Prepare for Volatility as Crisis-Era Policies Unwind | Capital Group

World Markets Review

June 2017

Prepare for Volatility as Crisis-Era Policies Unwind

“Inflexible policy normalization implies volatile prices”

— Wesley Phoa

Wesley K. Phoa Portfolio Manager/Analyst Los Angeles office 21 years of experience (as of 12/31/2019)

In this month's LDI market commentary:

• June’s muted bond market activity

• The outlook for the health care sector

• Rising volatility expectations for LDI investors

June’s Bond Market Activity — Muted and Short of Expectations

The Federal Reserve took another tightening step in June, which supported the rally at the long end of the curve. Encouraging news from the European Central Bank later in the month, coupled with solid economic news, reversed the rally and resulted in a noticeable 13-basis-point flattening in the curve. Equity markets continued to rally.

Ten-year Treasury yields rose 10 basis points to 2.30% while 30-year Treasuries dropped 3 basis points to 2.83%. Investment-grade credit spreads showed no movement for the month. Energy bonds were weaker across the board due to lower oil prices.

June new issuance was short of expectations at $81 billion. Expectations for new issuance in July are $70 to $80 billion. Year-to-date issuance is up 3% from 2016.

Sector Outlook — Health Care

With a changing of the guard in Washington, D.C., the health care industry will likely face modest headwinds as government funding for health care comes under pressure. In particular, the potential to dial back the ACA’s Medicaid expansion will impact health care utilization, which should have broad-based effects. However, the impact will likely be quite minor for most companies in the investment-grade health care universe.

M&A activity remains robust in health care as companies build scale and scope to respond to changes in reimbursement. With debt being a disproportionate source of M&A funding, health care remains an area with risks for corporate bond investors. At the same time, most companies commit to de-leveraging their balance sheets following an acquisition. Thus, recently levered companies continue to provide attractive investment ideas. A recent example is Abbott Labs, which completed its acquisition of St. Jude earlier this year. St. Jude gives Abbott significantly more scale in cardiovascular devices to better compete with the likes of Medtronic. Abbott Labs issued $15 billion of attractively priced bonds to fund the acquisition.

Structural Issues — Rising Volatility Expectations

In recent trading sessions, the rallying trend in sovereign bond yields has reversed, partly in response to the market’s perception that major central banks ― the Fed, the ECB and the Bank of England ― have become more determined to normalize monetary policy ― and eventually their balance sheets ― even in the face of temporary soft patches in economic activity and inflation.

Stepping back from attempts to interpret each short-term market fluctuation, there is a more structural monetary policy dilemma operating here. Traditional monetary policy involves adjusting a short-term interest rate in response to economic data and changes in the outlook. This is a highly flexible mechanism: as new information comes in, the central bank can adjust rates more rapidly, or more slowly, or even reverse course.

The new policy tools deployed after the financial crisis ― forward guidance on the policy rate and especially quantitative easing via the balance sheet ― are fundamentally different. Each of them involves a commitment to a course of action over a prolonged period: to keep the policy rate at zero for a long time or to purchases a given (huge) quantity of bonds. This commitment has to be maintained in the face of shorter-term economic fluctuations.

Central banks must now deal with the same self-imposed inflexibility in reverse. The Fed has indicated a commitment to unwind its balance sheet gradually but relentlessly, at a pace that is relatively insensitive to economic developments (unless there is an actual recession). The ECB is likely to adopt a similar policy when the time comes. And the Fed can no longer use forward guidance as a policy tool, since it wants to reestablish the short-term rate target as its primary policy instrument, and therefore wants the path of rate hikes to be sensitive to economic data, as it traditionally was.

Monetary policy is a major driver of financial assets, and inflexible policy normalization implies volatile prices. Importantly, this condition does not imply a bearish outlook. Rather, it suggests that asset prices may become more sensitive to economic shocks, as central banks are less inclined to flex policy to buffer shocks in either direction.

(Portfolio managers Andy Barth and David Lee, along with analyst Mital Kotecha, contributed to this report.)

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