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Subadviser to the ASTON/TCH Fixed Income Fund CHTBX CTBIX March 17, 2016 The Outlook For Actively Managed Fixed Income In An Era Of Rising Rates Presented by: Scott M. Kimball, CFA Senior Portfolio Manager Adam M. Phillips Product Specialist Sponsored by
TCH perspective: Exploring rising rates % 6 Fed Funds Effective Rate 5 4 3 2 1 0-1 -2-3 -4 Mar 05 Aug 05 Jan 06 Jun 06 Nov 06 Apr 07 Sep 07 Feb 08 Jul 08 Dec 08 May 09 Oct 09 Mar 10 Aug 10 Jan 11 Jun 11 Nov 11 Apr 12 Sep 12 Feb 13 Jul 13 Dec 13 May 14 Oct 14 Mar Aug The first rate hike in the US in nearly a decade offset some stimulus provided by non-traditional policies, as policy remains highly accommodative; and the tightening path is likely to remain measured, continuing to undershoot FOMC projections. The hike resulted in higher Treasury rates for certain maturities, but as we have expected, to date the yield curve has flattened as longer interest rates have declined. Atlanta Fed Wu Xia Shadow Fede US Federal Funds Effective Rat Source Federal Reserve Financial Conditions 101 100.5 100 99.5 99 98.5 Dec 10 Mar 11 Jun 11 Sep 11 Dec 11 Mar 12 Jun 12 Sep 12 Dec 12 Mar 13 Jun 13 Sep 13 Dec 13 Mar 14 Jun 14 Sep 14 Dec 14 Mar Jun Sep GS Financial Conditions Index GS Source: Financial Bureau Conditions of Labor Index Statistics (w/ Oil) 3
TCH perspective: Reversion to the mean ain t what it used to be The Fed s balance sheet remains significantly enlarged since the crisis, with limited expectation to decline near term and a stated purpose of supporting long interest rates and maintaining an accommodative monetary policy. Over the intermediate term, the Fed will likely maintain its balance sheet as a means to ease the policy transition and continue support for both financial and housing markets While periods of higher interest rates persist in the collective memory, the long term trend suggests current rates are not as much below the mean as might be imagined Fed policy isn t the only factor constraining rates 4.0 (%) 3.0 2.0 1.0 Treasury Yield Curve 12/31/20 09/30/20 12/31/2014 Trillion $ Yield % 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5-18 16 14 12 10 8 6 4 2 0 Federal Reserve Balance Sheet 8/1/2007 1/1/2008 6/1/2008 11/1/2008 4/1/2009 9/1/2009 2/1/2010 7/1/2010 12/1/2010 5/1/2011 10/1/2011 3/1/2012 8/1/2012 1/1/2013 6/1/2013 11/1/2013 4/1/2014 9/1/2014 2/1/20 7/1/20 12/1/20 Source: Federal Reserve 10 year Treasury yields 2/1/1962 8/1/1964 2/1/1967 8/1/1969 2/1/1972 8/1/1974 2/1/1977 8/1/1979 2/1/1982 8/1/1984 2/1/1987 8/1/1989 2/1/1992 8/1/1994 2/1/1997 8/1/1999 2/1/2002 8/1/2004 2/1/2007 8/1/2009 2/1/2012 8/1/2014 0.0-1.0 3 mo 6 mo 2 yr 5 yr 10 yr 20 yr 30 yr Sources: Bloomberg L.P., BMO Global Asset Management 10 year Treasury yield 120 per. Mov. Avg. (10 year Treasury yield) Source: Bloomberg 4
TCH perspective: Policy divergence, developed market growth % 8 6 4 2 0-2 -4-6 -8-10 -12 Jun 05 Dec 05 Jun 06 Dec 06 Developed Market GDP YoY% Jun 07 Dec 07 Jun 08 Dec 08 Jun 09 Dec 09 Jun 10 Dec 10 Jun 11 Dec 11 Jun 12 Dec 12 Jun 13 Dec 13 Jun 14 Dec 14 Jun Global policy divergence will remain an important theme in 2016, with the ECB and BOJ furthering their QE programs; low inflation will likely support a easier Fed, despite the first shift in gears. Developed market global consumption remains an anchor for growth with energy prices as a tailwind EM slowdown fears belie still significant growth, with bottoming out expected to emerge in more stressed geographies U.S. EU Japan Sources: Bloomberg L.P., TCH, LLC 5
TCH perspective: Commodities and the big repricing Global volatility, led by geopolitical instability and a slowdown in China s growth have caused much gnashing of teeth across all market participants. The commodity-level imbalances are unlikely to change over the near-term as disappointing data from China continues to weigh on global growth expectations. OPEC effectively abandoning price controls make forming a trough in oil prices painfully slow. The relative decline in oil prices roughly equals the worst crisis in 40 years. Given the severity of price declines, another severe leg down has become less probable for most commodities. Comparison of current commodity price levels with previous crisis lows Low point (relative to 5-year rolling avg. price) Jan-16 Avg. Low previous crises 2008 financial crisis 1997 Asian financial crisis 1980s economic slowdown Copper -38% -36% -44% -39% -26% Oil -61% -45% -35% -40% -59% Gold -21% -27% -35% -25% -32% BBG index -41% -32% -35% -27% n.a. Source: Bloomberg, TCH, Barclays While the decline in commodity prices have stirred up significant concerns for global growth, there is evidence that conditions within the U.S. remain favorable for further expansion and consumption More importantly, credit valuations have outstripped the severity of the fundamental backdrop as spread differentials/multiples are now wider than at any other time including 2008 Source Barclays 6
