We are seeing an increasing number of non-traditional investors (tourists, as they are known to insiders), venturing into the ABS, CLO and bank capital markets. We are seeing some allocations being made by a few traditional mutual funds, hedge funds and family offices as traditional bonds become tighter in yield and higher in price. We saw this happen to the leveraged loan market last year when a stellar performance was followed by, thankfully not by a crash but a definite deceleration in returns to below coupon yield. It’s not time to exit the structured credit or bank capital markets yet, but we are watching the space very closely.
For now, selection is key and choosing the right fund manager makes all the difference. We remain optimistic for the new US agency mortgage backed securities asset class, the old non-agency MBS, junior CLOs and bank capital. If anything, an influx of retail funds could boost the market for these less accessible markets, but conversely would spread the over-valuation from traditional markets to these areas as well.
And in India, Q1 economic data was decidedly weaker as the effects of demonetization ripple through the market. In the long run, demonetization accelerated the penetration of the formal financial infrastructure as well as transparency, but the short run effects appear to be lingering. Q2 high frequency data is more encouraging and we expect that India will continue to recover from its slamming on the brakes to dislodge black money. We like the equity markets and balance that with local fixed income where interest rates have room to be cut and inflation is receding.
This week, the ECB meets to decide on policy. It will an interesting meeting given that Draghi in June opined that the Eurozone economy was sufficiently strong to stand without too much accommodation, a signal that the ECB quickly moderated. A lot is riding on this meeting, not least since the EUR is strong and could confound plans to taper QE, or could cutoff the recent recovery in Europe. Also on the agenda will be how to deal with the dearth of bunds relative to purchase program, a limitation which could force a moderation in QE, and how, if QE was tapered and eventually rolled back, peripheral countries’ bond yields and borrowing costs could be managed even as bund yields rise on the back of a stronger German economy. One size does not fit all easily. We expect a return to the unconstrained LTROs but will soon discover if we are right or not.
Also, while the next FOMC is three weeks away, Fed governors will be speaking very actively this week, providing the market with opportunities to glean some signal as to the timing, magnitude and mechanics of balance sheet normalization.