The Municipal Bond World, According to John Derrick
July 19, 2014
by Frank Holmes
of U.S. Global Investors
As we move into the second half of 2014, the Federal Reserve has continued to reduce its stimulus measures intended to boost the U.S. economy. Just this week we heard rumors from Fed officials that if the job market improves faster than expected, key interest rates may be increased sooner than expected.
While the Fed is gradually reducing stimulus measures in the U.S., other areas of the world are embarking on new monetary stimulus measures. More than ever before, we are feeling the impact of the global economy, with monetary stimulus programs in Europe and Japan taking pressure off of the Fed, and ultimately contributing to the bond market rally we have seen so far this year. The European Central Bank (ECB) recently cut its rates to negative on worries of deflation and on the possibility of slower or no growth in the eurozone.
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I sat down with Director of Research John Derrick, who also manages our Near-Term Tax Free Fund (NEARX), to get his thoughts on interest rates, the bond market and what investors should pay attention to as we move into the second quarter of 2014.
After hearing what the Fed officials said on interest rates this week, what is your outlook?
There are a lot of Fed officials with their own opinions, but I think it’s important to focus on what the Fed Chairman is saying. Janet Yellen said that rates are not going up, and although we’ve seen steady labor market improvements, it hasn’t been anything dramatic. For these reasons, I think an interest rate increase is still at least a year away.
How will this affect the municipal bond market?
Each time the Fed has announced tapering measures, investors have been fearful. If you look back at each of these instances, though, whenever the Fed took stimulus away, the market rallied due to fear of economic slowing. We did see a solid rally in the bond market during the first half of this year. I think interest rate increases are far enough away to still have a constructive position within the bond market, so to me the outlook is positive moving towards 2015.
How can investors take advantage of municipal-bond benefits?
On a tax-adjusted basis, municipal bonds have a very compelling risk-reward profile, which means the risk-adjusted returns are high. To take advantage of this, I would encourage investors to add exposure to their portfolio by investing in a product that holds high-quality, traditional municipal bonds. These are the type of bonds we look for and hold within the Near-Term Tax Free Fund. Our fund is in the “sweet spot” you could say; not too long, not too short, with some interest rate risk, but manageable for most investors. NEARX has generated consistent, positive annual returns and has been run by the same portfolio manager for 15 years.
For investors that like to sleep well at night, I think the fund is an attractive way to gain exposure to muni bonds. This is not the type of fund where you are going to be surprised with an unusual credit event that causes a significant impact. When choosing investments for the fund, I have a buy and hold mentality, letting the investments benefit the fund over time. The turnover of NEARX is very low and it has performed very well against its peers; take a look at the recent performance. Additionally, the fund seeks preservation of capital, and has a floating $2 NAV that has demonstrated minimal fluctuation in its share price.
How has the situation in Puerto Rico spooked the bond market?
Puerto Rican municipals are an area of the market that nobody really thought could declare bankruptcy, so what happened there didn’t help investors’ views of the muni market. We still have a small exposure to Puerto Rico within our fund. Our Puerto Rican positions are insured, however, which is important to help mitigate the risk aspect in this type of investing.
Our Near-Term Tax Free Fund has an overall Morningstar rating of 4 stars.* The fund is diversified and invests in municipal bonds with relatively short maturities, seeking to provide tax-free monthly income. If you’re looking to add tax-free bonds to your portfolio, with the option of modest allocation to this area of the market, I encourage you to request an information packet and take a closer look.
*Morningstar Overall Rating™ among 163 Municipal National Short funds as of 06/30/2014 based on risk-adjusted return.
- Major market indices finished higher this week. The Dow Jones Industrial Average rose 0.92 percent. The S&P 500 Stock Index advanced 0.54 percent, while the Nasdaq Composite gained 0.38 percent. The Russell 2000 Small Capitalization Index fell 0.72 percent this week.
- The Hang Seng Composite rose 0.79 percent. Taiwan fell 1.00 percent and the KOSPI advanced 1.54 percent.
- The 10-year Treasury bond yield fell four basis points to 2.48 percent.
Domestic Equity Market
The S&P 500 Index bounced back after last week’s selloff, rising about 50 basis points. Technology stocks led the way with strong results from oldies such as Intel and Microsoft. Financials and telecom services also had a good week, while health care brought up the rear.
