2nd Quarter 2010 Commentary
Despite some evident weakness, the U.S. economy expanded 2.7% during the first quarter of 2010, supported by strengthened consumer spending and the sharpest year-over-year corporate profit gains in more than a quarter century. Inventory restocking accounted for 1.9% of economic growth as the level of inventories rose for the first time since March 2008. Growth was adversely affected by declines in residential construction and the sharpest decline in local government spending since 1981, however. Following the loss of more than eight million jobs throughout the recession, the economy created nearly 900,000 new jobs through the first half of 2010, with almost 600,000 coming from the private sector.
Notwithstanding stronger final demand and increased business spending, significant slack persists, dampening inflationary pressures. May marked the second consecutive month of declines in consumer prices, with year-over-year prices rising a modest 2%. Housing accounts for more than 40% of Consumer Price Index (CPI), and the challenges facing the residential market suggest a benign near-term outlook for inflation.
On June 30, the Congressional Budget Office (CBO) released its Long-Term Budget Outlook, describing the outlook as "daunting," as its projections "provide a clear indication of the serious nature of the fiscal challenge facing the nation." According to the CBO, the projections "would reduce national saving, leading to higher interest rates, more borrowing from abroad, and less domestic investment—which in turn would lower income growth…. would also reduce lawmakers' ability to respond to economic downturns and other challenges… (and) would increase the probability of a fiscal crisis." In our view, the "unsustainable" path of growth in debt suggests we are in the early stages of a secular rising interest rate environment led by higher Treasury yields.
Treasuries Outdo Corporate Bonds
The Fund underperformed its Barclays Capital Aggregate Bond Index benchmark during the quarter. The absence of US Treasury bonds from the portfolio hurt performance, as that group posted positive returns as rates declined amid an overall flight to quality. Long-term Treasuries outperformed intermediate Treasuries by 860 basis points as the yield curve shifted in a bull-flattening fashion. The 30-year Treasury reached its lowest yield (3.89%) since April 2009, and the two-year Treasury reached an all-time low of 0.60%.
Mortgage-backed securities performed in-line with duration-matched Treasuries during the period. Option-adjusted spreads tightened as investors anticipated slower prepayment speeds in response to tougher underwriting standards and lower home prices that limit refinancing despite record low mortgage rates.
The Fund's hefty stake in Corporate bonds underperformed duration matched Treasuries. Long corporates outperformed intermediate corporates by 352 basis points, boosted by lower long-term Treasury yields. On a duration-adjusted basis, however intermediate corporates outperformed long corporates by a similar amount.
Overall, the economy appears to be in a soft patch in what we believe is a moderate recovery led by improving final demand, a sharp inventory correction, and an improved outlook for business spending. Business spending is supported by increased profitability and a strengthening U.S. dollar, along with accommodative monetary and fiscal policies. The recovery is fragile and is somewhat less robust when viewed from an historical context. Consumer spending may be affected by continuing challenges in the housing market, increased market volatility, and near-term declines in the equity market, as well as a gradual recovery in the labor market. Final demand may also be adversely affected by a higher savings rate and less access to credit. The impact of government austerity measures, including a combination of higher taxation and lower spending, represents a key risk factor to global economic growth in the near-term.
On June 30, the U.S. House of Representatives passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. From a credit perspective, we believe any final legislation will reduce risk through initiatives such as limitations on proprietary trading, regulation of OTC derivatives, and the elimination of TruPs (trust preferred securities) from Tier 1 capital. In our view, financial regulatory reform will prove to be positive for debtholders as it strengthens overall creditworthiness of financial institutions. In conjunction with our expectations that we are in the early stages of a secular rising interest rate environment, we believe corporate bonds offer the best relative value within the investment grade universe of fixed-income securities.
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.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.
Before investing, carefully consider the fund’s investment objectives, risks, charges and expenses. Contact 800 992-8151 for a prospectus containing this and other information. Read it carefully. Aston Funds are distributed by BNY Mellon Distributors Inc.