inflation expectations from the FOMC and economists didn’t help the matter. The Barclays U.S. TIPS Index was virtually flat for the month, returning -0.01% and bringing the year-to-date return to 2.94%. Prior to May, this sector held up extremely well, even as inflation data continued to move lower. The view that the near-term future of a global recovery was going to see hiccups and might potentially stall helped push breakevens narrower (or underperformed nominal Treasuries). Adding to this was the downward pressure on oil, as it averaged just over $79.00 per barrel for the month after bouncing off the $68.00 intra-month low.

The cash and short-term markets had a hint of déjà vu, with daily trading and liquidity concerns reminiscent of late 2008. ”Hint” is the operative word, though, as confidence might have been shaken but was not destroyed. European concerns, particularly within the banking system, drove funding pressures higher within the interbank markets. As a result, the three-month Libor spread moved higher throughout the month to end around 53 basis points. Three-month Libor has more than doubled from its low on February 4 of 0.24875%. Although these levels are inflated, they didn’t have as much impact as the rumors that actual funding levels at certain banks were higher than those posted. The ongoing concern is that the health of financial institutions is starting to deteriorate once again and if so, it is uncertain whether this deterioration would be contained to European banks or if it would find its way back to U.S. financial institutions.

Money-market-type securities (excluding Treasury-related securities) were less liquid toward the end of the month. I would credit this to a combination of factors which included normal month-end pressures, a long holiday weekend and the lingering effect of funding pressures. Adding to month-end pressures were persistent market dislocations, particularly in the Financials sector. Two measures of risk—the TED spread and Libor—increased throughout the month. The TED spread moved higher from 18 basis points to 37 basis points, while three-month Libor increased 10 basis points to 356 basis points from 346 basis points. Historically, three-month Libor should trade on average 15 basis points above the federal funds target rate. Even if you take the upper end of the federal funds range of 25 basis points, current levels show modest strain within the front end of the curve. Commercial paper outstanding fell modestly in the month of May, ending at $1,073.4 trillion versus $1,108.6 trillion on April 28. Lack of issuance was driven largely by the absence of foreign financial institutions, due to the lack of U.S. demand around the European banking sector

Sovereign and regulatory risk hit full throttle in May, sending the market into a state of uncertainty and fear. Volatility spiked as the European debt crisis continued to make waves despite a $960 billion bailout led by the European Union (EU) and the International Monetary Fund. Germany’s unilateral short-selling ban further exacerbated the volatility, as market participants interpreted this move as a sign of growing discord among EU member countries. These concerns were particularly evident in U.S. dollar-funding metrics, as the Libor-OIS Index widened 20 basis points throughout May, while the USD 2-10 swap spread flattened 21.5 basis points. In addition, concerns over slower growth in China, financial and regulatory reform in the U.S. and the inability of BP to stop the oil spill off the Gulf of Mexico increased investor caution. Moreover, market illiquidity played a role in the volatility, as many participants entered the month of May with overweight positions in credit and short positions in U.S. Treasuries. As traders sought to unwind these positions, sellers flooded the market and few buyers emerged, resulting in a thin market and spread widening.

Risk markets in general were hurt in the flight-to-quality trade that left U.S. equity markets down 7.92% and the VIX up 43.53%. Investment-grade credit markets were not spared as investors sought to shed risk. Aggregate investment-grade option-adjusted spreads, as measured by the Barclays Capital Credit Index, ended 40 basis points wider for the month, with the index underperforming Treasuries by 237 basis points. There were no safe havens within high-grade as weakness was exhibited across all sectors. Broad-sector Financials performed worst, underperforming Treasuries by 310 basis points, while Industrials and Utilities underperformed by 225 and 264 basis points, respectively.

In the primary markets, would-be issuers remained on the sidelines, waiting for spreads to stabilize and sovereign-debt woes to subside. A total of just $32 billion of new issuance was priced in May. According to Bloomberg, this represented a 77% decline from the same month last year and was markedly less than the $75 billion investors had anticipated.

At this point, it feels as though the worst may be behind us. Investment-grade markets seemed fairly priced now, as two-way market flows have reemerged providing a greater degree of liquidity. However, volatility will likely remain elevated as there is still a great deal of uncertainty regarding sovereign risk and regulatory reform. We will look for new developments out of the eurozone to cue risk sentiment in the near term. In the U.S., the economic recovery remains on track, and markets have the potential to rally once risk sentiment is restored. However, it is likely that the banking sector will remain under pressure, as proposed financial regulation has the potential to negatively impact earnings and result in rating downgrades.

The municipal market had a sustainable rally in May, helped by the action within the Treasury market. Without the assistance of the Treasury rally, investors might have moved away from the sector or from the very front end at the very least, since risk was still prevalent in the municipal sector. State risk remained at the forefront, with added pressures from government regulation. The Securities and Exchange Commission (SEC) launched a nationwide probe into Build America Bond (BAB) pricing, stating that one out of every two BAB deals will be audited. The House passed the jobs bill, which included an extension of the BAB program through 2012 with the subsidy declining from 35% to 32% to 30% over time. The Barclays Capital Municipal Bond Index returned ¾ of a percent for the month, extending the year-to-date return to 3.25%.

The 10-year AAA-rated general-obligation debt percentage started the month at around 82%. At month end this ratio was at 91%, a level that is cheaper than its historical averages. The intra-month high was 97% on May 25. These levels show that there is value within the sector versus Treasuries, even as outright yields remain low. We would expect this ratio to move back in line as Treasuries move off their current overvalued levels. Issuance was strong, with the calendar exceeding $36 billion, of which $10 billion came from the BAB program.

We still hold the view that a tug of war exists between improving fundamentals and European sovereign risk, and we expect this battle to remain in the near term. Although it feels as if there is a temporary reprieve from new releases of bad news, the heart of the problem remains. This lingering effect should keep Treasuries range-bound with a soft flight-to-quality bid. We continue to feel that Treasuries will move higher throughout the year with a 4% target on the 10-year. At the beginning of the year, we placed a 3.75 to 4.25 range on the 10-year. Although it is currently trading at 3.34%, the average for the year is 3.66%, close to the bottom end of our range. We remain cautiously optimistic on the economy, as we see signs that various pockets of weakness are firming. However, May’s disappointing payroll report showed that the labor market has a long way to go in its healing process.

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

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only.

There are risks involved with investing, including loss of principal. No mention of particular securities should be construed as a recommendation or considered an offer to sell or a solicitation to buy any securities.

SEI Investments Management Corporation or its employees may sometimes hold positions in the securities discussed here.

SEI Global Fixed Income Management is a unit of SEI Investments Management Corporation which serves as the investment advisor.



Glossary

The Barclays Capital Credit Index is an unmanaged index composed of U.S. investment-grade corporate bonds.

The Barclays Capital Global Aggregate Bond Index is an unmanaged market-capitalization-weighted benchmark that tracks the performance of investment-grade fixed- income securities denominated in 13 currencies. The index reflects reinvestment of all distributions and changes in market prices.

The Barclays Capital Municipal Bond Index is an unmanaged index composed of investment-grade municipal bonds with maturities of one year or more.

The Barclays Capital U.S. Aggregate Bond Index is a benchmark index composed of U.S. securities in Treasury, Government-Related, Corporate, and Securitized sectors. It includes securities that are of investment-grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $250 million.

The Barclays Capital U.S. Treasury Index is an unmanaged index composed of U.S. Treasuries.

The Barclays Capital U.S. TIPS Index is an unmanaged index composed of all U.S. Treasury Inflation- Protected Securities rated investment grade, have at least one year to final maturity, and at least $250 million par amount outstanding.