Week ending July 2, 2009 Market Update

COMMENTARY
Overview



The US economy lost 467,000 in June, disappointing investors who had expected a smaller decline. The ongoing deterioration in the labor market raises the risk that the stimulus-driven rebound in household purchases may not be sustainable. This marks the first time in four months that the number of jobs lost rose from the prior month. The number of jobs shed in 2009 now totals nearly 3.4 million, more than the 3.1 million lost in all of 2008. The unemployment rate continues to inch towards double digits, climbing to 9.5% in June. Manufacturing and construction have posted the most job losses, cutting 1.9 million and 1.3 million jobs, respectively, since the recession began in December 2007. Though the government fiscal stimulus package has bolstered household incomes, Americans remain cautious, choosing to use most of the money to rebuild savings. Indeed, personal savings as a share of disposable income rose to 6.9% in May—its highest level since 1993.




Treasury Bonds

Treasury yields rallied this week, led by shorter maturities as investors took solace in the idea that the Federal Reserve would be accommodative with monetary policy for as long as it took to steady the economy. Previous uncertainty about the extent of government support for Treasury yields have abated with the rally. A weaker non-farm payroll report coupled with lower equities reinforced the rally in interest rates. Agency spreads, on the other hand, widened modestly as investors seek more compensation for accepting agency credit risk.

Large-Cap Equities

The stock market ended the week lower during this holiday shortened week. The equity market fell for the third consecutive week on light volume due to disappointing economic data and lower commodity prices. The S&P 500 index fell about 2% for the week with large-cap stocks outperforming small-cap stocks and large-cap growth stocks outperforming large-cap value stocks. The best performing sector was consumer staples and the worst performing sector for the second consecutive week was energy. In the headlines this week, General Mills, Inc (GIS) raised their quarterly dividend and reported fourth quarter earnings of 86 cents per share, beating analyst estimates of 81 cents per share. The company attributed the strong quarter to improved gross margins. Shares of GIS rallied almost 4% on the positive news.

Corporate Bonds

Investment grade primary activity was surprisingly active once again given month/quarter-end falling on a compressed end of the week. This week’s key issue came from Oracle Corp who issued a $4.5 billion deal across the curve. Similar to most recent deals, it was oversubscribed and performed well after issuance. The payroll number today did not cause spreads to sell-off as most market participants headed out the door early for the long weekend.

Investment grade corporate spreads tightened most of the week despite a worse-than-expected payroll number. Secondary trading was beyond doubt in the back seat this week as the new issue market seemed full of zip for a shortened week. The Barclays Credit Index Option-Adjusted Spread (OAS) finished the week at +274, tighter by 4 basis point (bps). Financials tightened by 10 bps (banks -8, insurance -21), industrials tightened by 2 bps (telecom flat, consumer non-cyclical -3, basic materials -5, capital goods -8, energy -1), and utilities tightened by 5 bps.

Mortgage-Backed Securities

Mortgages outperformed Treasuries in a low volume, holiday shortened week. The rally in Treasuries coupled with active buying by the US Government and a drop in volatility helped agency pass-through spreads tighten by 5-7 basis points. Mortgage originations were readily absorbed by market participants and foreign central banks offered incremental support. The headline story of the week was the Obama Administration call to offer refinance relief to borrowers that are underwater on their mortgages by easing conforming loan-to-value guideline restrictions from 105% to 125%. This will boost, but only on the margin, prepayment speeds for outstanding Fannie Mae and Freddie Mac mortgages. Market reaction was surprisingly benign and more focused on the macro environment of economic data and interest rate direction.

Municipal Bonds

A quiet week in the municipal bond market saw bond yields move lower to conclude the second quarter of 2009 and the fiscal year-end for state and local government issuers. Cash flowing into municipal bond funds and the reinvestment of proceeds from maturities helped bolster the market. Two-year AAA-rated GO bond yields ticked down 4 bps to 0.94%. Ten-year AAA-rated GO bond yields also moved 4 bps lower, to 3.21%. California again dominated headlines, this time with news that the state is set to issue IOUs (“registered warrants” in official jargon) to select payees in order to meet obligations under California’s strained cash situation. The last time the state was forced to issue IOUs was 1992. Lawmakers have yet to reach a solution to the looming budget problem, forcing the Governor to invoke a fiscal emergency. Despite all this, on the week, the difference in yield on CA GOs and AAA GOs actually tightened by 3 basis points.