- The technology sector rose more than 1.5 percent. Intel rose 8 percent as the company reported strong results across product lines including PCs, laptops and mobile. Large cap tech was well represented this week with strong performances from Microsoft, Google and Facebook.
- The financial sector was strong as the brokerage stocks performed well, mostly on the back of earnings. Citigroup led the way, rising 5.45 percent, but JP Morgan, Goldman Sachs and Morgan Stanley were also outperformers and not far behind this week.
- Time Warner was the best performer in the S&P 500 Index this week, rising more than 20 percent. Time Warner, whose stock closed the week at $87.23, confirmed that it had rejected a takeover proposal from Twenty-First Century Fox that valued Time Warner at $85 billion.
- The health care sector was the worst performer this week. In Federal Reserve Chair Janet Yellen’s written report to Congress this week, the Fed highlighted concerns regarding valuations in several markets and specifically mentioned small cap biotech companies as an area of concern. These comments weighed on the entire biotech sector, with Biogen Idec, Celgene and Regeneron Pharmaceuticals among the worst performers for the week.
- The consumer staples sector also underperformed this week. The key negative driver for the sector was the conclusion of the long-running takeover saga in the tobacco area with Reynolds American entering an agreement to acquire Lorillard. This effectively ended the speculation around what price would be paid, and both stocks fell for the week along with other tobacco names such as Altria Group.
- Sandisk was the worst performer in the S&P 500 this week, falling roughly 10 percent. The company reported earnings this week, and while it beat on both the top and bottom lines, the company guided third quarter revenue below consensus.
- We are in the middle of earnings season. With a good initial reaction to earnings so far from the market, it might pay to be optimistic next week. Key companies reporting next week include Haliburton, Apple, Biogen Idec, Facebook and Starbucks.
- With biotechs under pressure this past week, a favorable report from Biogen Idec and Gilead Sciences might be enough to change sentiment in the group.
- The path of least resistance for the market appears higher as this “classic” bull market phase of grinding higher with low volatility remains intact for now.
- Volatility has been remarkably low and this bull market has been an abnormally smooth ride. The calmness won’t last forever, as late summer and early fall have traditionally been more volatile.
- At almost 18 times trailing earnings, the S&P 500 is not cheap. Valuation may be a headwind for future market gains.
- Geopolitical tensions are on the rise with the downing of a civilian jetliner in Ukraine, a ground war in Gaza and increased Russian sanctions. The market has been able to shrug off these events so far but an escalation could be the catalyst for a long-awaited correction.
Treasury yields were mixed this week as the short end of the yield curve rose a few basis points while the long end of the curve declined. The 10-year Treasury yield fell to near 52-week lows, with the catalyst being the downing of a Malaysian airliner over eastern Ukraine on Thursday. Fed Chair Janet Yellen also testified in front of Congress this week to give her semi-annual testimony. She more or less reiterated that the U.S. economy will need easy monetary policy for years and an interest rate hike is not coming anytime soon.
- Fed Chairwoman Yellen reiterated the Fed’s preference for easy monetary policy for the foreseeable future.
- U.S. bank loans grew an annualized 7.7 percent in the second quarter, which is the fastest pace in almost six years.
- Chinese fiscal spending rose 26 percent in June, year-over-year. In a sign that the central government is attempting to stimulate the economy, Chinese banks lent out about 20 percent more than expected in June. This is potentially a very positive development for global growth prospects.
- Housing starts and building permits both fell sharply in June. The industry has not been the positive catalyst many were looking for in 2014.
- Retail sales grew a modest 0.2 percent in June, which was less than expected.
- June industrial production also disappointed, rising 0.2 percent and was the weakest since weather disrupted January activity.
- Geopolitical tensions are on the rise with the downing of a civilian jetliner in Ukraine, a ground war in Gaza and more Russian sanctions. Bonds could benefit from a flight to safety in this environment, which is largely what occurred this week.
- Housing data has been mixed at best, and next week we get new and existing home sales for June. Weak data could help lift the bond market.
- With key global central banks back into easy policy mode and inflation trending lower in many parts of the world, the path of least resistance for bond yields is likely down.
- The economy does have some positive momentum and appears poised to continue to build on that as we move solidly into summer. With the European Central Bank (ECB) and Bank of Japan taking the global lead in easy monetary policy, the Fed may transition to a tighter policy sooner than many expect.
- The Consumer Price Index (CPI) is scheduled for release next Tuesday. With inflation concerns beginning to build, a higher than expected result could negatively impact the market.
