By Rajiv Sobti
We view [the recent] inaction and statements by the Fed as an important positive catalyst for the medium term trajectory of risk assets, both in fixed income and equities.
In a surprising shift in stance, the Fed postponed the initiation of the QE tapering, expressing concern that “rapid tightening of financial conditions in recent months could have the effect of slowing growth.” While acknowledging that labor conditions had improved, the Fed favored instead to wait and “see the effects of higher interest rates on the economy, particularly in mortgage rates on housing.” We had been surprised at the degree of hawkishness priced in for the Fed despite mediocre economic data, especially in the housing market.
We have strongly emphasized the critical role targeting the housing market plays in the Fed’s agenda to promote employment and growth. The wealth effect in housing offers the highest economic multiplier, as most homeowners are highly levered in this asset class and many are still underwater on their mortgage. Also, housing recovery has the power to stimulate economic activity across many highly labor intensive industries.
As charted above, the rise in fixed mortgage rates in the past few months led to deterioration in housing affordability and the collapse of mortgage refinancing activity. This stall in the recovery of the housing market raised the Fed’s concern regarding the ability of the US economy to reach the “escape velocity” necessary for trend economic growth, as reflected in their projections. Had labor markets been robust enough to overwhelm the negative impact of higher mortgage rates and maintain the housing recovery, the Fed would have proceeded with the tapering.
The Fed’s delay of the tapering supports the housing market and reduces the tail risk to housing-related assets. The delay of tapering also removes Fed hikes from the yield curve that had been prematurely priced in. Finally, the continued liquidity injection by the Fed into safe assets will flow to riskier asset classes through the portfolio balancing effect.
With this week’s Fed news playing out as we’d hoped, our reaction has been straight forward: we’ve significantly increased our risk positioning from the conservative levels we had maintained this summer. There are four important investment opportunities that the current environment presents which marry improving fundamentals, strong value and the performance catalysts from the Fed’s announcement.
1. CMBS investments: Securitized markets have been weighed down by concerns that higher interest rates will lead to lower collateral values and higher default rates, as the same rental income needs to back a higher servicing cost. The CMBS sector in particular did not participate in the rebound of US risky assets in the prior two months. Legacy CMBS (pre 2008) issues were impacted by the fears that many properties will not be able to refinance their mortgages in the coming two to three years due to higher cap rates and lower collateral values in a high rate environment. New issue CMBS, while underwritten to recent collateral values, had to bear the burden of lower debt service coverage ratios as well as higher cap rates farther down the road.
The fundamentals for CMBS have been robust – property values are rising but spreads have significantly underperformed corporate credit – widening significantly since May. In certain cases, CMBS spreads had returned to August 2012 levels. Without taking significant credit risk, legacy mezzanine AAA spreads (currently rated BBB) trade at spreads of approximately 450 BPS in contrast to riskier B rated high yield at 400 BP. New issue AA and A trade at spreads of 75 -100 BP above similarly rated corporates with strong collateralization. (The underlying credit fundamentals of the CMBS sector have actually improved significantly and a detailed analysis will be provided in the monthly investment letter.) These are, in our view, the most compelling values in fixed income globally and provide strong total return potential over the next 12 months.
2. We have been a strong advocate of European credit since August 2012 and over the last three months have moved that endorsement to European equities. European growth has turned positive limiting downside risks, monetary policy is likely to be accommodative, valuations remain 20%-30% below U.S. equity valuations and investors are underweighted. At this point the tightening potential in European credit is limited. We have implemented a strategy of long call options on Eurostoxx partly funded and hedged by call options on credit. We also have outright risk reversals on European equities. We expect the global equity markets, led by Europe, to make further gains through year-end led by European equities.
3. With the potential downside in core fixed income rates reduced by the Fed and yet a reasonable growth rate in the economy, we expect rates to be contained in a more narrow range than in recent months. Given the elevated levels of implied volatility, we find opportunities to sell volatility on MBS as very attractive, given that the stability of MBS rates is an even greater focus of the Fed relative to U.S. Treasury yields.
4. In G-4 rates, we are generally neutral on duration with a bias towards curve flatteners in the U.S. and curve steepeners in Europe. Unexpectedly strong growth would re-engage the Fed tapering and potentially damage risk assets – in this environment the curve would likely flatten aggressively in the U.S. – thus this position provides a hedge to the portfolio. In Europe, on the other hand, the tightening embedded in the curve is unlikely to be followed through by the ECB and would lead to a steepening yield curve between intermediates and the long end.
Overall, improving fundamentals, favorable valuations and continued Fed support make a compelling case for a more aggressive risk posture in selected assets, especially assets like CMBS that have been beaten down his summer.
Rajiv Sobti is founder and chief investment officer of Karya Capital Management, a fixed-income focused macro hedge fund firm based in New York. This column was adapted from a recent letter to the firm's investors.