Newsletter | Episode 22

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Episode 22 | Steve Tananbaum, Mary Deatherage, Rob Sechan

Forward

This Week on Wall Street

The market quietly waited for the Fed early in the week, but volatility resumed Thursday afternoon following the FOMC’s decision to keep interest rates at 0%. Stocks traded in a range Thursday immediately following the decision, turning sharply lower overnight into Friday’s session. The S&P 500 fell 1.6% Friday to finish the week down 0.2% while the Nasdaq edged higher by 0.1%. T he Dow closed down 0.3% and is now down more than 8% on the year.

Small-cap stocks, traditionally less correlated to global growth, outperformed as the Russell 2000 finished the week up 0.5%. Analysts attributed Friday’s sell-off to concerns over the Fed’s downbeat view of global growth and ongoing uncertainty over US monetary policy.

US treasuries rallied after the Fed decision, with the 10-year seeing the biggest change on the week as yields fell six basis points to 2.13%. The two-year note saw its biggest one-day decline since December 2010 as yields fell off four-year highs. For the week, yields on the two- and 30-year fell four basis points to 0.67% and two basis points to 2.93%, respectively.

After a 5.8% rally in WTI crude prices Thursday, oil gave back its weekly gain Friday with a 2.7% loss. WTI crude finished the week at $44.68/barrel.

Fed

Early in the year, the September meeting was viewed as probable timing for a rate hike, assuming the positive trend in economic data continued. However, despite US economic growth looking very healthy over the last few months, by the time this week's meeting rolled around, the odds of a hike were only around 25%. The Fed acknowledged weakness in the global economy played a significant role in its decision.

Opinion was largely split among observers over whether the Fed should hike rates, doves pointing to still-tepid growth and inflation with hawks pointing to a much-improved employment picture and potential distortions created by a six-year period of zero-bound rates. The FOMC indicated it will revisit the possibility of a hike at the October and December meetings.

Asia

China and Japan both released disappointing industrial production reports early in the week, reinforcing the global growth concerns that contributed to the Fed’s punt. China’s industrial production rose at an annualized 6.1% rate in August versus expectations of 6.6%. Retail sales growth, however, topped expectations with 10.8% growth year-over-year.

S&P cut Japan’s long-term credit rating one notch to A+, pointing to low growth and inflation, with public debt projected to increase to 2.5x GDP next year.

US economic data

Domestic data continued to paint a rosy picture of the US economy as core retail sales climbed at a healthy clip of 0.2% in August while July's strong gain was also revised upward to 0.7%. Weekly jobless claims declined Thursday to 264,000, their lowest levels since July.

US Core CPI rose 0.1% in August and has climbed 1.8% in the past year. Building permits topped expectations in August with growth of 3.5%, with permits for single-family homes experiencing their largest increase since January 2008.

Europe

The Eurozone’s trade surplus set an all-time record with a weaker euro boosting exports by 7% from a year ago, while imports climbed only 1%. Eurozone industrial production also rose 0.6% in July, above expectations of 0.2%.

Greek elections took place Sunday with incumbent PM Alexis Tsipras' Syriza party appearing to maintain a plurality. The vote further cements the country's recent bailout agreement with Eurozone creditors.

Corporate news

Hewlett-Packard (HP) announced plans to cut its workforce by around 10%, or more than 30,000 jobs, over the next three years, mostly in its enterprise business.

Anheuser-Busch InBev (BUD), the world’s largest beer producer, is seeking to acquire its closest rival SABMiller. The merged company would sell one-third of the world’s beer and have around 80% market share in the US, which could draw regulatory scrutiny.

European telecom giant Altice has agreed to buy Cablevision (CVC), the US’ fourth-largest cable company, for $17.7 billion.

Week ahead

Monday: US existing home sales
Tuesday: China flash PMI
Wednesday: EU flash composite PMI
Thursday: US durable goods orders, US weekly jobless claims
Friday: US final Q2 GDP

Episode Playback

Did you miss Sunday's show featuring Goldentree's Steven Tananbaum, Morgan Stanley's Mary Deatherage and UBS' Robert Sechan II? Watch all segments, extended interviews and web extras at WallStreetWeek.com

Episode Feature

Business cycle investing suggests certain asset classes outperform during different phases of an economy’s ebb and flow. Long-term investors may diversify a portfolio in order to smooth out cyclical fluctuations, while active managers may look to time entries into and out of certain assets to achieve alpha. As a credit investor, Goldentree CIO Steve Tananbaum explains that his fixed income investment analysis consists both of value calculation and business cycle evaluation.

While Tananbaum doesn’t see many fixed income assets right now that represent traditional good value, the new paradigm created by unprecedentedly accomodative monetary policy means you have to place particular emphasis on timing the cycle correctly.

“What I'm focusing on is, 'where do I think we are on the cycle?' And where do I feel we are in credit and in the economy? It seems like we're pretty far along the cycle. Previous times the Fed has raised earlier relative to where the cycle is. If you think a typical cycle is eight to 10 years we're further through the cycle.”

The business cycle traditionally consists of the early, mid, late and recession cycle phases. In the early phase, lower quality risk assets rebound amid stimulative policy. Within the credit space, that means the lowest-rated bracket of the junk bond market, which outperforms early in the post-crisis US economic recovery, enjoyed a sharp snapback but has weakened considerably this year as the market anticipates rising interest rates.