- Federal Reserve Bank of St. Louis President James Bullard stated that the economy is “closer to normal” than many realize and that the Fed could raise interest rates as soon as the first quarter of 2015.
For the week, spot gold closed at $1,311.10, down $27.52 per ounce, or -2.06 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, lost 1.41 percent. The U.S. Trade-Weighted Dollar Index gained 0.39 percent for the week.
|July 15||Germany July ZEW Survey Expectations||28.2||27.1||29.8|
|July 15||China June Retail Sales YoY||12.5%||12.4%||12.5%|
|July 17||Eurozone June CPI YoY||0.8%||0.8%||0.8%|
|July 17||U.S. June Housing Starts||1025K||893K||1001K|
|July 22||U.S. June CPI||2.1%||–||2.1%|
|July 23||HSBC China July Manufacturing PMI – Preliminary||–||–||50.7|
|July 24||Hong Kong June Gold Exports to China||–||–||52.3mt|
|July 25||U.S. June Durable Goods Orders||0.5%||–||-0.9%|
- The paradigm has shifted as ETF holdings posted record growth and gold fell. Gold posted its largest daily drop of the year on Monday, after concerns of financial stress in Portugal eased, and investors awaited Federal Reserve Chairwoman Janet Yellen’s semi-annual monetary policy testimony to the Senate. The big positive for the gold market came when ETF investors rushed to buy as gold dropped. On Monday as prices tumbled, assets in the SPDR Gold Bullion ETF rose to 808.73 tonnes, thus setting the single largest daily gain since August 2011. Commerzbank analysts stated that “ETF investors clearly took advantage of the reduced price of gold as an attractive opportunity to buy.”
- Indian gold imports surged 65 percent in June after the central bank allowed more banks and traders to buy bullion overseas. The news is encouraging as it occurred during a period when the investors speculated import restrictions could be reduced, which would have had larger buyers deferring purchases in anticipation of a possible import tax reduction. More importantly, monthly gold consumption in China and India represents the largest source of demand for bullion; thus, any increase, albeit small, can push the gold supply and demand further in favor of higher prices.
- On Monday, BCA Research announced that its long energy, short gold miners pair trade was unwound, triggering its stop-loss level. The news underpins a recurrent theme in this year’s gold space: short gold trades are getting squeezed. BCA stated that while its growth-biased strategy remains intact, recent data has shown growth slippage outside the U.S., which could add support to gold and gold miners if reflationary forces pick up.
- According to a recent Mineweb article, big investment banks including JP Morgan in particular, have reportedly been building short positions in gold and silver to a level not seen since the big gold price smash down of April 2013. Not surprisingly, this week we saw the return of last year’s massive gold futures dumps into the market. Sharps Pixley reported that a $2.3 billion notional trade was dumped into the market early on Tuesday, minutes before Janet Yellen’s semi-annual testimony to the Senate.
- In her testimony to the Senate, Yellen warned that if the labor market continues to improve quicker than anticipated by the Committee, then increases in the Federal Funds Rate target would likely occur sooner and more rapidly than currently envisioned. Ironically, famed hedge fund manager Dan Loeb, in his quarterly letter, stated that anticipating a rate hike from the Fed is like “Waiting for Godot” (referring to Samuel Beckett’s play where two characters wait endlessly for a friend to arrive who never does).
- Bloomberg strategist Andrew Robinson warned of this week’s gold drop by saying the metal could retreat from its four-month highs as momentum turns bearish. In his note, Robinson used technical analysis tools to argue that gold was due for a retracement on stretched relative strength indicators.
- On a recent chart book published by CIBC World Markets, the bank’s analysts suggest current real rate levels in the U.S. have coincided with $1,400 gold prices in the past. With real rates treading water around 50 basis points, thanks to both rising inflation and lower government yields, gold could be set up to outperform and rise towards $1,400 as shown in the chart below.
- Citigroup issued a recommendation to turn strongly bullish on platinum as supply and demand factors have pushed the market further into deficit. In addition, the bank is especially positive on copper and nickel, while it updated its views on gold. For bullion specifically, Citibank highlights strong retail buying, positive ETF flows and rising inflation concerns as reasons that underpin strong support for the yellow metal.