Due to the holiday-shortened week, there were no major new deals to note. In fact, only 3 deals breached the $100 million threshold in terms of deal size, including the $220 million Orange County John Wayne airport revenue deal. The deal offered a maximum yield of 5.55% in 2039 for the AA-/Aa3 credit. The new issuance calendar for next week is thin as the summer doldrums appear to have descended over the market.

High-Yield Bonds

The high yield market completed the second quarter of 2009 as its best quarter in the past 25 years of the modern high yield market. For the second quarter, the Merrill Lynch High Yield Index was up a stunning 22.5%, with performance mostly driven by the more risky CCC-rated segment of the market. CCC-rated bonds, which comprise approximately 25% of the broad high yield market, were up 45% during the second quarter and benefitted from the risk rally which began in mid-March 2009. The CCCs are scattered across industries but are concentrated in the cyclical industry sectors, such as automotives, chemicals, paper/packaging, retail and restaurants. The industry sector that led the market was the broad financial sector (banks, finance and insurance companies), which was up over 46% on a blended basis during the second quarter. The high yield financial sector, a largely BB/B rated sector, has grown dramatically during the course of 2009, as the rating agencies have aggressively downgraded the hybrid debt of companies such as Bank of America, Citigroup and Royal Bank of Scotland (RBS) amongst numerous others. The financial industry sector has grown from less than 4% of the broad high yield market in early 2009 to now over 12% posts the ratings downgrades. The high yield financial sector has benefitted from the strong equity market rally in financial stocks in April and May and the positively viewed release of the stress test results in early May by US regulators.

High yield issuers have been taking advantage of the market recovery in the second quarter to issue new debt at more attractive price levels. New issuance in June totaled $16 billion, and while this figure is down from May’s levels it represents the second best monthly volume over the past 2 years. Year-to-date 2009, high yield issuers have raised $60 billion, 39% ahead of the first 6 months of 2008.




Western European Equities

European stocks went down this week. The sectors with the worst performance were autos & parts (-0.6%) and utilities (-0.6%). A bad outlook for the entire autos & parts sector and especially the negative sales numbers in the US market were reasons for the sector’s poor performance. Peugeot declined the most with -5.5%. In the utility sector, E.on stock drove down the sector with a decline of 3.6%.

The best performing sectors were banks (+2.0%) and oil & gas (+2.0%). The rally in the banking sector was caused by a new Bad Bank model in Germany, a positive stress test for Greek banks, and a new loan program of the Swedish Riksbank. The week’s best performer was Commerzbank (+12.4%). In the oil & gas sector, Acergy (+13.4%) and Petrofac awarded big contracts pulling the entire sector upwards. Statoil gained after the announcement that they start commercial operations of their gas cavern in the UK.

Eastern European Equities

The CECE index of equities traded in Central Europe (Czech Republic, Hungary, and Poland) gained +0.4% this week, while the Russian stock index RTS went up +0.5%.

Russia’s international reserves, the world’s third-largest stockpile behind Japan and China, grew $3.4 billion last week after a rise of $500 million in the previous week, as capital outflows stopped and the central bank refrained from currency-market intervention. The central bank has curtailed its purchases of foreign currency as is moving toward a free float of the ruble. Between August and January, the central bank drained over a third of the country’s reserves to stem a 35% devaluation of the ruble to the dollar.

Meanwhile, emerging Europe’s central banks have room to lower interest rates as inflation slows, according to analysts. Inflation has slowed in eastern Europe as the global recession started, sapping demand for the region’s exports and squeezing access to credit and foreign investment. While recession and disinflation will continue to drive central bank policy, it is expected that central banks in emerging Europe maintain an easing bias.

Global Bonds and Currencies

The major non-US government bond markets closed the week on a rallying note. The first half of 2009 was a rollercoaster as expectations of a global economic recovery have gone through several iterations – from Armageddon to “green shoots” to now a potential “W” shaped economic cycle. As the implementation of the global stimulus throughout 2009 has steadied the deterioration of economic data, central banks are coming to grips with the fact that accommodative monetary policies (overnight interest rates at approximately 0%) will most likely have to stay in place well into 2010. The European Central Bank, despite earlier protestations that inflation was their primary concern, announced at its July policy meeting that “the current rates are appropriate” with the additional innuendo that the current 1% level would not necessarily be the low and further rate cuts are a possibility. The front end of global yield curves outperformed their 10-year yield counterparts by roughly 5 bps.

Currency directionality remained becalmed as the Japanese yen, euro, and British pound were all unchanged versus the US dollar for the week. As overnight interest rate parity has been achieved, the next major driver of the USD trend either stronger or weaker will be the market’s assessment of relative stability of individual country balance sheets (fiscal stimulus, bond supply, growth prospects to name a few). As the capital markets seek the answers of when the global recovery will become real, currencies have adopted the same range-bound mentality recently observed in bond yields and equity markets.

