Fixed Income Capital Markets Trading Desk Commentary

A Case for Credit

Weekly Market Comment: By: Fixed Income Strategy Group
Date: August 11, 2013

3mth Libor 2-yr 3-yr 5-yr 10-yr 30-yr DJIA S&P 500

08/09/2013 0.265% 0.30 0.61 1.35 2.57 3.63 15,424.51 1,691.42

08/02/2013 0.266% 0.30 0.57 1.36 2.60 3.69 15,646.5 1,707.27

Wkly Change -.001 Unchg +4 -1 -3 -6 -1.49% -1.07%%

U.S. bond yields were mixed last week, with short term yields slightly higher and the 10-year down 6 bps. After suffering a beating in June, portfolio managers have had time to readjust to a new world of rising rates and wider spreads. Bonds no longer hold the favored nation status of the past few years, as both domestic and European economies improve and fears of a hard landing in the Chinese economy appear to have dissipated. As a result, central banks, led by the U.S. Federal Reserve, are preparing an orderly exit from the bond market in the coming year. Equity indices closed lower last week. The Dow led the drop by falling 1.5 percent followed by 1.1 percent on the S&P 500 and -.80 percent on the NASDAQ. Most major industry sectors including telecom, industrials, financials and utilities fell. The lone gainer on the week was materials. Despite the previous weeks poor performance, all equity indices are up quarter-to-date. The debate over the timing of the Feds tapering announcement seesaws between September and December. Recent economic news could support either date, but the genie is out of the bottle and the markets appear prepared for the inevitable. September 19th, the conclusion of the next FOMC meeting and date of the next official press conference, will be the most logical time to provide a detailed plan. The reduction in Treasury auctions will provide an opportunity for the Fed to decrease the level of buying without great market disruption in addition to reducing MBS purchases. I expect an equal weighting of both in the Feds plan. Be Brave In light of this forecast, I continue to favor repositioning in shorter duration bonds with an overweight in lower investment grade credit. The spreads remain very wide in the credit markets, especially municipal bonds, a sector that has been plagued with a series of negative events in addition to the ongoing issues associated with the Detroit bankruptcy filing. For those that have a longer investment horizon, (e.g. 1-2 years), this sector offers attractive opportunities to capture yield in shorter duration bonds. To put it more bluntly, when everyone seems to be running away out of fear, the brave ones walk toward to source and find there is very little to fear. Credit due diligence is essential in any market environment, but especially in a recovering economic scenario. The U.S. consumer has just begun to regain its

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D.A. Davidson & Co. propensity to shop (saving appears to be a passing fad of the Great Recession) and hopefully companies will have an incentive to invest in the coming year. All of these metrics bode well for U.S. corporate earnings and local government revenues. In the near term, the corporate spreads will ebb and flow with each news report which may cause more outflows from funds. The rates sector of the bond market will offer opportunities to sell longer duration bonds and reduce exposure to rising interest rates without a significant reduction in current portfolio yield. The economy is grinding higher, but the pace has been painfully slow. Last weeks report from the Institute for Supply Management (ISM) on services showed better than expected expansion and the trade deficit narrowed which should provide a boost to second quarter GDP growth. The unemployment rate fell to 7.4 percent in July, after hovering at 8 percent in 2012, 9 percent in 2011 and 2010. The tepid pace exists in spite of the most aggressive monetary stimuli in history. Many have noted the severity of the recession as a reason for the slow growth environment, but the absence of effective fiscal stimuli is also to blame. Business investment led the country out of the Great Recession, but the pace of spending has decelerated in the past year. Company executives are more cautious to commit to permanent expenditures such as new hires, acquisitions and inventory due to uncertainties surrounding tax and healthcare liabilities in addition to a frugal consumer. Focus Shifts to Fiscal Policy The market should begin to focus on the most pressing fiscal issues in the coming months which include (1) the debt ceiling needs to be raised and a new budget cycle begins, (2) the expiration of the continuing resolution in September, (3) the impact of the Affordable Care Act on businesses as provisions are implemented in early 2014. The negotiations regarding the debt ceiling and budget will occur in September and October. It wasnt long ago that a logjam led to a credit downgrade of U.S. debt and a selloff in Treasuries as investors expressed dismay at the lack of fiscal leadership in the U.S. I anticipate more spending cuts to emerge from the negotiations but no action on tax reform, to the detriment of domestic businesses. The continuing resolution allowed the government to maintain funding for various programs (thus avoiding work stoppages) without a budget. This extension of the programs will expire on September 30th. The expiration of a continuing resolution has become an annual event in this country, and although a last minute compromise always seems to emerge, the angst that comes along with a threat that workers may be furloughed and government spending severely reduced always creates another uncertainty that rankles market participants. In the event I am wrong, the market disruption may be minor since only non-essential functions of the government will cease operations. The potential additional cost of healthcare for both individuals and business may also constrain growth next year as the industry adjusts for new payment schemes. The uncertainty associated with fiscal policy will continue to restrict the pace of the economic recovery in the next year, which suggests GDP growth will remain below 3.00 percent in 2014. Watch Retail Sales Trends Key data to be released this week include the July retail sales report, expected to show a slight pullback from the previous month, but generally good trends excluding autos. After surging the past six months, the pace of auto sales is expected to slow. The back-to-school season has just begun, but the news has been disappointing thus far and may be an indication of tepid consumer spending in the coming months. Inflation data in the form of the producer and consumer price indices will provide some insight as to

D.A. Davidson & Co. how far we are from the Feds 2.0 to 2.5 percent target. The core CPI estimated to rise 1.7 percent yearover-year. Manufacturing reports on industrial production, the New York manufacturing index and Philadelphia Business Outlook are all likely to show a slight improvement in activity. A light Fed calendar ahead of the Kansas City Economic Summit in Jackson Hole at the end of the month. Atlanta Fed president Lockhart and St. Louis Fed president Bullard are all scheduled to speak this week.