- Raymond James’ analysts published a research report on Dundee Precious Metals entitled “More Precious than Meets the Eye.” In the report, analysts highlight Dundee’s diversification and vertical integration, together with its strong growth prospects as reasons to buy the stock. In addition, a recent refurbishment of the company’s Tsumeb Smelter could become a significant profit generator. The analysts also state that Dundee’s shares trade at discount multiples relative to other junior gold producers, making this valuation attractive for new buyers into the stock.
- Goldman Sachs’ Jeffrey Currie has reiterated his bearish call on gold even as bullish wagers increase. According to Currie, gold has found support on investor concerns about inflation. In his view however, gold will weaken as evidenced in the fears of economic recovery trumping inflation.
- According to Boenning & Scatterhood, U.S. Treasury data is showing a slowdown in tax receipts since the economic slowdown began over a year ago. The firm argues that the weakening of tax receipts suggests the U.S. economy is not experiencing a weather bounce as some predicted, and reiterates its belief that the U.S. will grow at just 1.5 percent this year.
- In addition, “epic disaster” is what the team at Zero Hedge (ZH) used to explain what happened with U.S. housing starts and permits in June. According to ZH, housing starts were expected to print at a solid 1,020K, to validate the much touted economic recovery. Instead, May numbers were revised downward, while June’s numbers crashed to 893,000 – a drop of 92,000. This is the biggest drop since the January polar-vortex effect, and the biggest miss to economists’ expectations since January 2007.
- Gold and related precious metals equities outperformed within natural resources this week amid geopolitical tensions in the Middle East and the crisis in Ukraine. Royal Gold and Franco-Nevada gained 2.3 and 1.7 percent, respectively.
- The Transportation Index made another 52-week high over the prior five days as the economy and trucking and rail fundamentals remain strong. Union Pacific and Norfolk Southern rose for an average gain of 1.6 percent, with Norfolk Southern reaching an all-time high.
- Companies that produce sand for fracking outperformed due to tight supply/demand issues. Specifically, Hi-Crush Partners and Emerge Energy Services gained 9.2 and 1.3 percent, respectively.
- The price of natural gas fell below $4 per MMbtu, the lowest since November 27, as inventories increased due to mild weather. The higher-than-expected increase in U.S. stockpiles could continue to put downward pressure on natural gas moving forward. Bellatrix Exploration dropped 3.43 percent this week as a result.
- Despite a slight pick-up in the price of iron ore, dry bulk shipping rates remain weak once again heading into the seasonally strong third quarter. The Dry Bulk shipping freight rate is down over 55 percent from its high in March. Knightsbridge Tankers declined 4 percent on the weak.
- Base metal equities lagged the natural resources sub-sector this week due in part to softness in the physical market for nickel. Sherritt International fell by 6.6 percent in the period.
- According to a forecast by Sanford C. Bernstein, Latin America will consume 28.9 million tons of liquefied natural gas (LNG) by 2025. This staggering amount of consumption from the world’s largest LNG market is more than double the 13.3 million projected for this year.
- Japan’s Nuclear Regulation Authority (NRA) has granted preliminary approval for two new nuclear reactors. Kyushu Electric Company’s Sendai plant will incorporate upgraded design and safety features for the two reactors. Final approval will be granted by the NRA after a month of public consultation. This news comes as a relief for Japan, which is currently dealing with its first summer without any nuclear power in 40 years. According to Cantor Fitzgerald Canada Research, the project will be favorable for supply and demand fundamentals of uranium.
- Chinese economic data in July beat many projections from economists. Most importantly was the surge in financing. Money supply grew 14.7 percent against the 13.6 estimate and aggregate financing was 1.97 trillion yuan against a 1.43 trillion estimate. The higher than expected growth in financing may correlate into much stronger demand for copper due to economic expansion.
- The Malaysian airliner that was shot down is believed to have been hit by a ground missile according to Washington. As it remains unclear who is to blame for the tragedy, markets remain in an uncomfortable state of uncertainty.
- After air strikes were deemed unable to neutralize the threat coming from the Gaza strip, Israel launched a ground military invasion into the region. The presence of ground forces, which is only expected to increase in the near future, has escalated the conflict between Hamas and Israel.
- Dubai was the best-performing country in the emerging market universe this week, rising 7.2 percent to a six-week high, as Arabtec Holding, the largest listed construction company, reversed the slide that sent Dubai’s market tumbling into a bear market on June 23. The construction company rebounded after Abu Dhabi government-owned Aabar Investments announced it was in talks to rebuild its holding in the Dubai-based builder.