“Historically, when you come out of a recession, the triple C, the most junior part of the lowest rated of part of the high yield market, does the best, and it usually does the best up until halfway through the cycle and then it underperforms. Broadly speaking, we feel that market's going to underperform.”

Tananbaum is not the first Wall Street Week guest to offer a cautious view on the junk bond market. Jeffrey Gundlach and Carl Icahn warned about a potential collapse and liquidity crisis on high-yield bonds in Episodes 1 and 3 , respectively. However, Tananbaum provided more specific analysis on the credits Goldentree will look to deemphasize within portfolios.

“As [host] Gary [Kaminsky] knows as we've talked over the last 18 months, it's one of our themes that triple C's, which had been the stars, you can call it 2009 through 2013, would begin underperforming in '14 and '15. They've underperformed by close to 1,000 basis points and we expect that to continue to be a tough part of the market.”

The recent weakness in junk bonds has made the sector a slightly better value, but Tanabaum was not ready to go as far as to label it a time to buy.

“In credit, it certainly went from I think 'not good' value in high yield, to 'mediocre' value to 'better' value. I wouldn't call it a buying opportunity, but certainly a better opportunity. If you look, for instance, at something like bank loans, you would have something like almost 50% of bank loans that were trading a couple months ago above par and now it's only about 15%. So that market has materially corrected. High yield bond [spreads] are wider by about 50 to 75 [basis points], so that's not a meaningful correction but better value.”

Although the current recovery never really fired on all cylinders reminiscent of a prototypical mid-cycle phase, Tananbaum notes we are starting to enter the late phase as the Fed looks to tighten monetary policy. Growth remains steady, if unspectacular, while credit tightens.

During the late-cycle phase, Tanabaum says there is clear precedent credit investors should follow. Junk bonds as a whole looks relatively unattractive, but if you are willing to take a more specific view of the category certain non-investment grade credits offer good relative value.

“When you're deep in the credit cycle, there's a playbook. The playbook is historically short duration, and higher quality below investment grade. Short duration means shorter-term debt… one to five years, versus seven to 10 years. You want to be in the higher quality, which would mean the higher rated of part of the below investment grade market, call it the double B market. And that's what we see as the neighborhood you want to be in.”

Tananbaum, like many others, is having a tough time finding compelling value anywhere in today's market, but given the important role bonds play in a portfolio, perhaps now is a time to settle for the most attractive relative value while minimizing duration risk.

Investment Primer
What are MLPs?

In episode 22, Rob Sechan talked about his favorable view of MLPs, so we’ve decided to include a primer on the topic.

A Master Limited Partnership (MLP) is a publicly-traded security in the form of a partnership that derives the vast majority of its cash flow from real estate, natural resources and commodities. Two types of partners exist within the partnership: the general partner and the limited partner. The general partner owns a small percentage of the MLP, usually around 2% and manages the MLP. The limited partner, similar to shareholders, owns the remainder of the MLP. This person or group is responsible for providing capital for the Master Limited Partnership. In return, they receive a periodic income from the MLP’s cash flow. The main difference between an MLP and a common stock is the taxation policy. MLPs are not taxed like a corporation; they do not pay taxes on their profit. Instead, the money is only taxed when unitholders receive income distributions.

Over the last decade, MLPs have gained increasing popularity as they deliver both income and growth. However, given their correlation to energy prices, many have sold off sharply over the past year. Successful partnerships have real assets and offer opportunity for expansion. With an average income distribution rate of almost 7%, MLPs in the Alerian MLP Index offer a relatively high yield. In comparison, the U.S. 10 year treasury offers a return of only 2.13%. Of course, MLPs trade as an equity security and therefore should not be considered a substitute for less volatile fixed income investments.

There are three different types of MLPs: upstream, downstream, and midstream MLPS. Upstream MLPs focus primarily on the exploration, recovery, development, and production of crude oil, natural gas and natural gas liquids - and are thus more sensitive to commodity prices. Upstream MLPs have sold off the most over the last 18 months.

Midstream MLPS are not as commodity price sensitive because they are mostly involved in the gathering, storage and transportation of oils and gases. Most MLPs available in the market today are centered on midstream operations. Lastly, downstream MLPs deal with the distribution of fuels to costumers, whether residential, industrial or agricultural.

Midstream MLPs have significant advantages over upstream businesses. As previously stated, upstream MLPs are extremely sensitive to commodity price. As their earnings are influenced by any market instability, they are forced to reinvest a large portion of their earnings for maintenance CAPEX. Douglas A. Rachlin, a Managing Director at Neuberger Berman, stated in a recent interview with Wall Street Week that be believes upstream companies have no place in an MLP structure. He reasons that these businesses should retain cash flow for reinvestment, not redistribution.

Recently, there has been some downward price pressure on MLPs as the price of oil has reached historic lows. Many investors fear for the energy industry as a whole. Even though midstream MLPs do not have significant exposure to commodity pricing, it appears they have been impacted by volatility.

The biggest risk MLPs face today is a United States economic downturn. Energy consumption drives the MLP value, so positive economic conditions are essential. MLPs benefit from increased driving, strong SUV sales, and high natural gas demand. A recession could jeopardize such favorable conditions.

Sources:
http://hvst.co/1V4Vcs4
http://hvst.co/1V4VejG

Have more questions about MLPs? Email us at prosper@wallstreetweek.com