4th Quarter Commetary
On January 1, 2013, the U.S. House of Representatives approved legislation that staved off a large portion of the income tax increases associated with the Fiscal Cliff. The bill maintained tax cuts for individuals earning less than $400,000 ($450,000 household), while increasing taxes for those earning above this threshold in generating an estimated $600 billion in additional revenue during the next 10 years. Had the House not acted, the resulting stalemate would have immediately increased taxes for all Americans and reduced certain domestic and defense expenditures by $110 billion.
The mandatory tax increases and spending cuts were put in place to prevent further increases in the nation’s debt ceiling, without which the U.S. could have faced sovereign default. Although Congress provided welcome tax relief for the majority of U.S. consumers, it merely postponed for 60 days a significant portion of the nation’s fiscal debate. In our view, this deal represents the “low hanging fruit” in these negotiations. As the U.S. once again reaches its statutory debt limit, the negotiations over spending will prove even more critical. The U.S. ratio of total amount of the debt outstanding has overtaken every $1 of GDP produced, indicating that the government must deleverage or face potential consequences such as a further downgrade of the U.S. sovereign debt rating.
Turning to monetary policy, the Federal Open Market Committee announced in December that it would purchase longer-term US Treasuries after the completion of its “Operation Twist” program to extend the average maturity of its Treasury holdings. This return to nominal Treasury purchases was not surprising to us, primarily given relatively benign inflation data. Furthermore, the unemployment rate remains elevated, job market participation is still anemic, and business fixed investment continues to slow. We view both hiring and business investment as strongly constrained by the neutral-to-negative sentiment of business managers and executives towards the government’s fiscal uncertainties.
While the U.S. public sector balance sheet reaches unprecedented amounts of borrowing, the private sector has streamlined its operations and borrowings. Thus, the recovery in corporate profits has also has occurred at a much faster pace than that of either investment or hiring. As we head into 2013, both the operating profiles and balance sheets for the private sector are in historically strong positions, while those of the public sector are at their weakest, and facing significant headwinds. Given the limited maneuverability of the public sector and its reliance upon political discourse, we believe this relationship is likely to hold for the intermediate future.
The Fund outperformed its Barclays Capital Aggregate Bond Index benchmark during the quarter. Sector, quality, and security selection aided the portfolio’s performance. An overweight stake in credit securities outperformed duration (a measure of interest-rate sensitivity) matched Treasuries during the quarter as the option-adjusted spread (OAS) on Corporate bonds tightened. An overweight stake in the bonds of large U.S. banks further boosted results as the Financials sector was a standout performer within the index. An underweight stake in Treasuries also helped portfolio returns, as that sector of the market was negative for the quarter. Moreover, much of the Fund’s Treasury exposure was in the form of Treasury Inflation-Protected Securities (TIPS), which benefitted from increasing inflation expectations and outperformed nominal Treasuries. Our decision to overweight lower-quality, investment grade bonds in the portfolio also helped relative performance as that group outperformed.
Portfolio structure also had a positive effect. The portfolio is structured in a barbell fashion, emphasizing high quality, floating-rate notes on the short-term end of the yield curve and lower quality investment grade securities on the long end. Longer duration credit securities outperformed during the quarter as spread curves flattened.
In the current fiscal and monetary environment, we anticipate that investment grade corporate issuers (and therefore their debt) will weather near-term volatility with a more attractive total return profile than government securities, with one notable exception—TIPS. In terms of inflation, we anticipate that the dollar may weaken against the backdrop of further fiscal concerns for the U.S., which would indicate the potential for increases in both energy and other commodity prices. We estimate that to reach a “normal” unemployment rate, the U.S. would need to add approximately three million additional jobs. Based on the Federal Reserve’s comments, however, it is likely that they will consider slowing the use of quantitative tools (e.g. Treasury purchases) in advance of the target employment rate. The healthy financial position of U.S. corporations indicates that there is substantial capacity to add labor quickly to reduce the nation’s unemployment rate, which we consider likely towards the second half of 2013—another factor which may increase inflation expectations. Higher inflation expectations and lower unemployment are both possible during 2013 and are consistent with the Committee’s dual mandate and Chairman Bernanke’s comments that 2013 could be a “good year” for the U.S. economy.
Taplin, Canida & Habacht (TCH)
Note: Bond funds are subject to interest rate and credit risk similar to individual bonds. As interest rates rise or credit quality suffers, an investor is susceptible to loss of principal.
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