- South Korea was the best-performing country in Asia this week, as its new Finance Minister Choi Kyung Hwan emphasized the fragility of Korea’s economic recovery and proposed plans for tax cuts, raising market expectations of an interest rate cut by the central bank in August.
- Telecommunications was the best-performing sector in emerging markets this week, led by True Corp., an integrated telecommunication provider in Thailand, as the junta leader ordered regulators to suspend new telecom licenses for a year. Chinese carriers continued to rally on optimism regarding reform policies to help reduce capital and operating expenses.
- Russia was the worst-performing emerging market for the week, falling about 8.2 percent after the U.S. and EU bolstered sanctions against Russia over its alleged support for separatists fighting in Ukraine. Investors are concerned the latest attempt by America and the EU to limit Russia’s access to financing will push the economy into a recession. The sanctions were imposed against Rosneft and fellow energy company Novatek, plus two banks.
- Russia’s industrial output growth slowed remarkably in June, hit by a drop in the mining sector and a lingering decrease in utility production. The performance in the industrial sector poses downside risks for economic growth, which the central bank expects to grow at a meager 0.4 this year. The consumer does not appear capable of supporting the Russian economy as retail sales climbed at the slowest pace since 2010, disposable incomes unexpectedly shrank after Western sanctions weakened the ruble, and inflation soared the fastest in almost three years.
- Technology was the worst-performing sector in emerging markets this week, led by bellwether chip foundry Taiwan Semiconductor Manufacturing which admitted in its quarterly earnings conference that it will trail rivals in the more advanced 14- and 16-nanometer production next year.
- Morgan Stanley, in its European Equity Strategy, argues the recent underperformance of both Europe and its banking sector looks tactically overdone and not warranted based on current relative earnings per share (EPS) trends. The strategists show that banks’ relative performance is now 2.5 standard deviations below their 12-month mean, as shown in the chart. Most interesting is the fact that this same metric did not get much lower than this even in the sovereign debt crisis of 2011/12. However, in contrast to the 2011/12 period, banks’ earnings revisions for the sector have moved out of negative territory, and for much of the last two years banks’ earnings revisions continue to be superior to the wider market.
- BMW will increase annual production capacity in China to 400,000 vehicles from its current 300,000 units after the automaker extended its partnership with Brilliance China Automotive for another 10 years. However, underlying the news is a change that could spur a new era of car ownership in China. As the Wall Street Journal reports, foreign auto makers are increasingly pushing traditional car loans in China, a market in which buyers traditionally pay for their purchase in cash. The shift is aiding profits as car makers can now reach younger buyers, a surprisingly underdeveloped segment of the market. As the chart below shows, car loan penetration in China is still in its early stages, boding well for a sustained leg up in growth.
- Rapid growth in monetization of mobile games in China is likely to attract investor attention in the upcoming quarterly earnings season for internet companies, and established mobile game developers and distributors should benefit. Mobile games account for 43 percent of the time spent on mobile devices in China, according to UBS, and more users pay to play games than any other mobile entertainment services.
- The latest round of U.S. and EU sanctions against Russia could prove disastrous for local companies facing $3.93 billion of dollar-bond maturities by year-end, according to Bloomberg data. Despite the central bank’s claim that it has enough instruments to support the financial market, the sanctions will prevent sanctioned companies and banks from accessing U.S. equity or debt markets for new financing. Similarly, the EU said it would halt lending for new public-sector projects in Russia by the European Investment Bank, and will use its influence to stop new lending by the European Bank for Reconstruction and Development. As a result, John-Paul Smith, an emerging-market strategist at Deutsche Bank, predicts the equity market will drop another 10 percent by year-end.
- Commodities from iron ore to copper and Brent crude will drop over the next five years as global supplies climb, according to Goldman Sachs. In a January report, Goldman stated the cycle that spurred higher commodities prices is reversing as increased U.S. shale oil output keeps energy prices low, which would eventually drive raw materials into a bear market. The forecast is particularly threatening for emerging markets that depend on commodity production and exports as their main source for growth and foreign reserves.
- More than six months after the Second-Child policy was approved in China, eligible couples have been slow to embrace looser restrictions based on provincial statistics. The growth prospect of China’s mass consumer sector such as infant foods and diapers has significantly diminished due to structural migration to e-commerce and rising competition to name brands.
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