TCH Perspective: MBS basis well-supported in 2016 The Fed s continued reinvestment of U.S. agency MBS cash flows, in conjunction with investor demand, will likely continue absorbing the bulk net supply. Bank demand is likely to remain strong with higher yielding MBS preferred over Treasuries. Money manager demand should be spurred by periodic bouts of credit risk aversion. On a relative basis, U.S. agency MBS presents a limited opportunity for significant excess returns, but the securities remain a highly liquid, safe haven as concerns for global growth and turbulent financial markets have increased risk premiums Bank Holdings of MBS ($Bn) 1,0 1,100 1,050 1,000 950 900 850 800 Bank Demand for MBS vs. U.S. Treasuries MBS U.S. Treasury (RHS) 450 400 350 300 250 200 0 100 Source: Bloomberg Bank Holdings of U.S. Treasury ($Bn) Zero Vol Spread 120 110 100 90 80 70 60 50 40 30 20 ZV Spread: Corporate vs. MBS Millions ($) 160 140 120 100 80 60 40 20 0-20 Nov 14 Dec 14 Jan U.S. Agency MBS Issuance & OAS Feb Mar Apr May Jun Jul Aug Sep Oct Nov 35 30 25 20 10 5 0 OAS (basis points) Corporate vs. MBS Zero-Vol Spread Differential Source Barclays US Agy MBS Gross Issuance US Agency 30 Yr MBS (Net Iss.) Fed Purchases OAS (bps) Source SIFMA, Wells Fargo 7
TCH perspective: Credit internals stable, despite mature cycle A monetary policy transition and increasing M&A activity suggest a mature credit cycle; however leverage generally remains consistent with historical averages Valuations are at the widest levels for any start of a tightening cycle in recent history (1994, 1999, 2004) mitigating some policy tail risk Earnings estimates remain solid despite commodity weakness skewing aggregate results Valuations are unlikely to retest recent tights, but solid macroeconomic underpinnings against the backdrop of historically wide valuations suggest some tightening, if not stabilization is warranted EPS 140 130 120 110 100 90 80 70 60 MSCI World Earnings Source: MSCI Percentage (%) 20 10 5 0-5 14.7.9.7 11.9 10.0 9.5 8.6 CY 2016: Earnings Growth 9.8 9.2 9.2 7.4 7.3 8.2 7.9 5.8 4.9 3.5 4.3 2.83.4 9.2-10 31-Dec- 30-Sep- - -11.8 Source: FactSet 8
TCH Perspective: How wide is too wide for spreads? Risk of a disorderly slowdown in China and geopolitical brinkmanship (OPEC) remain key sentiment drivers in financial and commodities markets. Oil declined nearly 20% to new lows in the fourth quarter and the market distress was exacerbated at the start of 2016. Credit spreads have reached valuations only seen in much more severe environments, with segments like long industrials and BBBs surpassing all but the 2008-09 crisis, despite stable if modest growth in the US, improvements in Europe and stabilization in many EMs. While commodities may take time to bottom out, credit spreads are pricing in very severe outcomes. Even neutral or modestly positive developments for many segments could result in positive excess returns for 2016. Recession, post-9/11, fraud scandals 9
TCH perspective: Relative value opportunities abound Within investment grade, widening credit spreads have been the most pronounced in longer-dated, BBB rated securities IG credit spreads have decompressed, but with significant bifurcation, presenting a tactical opportunity Sectors such as metals & mining and energy have seen pressure with little differentiation between issuers, furthering the near-term opportunity Normalization expected: Near-term between issuers, followed by crosssector over the intermediate term 10
TCH outlook and investment strategy YIELD CURVE ANALYSIS Positioning and Rationale U.S. growth outlook for 2016 likely in the range of 2.5% consensus, but inflationary outlook likely to remain subdued U.S. growth to lead developed markets in 2016 as Fed policy normalization continues, patiently. The ECB and BOJ remain highly accommodative Commodity & energy prices have muddied inflation expectations; however, positive U.S. jobs and wage data may provide some stability Fed outlook: Continue structuring for trajectory rather than timing; After a brief mention, the Fed has moved past global volatility, refocusing on the US economy U.S. Treasury futures imply a slow ascension to a historically flatter term structure and lower point of neutrality, consistent with Fed language Duration construction: Neutral, with bias towards barbell as opportunities within Treasury and credit term structures are created; Global volatility and yield spreads both supportive of U.S. rates SECTOR OUTLOOK Investment Grade Credit: Global growth concerns have led to a decompression in credit spreads, widening and steepening OAS curves with little differentiation; however, continued outperformance from the U.S. economy will likely lead the period of normalization which typically follows; U.S. IG will likely recognize further support from global yield substitution effect Securitized: U.S. agency MBS to realize continued support from low supply and Fed reinvestment; While the total return potential appears limited relative to cross-sector opportunities, they remain a safe haven during periods of uncertainty Beta Sectors: Market volatility has created bottom-up opportunities in the wake of macro concerns; Should the tightening of U.S. monetary policy transmit to the credit markets U.S. high yield should be better positioned for normalization vs. EMD QUALITY DECISIONS The ratings migration within U.S. credit continues to trend downward; however, the compensation for down in quality trade within investment grade has increased significantly; Wider, steeper OAS curves and bifurcated quality buckets offer relative value opportunities SECURITY SELECTION Favor nominal Treasuries over TIPS given interest rate and global macro outlook Credit: Utilize steeper OAS curves for compelling relative value cases and dislocations Significant primary market supply should create additional opportunities in secondary Industrials- Broad selloff lacks differentiation, opportunities in issuers benefiting from lower commodities Financials- ECB policies supportive of European banks; U.S. sub-debt structurally attractive U.S. Agency MBS: Favor large cohort FN/FG 3.0% and 3.5% w/ low pay-up to establish basis 11
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