The Federal Reserve’s interventions have added US$10 trillion to the American economy – at the same time as fiscal stimulus has added to U.S. debt. Still, GDP growth over the past decade has been stubbornly low.
So says Ignacio Sosa, director of the product solutions group at DoubleLine Capital in Los Angeles, a firm that manages the Renaissance Flexible Yield Fund. He adds, “A lot of money has been spent and a lot of growth has yet to appear, but what has appeared is […] valuations appear to be quite stretched.” He points to both stocks and bonds.
For this trend to reverse quickly, he says, “you probably would need some sort of a recession.” However, he finds the indicators that his firm watches aren’t suggesting a U.S. recession will occur in the near term.
In fact, leading indicators are “nowhere near the danger zone,” he adds, and the same goes for economic indicators that have been negative but not alarming.
One indicator Sosa’s firm tracks is the unemployment rate. “We plot the unemployment rate against a simple moving average,” he explains. “If you look at [that rate] using the 12-month moving average, typically when you have a recession one of the first things that happens is the 12-month moving average line crosses over the actual line for the unemployment rate.”
“That hasn’t happened,” says Sosa, who notes that even if it did, a recession wouldn’t necessarily be imminent.
Sosa also plots the unemployment rate against the 36-month moving average. When he looks back at everything that has occurred since the 1930s, he says, “Every time there’s [been] a recession, the 36-month moving average line [has] crossed over the simple unemployment line.” But looking at today’s economy, that hasn’t yet happened either.
As a result, he’s optimistic. “What we’re looking at is no recession in the near term, unless there’s a big geopolitical event or something completely unforeseen. So valuations could stretch longer than they should […].”
Since November 2016, the S&P 500 has risen steadily, from 2,085.18 points on November 4, 2016 to nearly 2,500 as of July 24.
Breaking down today’s market
One area Sosa is looking at is securitized credit. “I think asset-backed securities, for example, are still attractive,” he says. “The mortgage market hasn’t kept up with the timing, let’s say, in corporate credit spreads. So there are opportunities there […].”
When picking mortgage-backed securities, Sosa’s firm likes non-agency mortgages — mortgages not guaranteed by the American government — “which we still think are attractive.” The collateralized loan obligations for these mortgages “are almost entirely investment grade, [though] there is a small portion that’s not,” he adds.
He also likes emerging markets. “At this point, we’re a little more neutral on the [U.S.] dollar than we were; we had been bearish on the dollar. But to us, relative to high yield – and especially relative to investment-grade American corporate bonds – emerging market dollar bonds seem more attractive to us.”
However, Sosa stays away from local currency-denominated emerging market bonds.
That’s because of the “tremendous volatility in the currencies themselves,” he explains. “That can wipe out any sort of gains that you have from holding bonds that increase in value because either the credit’s improving, so spreads are contracting, or interest rates are going down and therefore the price of the bond is going up.”
Sosa points to the scandal involving Brazilian President Michel Temer, who took office in August 2016; in June 2017, Temer was formally accused of accepting bribes and, as a result, was charged with corruption. However, the trial was rejected on July 13 by a congressional committee.
Still, in the midst of that process, the country saw “a one-day move of [more than] 3% in the value of the Brazilian real. We don’t think you get paid for that, so we don’t introduce volatility that doesn’t really deliver the kind of excess returns we would like to see.”
But Sosa’s cautious on investment-grade credit. As of mid-June, he said, “It’s trading near its most expensive levels in recent memory. The same thing goes for high yield, [but] in high yield you get a little bit more spread. In investment grade, you get very little additional spread and much longer duration—in other words, you’re much more exposed to interest rate moves.”
Compared to other bond asset classes, “A portfolio of investment-grade bonds is more likely to track movements in long-term interest rates than other asset classes in the bond world,” he says. “To us, you’re not getting compensated enough to take that risk, particularly if you think, as we do, [that] interest rates are slowly but surely headed up.”