Rotation trade
Corporate credit markets continued to trend higher this week amid encouraging U.S. economic data, strength in U.S. equities and ongoing rotation out of safe-haven investments and into income-producing assets. Financial markets are benefiting from a set of benign circumstances that include low interest rates, tame inflation, strong employment and steady U.S. economic growth. High yield bond prices moved higher throughout the week, hitting a 12-month high on July 20 and have now more than made up for any declines sustained in the immediate aftermath of the Brexit vote.1 Month to date, high yield bonds are providing gains of approximately 2.6% and are currently on track to post their sixth consecutive monthly gain.1 This week saw inflows into high yield bond mutual funds, bringing the three-week tally to $6.2 billion.2 For senior secured loans, prices improved in each of the past 17 trading sessions on the back of improved supply and demand dynamics and an overall decline in broader financial market volatility. Institutional demand remains solid, as two of the largest CLOs (collateralized loan obligations are the largest buyers of senior secured loans) priced this week, bringing year-to-date CLO issuance to nearly $32 billion.4 Senior secured loans are now providing month-to-date returns of 1.29% and year-to-date returns of 5.58% amid solid demand and lower overall new issuance volume.2

Slow but stable
Encouraging U.S. economic data took center stage in what was an otherwise relatively quiet week in the financial markets. In a sign of ongoing labor market strength, weekly U.S. jobless claims fell to a three-month low and have now remained below 300,000 for 72 consecutive weeks.5 Existing home sales also rose to their highest level in nine years and the U.S. Leading Economic Index rose 0.3% in June after declining in May.6,7 This week’s strong economic data, combined with last week’s solid U.S. retail sales and June’s stronger-than-expected payrolls report, have raised the possibility of another interest rate hike by year-end.8,9 While Fed Fund futures indicate that the odds of a U.S. Fed rate hike remain low, recent economic data has renewed talk of a potential rate hike.10 As a result, the U.S. dollar and U.S. Treasury yields have crept steadily higher, with the yield on the 10-year U.S. Treasury Note rising above 1.6% after hitting a record low of 1.31% two weeks ago. 11

Ongoing accommodation
Any thoughts of a potential interest rate hike should be tempered by the reality of ongoing central bank accommodation around the world. This week, the European Central Bank signaled that it was likely to ease monetary policy in September and last week the Bank of England held out the prospect of further easing in the wake of the Brexit vote.12 The next few weeks bring several central bank meetings, including the U.S. Federal Reserve’s meeting beginning July 26. When it next meets, the U.S. Fed will likely give a nod to improving U.S. economic data and the recent stabilization in financial markets without fully committing to a timeline for the next rate hike. In minutes from its April meeting, the Fed signaled that a rate hike was coming in either June or July, only to have to reverse course after May’s disappointing jobs figures.13 Between the Fed’s July policy meeting and its next meeting in September, the Fed will have the benefit of two more U.S. nonfarm payrolls report and a more complete read on second quarter GDP growth. Next week, investors look to an update to the Fed’s assessment of the U.S. economy, the advance estimate of second quarter GDP and a fresh read on U.S. consumer confidence. 14

Chart of the week: Lowered expectations for pension funds

  • The California Public Employees’ Retirement System (CalPERS), the nation’s largest public pension fund, earned a return of 0.61% on its investments for the fiscal year ended June 30, 2016.15 CalPERS’ portfolio return was brought down by its investments in public equity markets, which returned -3.64%, and boosted by strong returns in fixed income and infrastructure investments, among other assets.15
  • 2016 was the second consecutive fiscal year in which CalPERS earned paltry total returns on its investment portfolio and is emblematic of a broader trend in which pension plans have steadily reduced their expected annual returns since the financial crisis.16, 17
  • As is illustrated in the chart, in 2009, pension plans expected an 8.0% total return on their portfolios. However, this figure has declined between 10 and 30 basis points in each year since. In 2015, pensions estimated a total return of just 6.9% as even the largest of institutions have faced challenges generating returns in a world dominated by low, or negative, interest rates, slow economic growth and global uncertainty.17
  • Indeed, individual investors today face similar set of challenges in their attempt to build diversified portfolios with attractive rates of return.

1Bank of America Merrill Lynch High Yield Master II Index

1Thomson Reuters Lipper

1Credit Suisse Leveraged Loan Index

1J.P. Morgan High-Yield and Leveraged Loan Morning Intelligence, July 22, 2016

1U.S. Department of Labor:

1National Association of Realtors:

1The Conference Board:

1U.S. Department of Labor:

1U.S. Department of Commerce:

1Bloomberg, based on CME data

1Federal Reserve Bank of St. Louis:

1The Wall Street Journal:

1U.S. Federal Reserve:

1The Wall Street Journal:

1CalPERS, based on preliminary returns:

1CalPERS 2014-2015 Comprehensive Annual Financial Report:

1Bloomberg Gadfly, based on data from Mercer:

The Alternative Thinking Week in Review market commentary and any accompanying data (“Market Commentary”) is for informational purposes only and shall not be considered an investment recommendation or promotion of FS Investments or any FS Investments fund. The Market Commentary is subject to change at any time based on market or other conditions, and FS Investments and FS Investment Solutions, LLC disclaim any responsibility to update such Market Commentary. The Market Commentary should not be relied on as investment advice, and because investment decisions for FS Investments funds are based on numerous factors, may not be relied on as an indication of the investment intent of any FS Investments fund. None of FS Investments, its funds, FS Investment Solutions, LLC or their respective affiliates can be held responsible for any direct or incidental loss incurred as a result of any reliance on the Market Commentary or other opinions expressed therein. Any discussion of past performance should not be used as an indicator of future results.