October surprise
Against the backdrop of weakening U.S. equities and a decline in oil prices, corporate credit markets were lower this week. High yield bonds returned approximately -1.23% in the week ended November 3, with prices weakening in each of the previous eight trading sessions.1 For the month of October, high yield bonds returned 0.13%.1 Although modest, it was the ninth consecutive positive monthly gain. Year to date, high yield bonds are providing gains of approximately 14.8% as of November 3, and remain on pace for their largest annual gains since 2009.1 More recently, however, high yield bonds have felt the effects of a climb in U.S. Treasury yields, weaker oil prices and ongoing outflows from the asset class. High yield bond mutual funds experienced a net outflow of more than $4.1 billion in the week ended November 2, the largest such outflow since August 2014.2 Nevertheless, flows into high yield bond mutual funds, at $6.6 billion, remain net positive in 2016.2 Investment grade bonds were also slightly lower this week, posting a more modest decline of -0.07% in the week ended November 3, and a return of -0.83% during the month of October.3 Notably, investors withdrew nearly $2.5 billion from investment grade bond mutual funds in the week ended November 2, as investors appear to be shifting away from longer-duration investments in favor of those whose values are less likely to be affected by a change in interest rate expectations.2 Bank loan mutual funds saw another $147 million in net inflows, marking the 14th consecutive weekly inflow into the asset class.2 Despite some mild weakness this past week, senior secured loans outperformed the S&P 500, high yield bonds and investment grade bonds in October, providing returns of approximately 0.77% last month, and are now providing year-to-date gains of 8.03%.4

Some further evidence
As expected, the U.S. Federal Reserve left short-term interest rates unchanged at its policy-setting meeting this week, but indicated that it remains on track to raise rates at its December 13–14 meeting.5 The November statement was revised to say the central bank was now looking for “some further evidence of continued progress toward its objectives” before hiking. By adding the qualifier “some” to language from its September statement, the U.S. Fed seemed to indicate that it is likely to raise rates in December barring a significant deterioration in the economic data between now and then. Regarding its decision to leave interest rates unchanged at this week’s meeting, two of the three Fed officials who dissented during September’s meeting repeated their disagreement, while the third, Boston Fed President Eric Rosengren, had previously said he would be comfortable holding off on raising rates until December.5 In the statement, the central bank said the pace of price gains “has increased somewhat since earlier this year” and removed language stating that inflation was likely to “remain low in the near term.”5 Taken together, the message appeared to match investor expectations for a December rate hike, with the pace of subsequent rate increases remaining gradual. After touching a high of 1.88% earlier in the week, the yield on the U.S. 10-year Treasury note declined to approximately 1.78% by week’s end as some uncertainty around next week’s U.S. election results appeared to overshadow the prospect of a near-term rate hike.6

Wage increase
Investors were looking to Friday’s nonfarm payrolls report for further clues about the strength of the U.S. labor market and whether it would signal ongoing momentum in the broader economy. While the 161,000 jobs added in October was slightly below expectations of 173,000, the report was generally viewed as solid and unlikely to alter the U.S. Fed from its path towards a December rate hike.7 Highlights from the report included a 0.4% month-over-month rise in average hourly earnings, an upward revision to August’s and September’s job gains, and a decline in the underemployment rate.7 Average hourly earnings rose 2.8% in October from a year earlier, adding to other economic data released this week that showed an uptick in price gains.7 Data from the Bureau of Economic Analysis showed U.S. consumer spending rose more than expected in September, increasing 0.5% after a 0.1% drop in August.8 Meanwhile, the core personal consumption expenditures (PCE) index rose 1.7% in the 12 months through September, moving closer to the U.S. Fed’s target of 2%.8 Following this week’s data, odds of a December rate hike have continued to move higher. At 76%, the market-implied odds of a December rate hike are now where they were the week before the U.S. Fed raised rates in December 2015.9

Chart of the week: Less productive

  • Following three quarters of contraction, nonfarm business productivity picked up significantly during the third quarter of 2016, growing at a 3.1% annual clip. Reflecting a healthy increase in output, quarter-over-quarter productivity growth reached its highest mark in two years.10,11
  • When combined with last week’s strong gross domestic product figure and Friday’s solid employment data, a clearer picture begins to emerge of firming economic conditions in the United States.12
  • Digging beneath the strong quarterly figure, however, a longer-term downdraft in productivity remains firmly in place. As the chart above highlights, for example, when measured on a less-volatile year-over-year period or a 5-year moving average, productivity growth is largely flat at just 0.00% and 0.57%, respectively. Both of these figures have now been anchored below 0.75% for five consecutive quarters.13
  • Because productivity growth is a critical factor in longer-term economic growth, the secular decline in productivity in the U.S. labor force since approximately the middle of 2004 points to a potential for continued slow economic growth moving forward. In fact, in what has become a “new normal” for investors, economic growth in the United States has been slowly trending lower for more than 50 years.14
  • Within such an environment, long-term interest rates are likely “to stay lower than we’ve come to expect in the past,” as the Federal Reserve Bank of San Francisco President John Williams asserted in an August 2016 Economic Letter.15

1 Bank of America Merrill Lynch High Yield Master II Index.
2 Thomson Reuters Lipper.
3 Bank of America Merrill Lynch Corporate Master Index.
4 Credit Suisse Leveraged Loan Index.
5 U.S. Federal Reserve, http://bit.ly/2esORGE.
6 The Wall Street Journal, http://on.wsj.com/2fmymLh.
7 U.S. Department of Labor, http://bit.ly/1gck641.
8 Bureau of Economic Analysis, http://bit.ly/2fmAe6R.
9 Bloomberg, based on CME data.
10 Bureau of Labor Statistics, http://bit.ly/1mCLDjk.
11 Bureau of Labor Statistics, http://bit.ly/2fgBtUK.
12 Bureau of Economic Analysis, http://bit.ly/1eZ44Hx.
13 Macrobond and FS Investments.
14 Macrobond. Global GDP growth (% change), based on five-year rolling average.
15 Federal Reserve Bank of San Francisco, http://bit.ly/2bbYuFD.

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