4th Quarter 2010 Commentary
Recovery Remains Modest
The U.S. economic recovery has been supported by accommodative fiscal and monetary policy, a strong inventory correction, improving financial markets, and export growth. Still, the recovery remains modest in a historical context and reflects deferred consumer and business spending, while sustainability is dependent upon growth in private final demand. Going forward, the recovery may be buoyed by the extension of income-tax cuts, a reduction in payroll taxes, and a weaker dollar resulting from a Federal Reserve policy that, in turn, could further stimulate export growth. Key risk factors for the economic recovery include a slower than expected recovery for the labor and housing markets, along with declining spending from fiscally-constrained municipalities that may impair a rebound in final demand.
During the third quarter of 2010, the U.S. economy expanded 2.6% supported by increased inventory accumulation and the sharpest rise in consumer spending since March 2007. The change in private inventories reflected a 10% increase in business spending supported by a 15% rise in investment in equipment and software. In November, the Bureau of Labor Statistics reported that the rate of unemployment increased to 9.8%, as job creation has not kept pace with the expansion of the labor force, and the weak housing market subtracted from final growth as residential fixed investment declined 27.3%. The weak labor market combined with the overhang of foreclosed properties and vacant homes remains a significant drag on housing prices and residential investment.
Longer-term, the Fed's aggressive purchase program could prove problematic as highlighted by the dissent of voting member Thomas Hoenig that, “a continued high level of monetary accommodation would increase the risks of future economic and financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy.”
The Fund outperformed its Barclays Capital U.S. Aggregate Bond Index benchmark for the fourth quarter, capping a solid year of outperformance in 2010. US Treasury bonds realized positive returns for the year as rates declined across the yield curve. In this environment, long-term Treasuries outperformed intermediate Treasuries, as the yield curve reached its steepest level on record. Interest-rates, particularly on the short and intermediate part of the curve were buoyed by moderate inflation data and a second round of quantitative easing by the Federal Reserve.
Overweight stakes in Mortgage-back securities and Corporate bonds aided relative returns for the Fund as both groups outperformed Treasuries on the year. Mortgage-backed securities benefitted from a supply/demand imbalance as Federal Reserve holdings peaked and new issuance through November declined 12% from 2009 levels. Corporates with a longer duration (a measure of interest-rate sensitivity) profile benefitted from the declining interest-rate environment. Financials were the best performing credit subsector in 2010, outperforming Industrials and Utilities. Financials benefitted from improving overall credit quality as well as new regulatory reforms including the Dodd-Frank Act and Basel III that are expected to enhance creditworthiness over time.
Outlook and Positioning
The Federal Reserve has engineered artificially low interest-rates and a sharp steepening in the yield curve via monetary policy and credit easing. On November 3, 2010, it announced its plans to purchase a further $600 billion of securities by the end of the second quarter of 2011, while maintaining its commitment to reinvest principal payments of existing holdings. According to the Fed, the sharp downward move in Treasury yields ahead of the announcement suggested that the second round of credit easing was anticipated by the market and was fully priced into valuations.
We believe the remedies for a weak economic recovery may fuel heightened inflationary risk over the intermediate- to longer-term. With nominal Treasury yields already reflecting the benefit of security purchases, in conjunction with our view that inflationary pressures will increase over time, we favor Treasury Inflation Protected Securities (TIPS) within the portfolio's allocation to government bonds. Importantly, break-even inflation rates remain below the longer-term actual rate of inflation, suggesting TIPS will outperform nominal Treasuries should inflation return to its longer-term average rate.
Despite being the best performing sector of the fixed-income market during the past two years, we believe Corporate bonds remain poised to outperform in 2011 as the economic recovery accelerates. Corporates stand to benefit from strengthened balance sheets and enhanced creditworthiness attributable to regulatory reform while new issue supply is expected to be manageable and met with strong demand.
We believe regulatory reform following the passage of the Dodd-Frank Act will reduce risk through initiatives such as limitations on proprietary trading, regulation of OTC derivatives, and the elimination of trust preferred securities from Tier 1 capital. Strengthened capital requirements imposed by the Basel Committee on Banking Supervision will further enhance creditors and fortify the global financial system. Corporate America capitalized on the reopening of the credit markets following the financial crisis by rationalizing debt maturity schedules, strengthening balance sheets, and reducing leverage, thereby significantly reducing investment grade refinancing risk going forward.
Valuations and risks suggest mortgages will underperform in 2011. Following the massive Fed purchase of mortgage-backed securities that exceeded 20% of all outstanding MBS in the benchmark Index, the option-adjusted spread for mortgages dropped below zero, implying investors were not being compensated for the prepayment risk associated with these securities. The Dodd-Frank Act mandates that the U.S. Treasury deliver a comprehensive housing finance reform proposal to Congress by January 2011. Although new structures for Fannie Mae and Freddie Mac following conservatorship are unknown, the Congressional Budget Office estimates the U.S. government would absorb $540 billion in losses if the government sponsored entities become public, while a private solution would potentially lead to losses for unsecured creditors.
Beyond the direct impact of potential losses on investments, a sovereign debt crisis remains a threat to the global economic recovery. The fiscal plight of peripheral European sovereigns may also impact the U.S. as government leverage threatens to impede the expansion, which may in turn slow export growth. The European Financial Stability Facility (EFSF), a special purpose vehicle created by the European Union to provide loans to troubled sovereigns, is expected to issue debt in the coming months and a successful offering would represent an important hurdle for the global credit markets, as well as the global economic recovery.
With this backdrop, the Fund's current fixed-income strategy incorporates expectations for higher interest-rates over time. In this environment, we are utilizing TIPS to help protect the portfolio and are maintaining a bar-bell portfolio structure emphasizing corporate bonds on the long end of the yield curve and high quality floating rate notes on the short-end. This reflects our view that credit curves will flatten over time driven by higher short-term interest-rates.
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.
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.