Emerging-Market Bonds

Emerging market dollar-pay debt spreads were tighter this week, although disappointing employment data in the US caused risk markets to retrace some of the gains from earlier in the week.

In Argentina’s midterm elections, the Kirchner coalition lost key races and several seats in congress. As a result, former President Nestor Kirchner resigned as the head of the Peronist party. Argentine assets including sovereign bonds were broadly stronger as a result of the market friendly outcome of the elections.

In Brazil, industrial production data release this week showed an increase of 1.3% in May, its fifth monthly gain and latest signal that the country may be recovering from the recession. Local rates and currency were roughly unchanged over the week.





ECONOMIC RELEASES



June 30S&P/Case Shiller Home Price Index – The 20-city composite index fell 18.1% year-over-year, less than the predicted 18.6% decline. The easing of the home-price slide underscores signs that the economic contraction may be easing.
Consumer Confidence – Confidence among US consumers dropped unexpectedly, with the index decreasing to 49.3 in June from 54.8 in May. Still, these figures remain significantly higher than February’s record low of 25.3.
July 1ISM Manufacturing – The Institute for Supply Management’s factory index rose to its highest level since August 2008, increasing 4.7% to 44.8 in June from 42.8 in May. Though readings below 50 signal a contraction, a third-quarter recovery in manufacturing is still expected.
Construction Spending – US Construction Spending fell by 0.9% in May, surprising economists who forecast a 0.6% decline. This decrease follows April’s revised 0.6% gain and can be largely attributed to a weak residential real-estate market.

Pending Home Sales – The index of signed purchase agreements rose by 0.1% in May, the fourth consecutive increase and a sign that the housing market may be recovering. The index was up 4.6% on a year-over-year basis.

Euro Zone Manufacturing PMI – The euro zone PMI rose to 42.6 in June—a 9-month high. It was above the flash estimate of 42.4, however, the index is still below the 50-mark, suggesting a contraction in the sector.
July 2Unemployment Rate – The US economy shed 467,000 jobs in June, pushing the unemployment rate to 9.5%, its highest level since August 1983. The figure follows a revised 322,000 drop in May and far exceeded expectations of a 365,000 decrease in payrolls for the month.
Euro Zone Unemployment – The euro zone seasonally-adjusted unemployment rate was 9.5% in May 2009, compared to 9.3% in April and 7.4% in May 2008. This is the highest rate in the euro zone since May 1999.

Euro Zone Interest Rate – The European Central Bank (ECB) kept key interest rates steady at a record 1.0%. ECB President Jean-Claude Trichet signaled that the ECB has no immediate plans to cut interest rates again and said the euro region’s economy will start to recover in the middle of 2010.

©2009 Payden & Rygel. All rights reserved


Week ending July 2, 2009


MARKET LEVELS


Friday* Last Week Dec. 312008 1 Yr Ago
Dow Jones Ind. Avg. 8,325 8,472 8,776 11,216
S&P 500 902 920 903 1,262
Nasdaq 100 1,802 1,830 1,577 2,251
The Russell 2000 500 509 499 672
DJ STOXX Europe 204 205 198 281
Nikkei Index 9,876 9,796 8,860 13,286
Fed Funds Target 0-0.25% 0-0.25% 0-0.25% 2.00%
2-Year U.S. Treasury Yield 0.98% 1.13% 0.77% 2.58%
10-Year U.S. Treasury Yield 3.47% 3.54% 2.21% 3.96%
U.S.$ / Euro 1.40 1.39 1.40 1.59
U.S.$ / British Pound 1.64 1.64 1.46 1.99
Yen / U.S.$ 95.95 96.13 90.64 106.00
Gold ($/oz) $931.33 $939.25 $882.05 $945.15
Oil $67.02 $69.63 $44.60 $143.57
*Levels as of 12:40 a.m. PST

MARKET RETURNS
Year to Date (1/1/09 - 7/2/09)
Dow Jones Industrial Avg -5.14%
S&P 500 -0.17%
NASDAQ 14.24%
Russell 2000 0.15%
MSCI World Index 5.72%
DJ STOXX Europe 600 (euro) 2.90%

Year to Date (1/1/00 - 7/1/09)
90 Day T-Bill 0.12%
2-Year Treasury 0.42%
10-Year Treasury -8.90%
ML High Yield Index 29.35%
JP Morgan EMBI Global Diversified 15.94%
JP Morgan Global Hedged -1.12%