2nd Quarter 2011 Commentary
Economic Soft Patch
The U.S. economy was in the midst of a soft patch throughout the first half of 2011 as consumer spending has been affected by higher food and energy costs, a tepid labor market recovery, further setbacks in the housing market, and global shocks—including geopolitical unrest in the Middle East, the Japanese earthquake/tsunami, and worsening fiscal conditions in peripheral Europe. U.S. economic growth decelerated during the first quarter from 3.1% to 1.9% as the sharpest drop in federal (-8.1%) and local (-4.2%) government spending of the past two decades and a moderation in consumer spending slowed the pace of the recovery.
The Fund underperformed its Barclays Capital Aggregate Bond Index benchmark during the second quarter. US Treasuries realized positive returns as the yield curve shifted in a bull steepening fashion in an overall flight to quality. In this environment, intermediate-term Treasuries underperformed long-term Treasuries, and shorter-term two-year Treasury rates reached a new all-time low of 0.32% and shorter dated T-bills again reached negative yields.
The portfolio's overweight position in Corporate bonds hurt relative returns as they modestly underperformed duration-matched Treasuries. Similar to Treasuries, long-term Corporates outperformed intermediate Corporates as the effect of declining rates was more pronounced on the long end of the curve. Mortgage-backed securities outperformed duration-matched Treasuries as prepayments remain slower than expected despite declining interest rates.
Utilities was the best performing credit subsector on both an absolute and a duration-adjusted basis during the quarter, followed by Industrials and Financials. Higher-quality, investment-grade securities also modestly outperformed on both an absolute and a duration-adjusted basis.
Although the Federal Reserve Board believes that softer economic growth rates partially reflects temporary factors, Chairman Bernanke asserted, “weakness in the financial sector, problems in the housing sector, balance sheet and deleveraging issues, some of these headwinds may be stronger and more persistent than we thought.” Despite persistently low borrowing costs, the housing market continues to weaken as year-over-year home prices declined 4%, marking the biggest drop since 2009. In May, existing home sales declined to a six-month low, while the inventory of homes available grew to 9.3 months. The weak residential housing market, in conjunction with a slow recovery of the labor market, suggests the supply of homes available for sale will continue to grow as foreclosures persist.
Following the conclusion of the two-day meeting on June 22, the Federal Reserve reduced its expectations for economic growth in 2011. Still, the Fed’s overall projections for 2011 suggest an expectation for a sharp rebound in economic growth in the second half of 2011, to levels above their own longer-run growth potential estimates.
Now that the second round of quantitative easing (QE2) has concluded (as of June 30), the Federal Reserve will maintain a neutral policy stance via the reinvestment of principal payments. Specifically, the Fed will purchase Treasuries as the securities on its $2.9 trillion balance sheet mature. Although overall demand for Treasuries from the Fed will slow, Treasury purchases will continue to reinvest principal payments of mortgage-backed securities and agency debt, as well as retiring Treasury securities. According to Chairman Bernanke, allowing the portfolio to run off “would be a first step in a process of exiting from our currently highly accommodative policies.”
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.