High Yield Market Outlook

High Yield has a relative performance over other asset classes YTD. However, I saw a tough road ahead later this year as the Fed might tighten the rates once or two in next three Fed meetings and the default rate will rise up due to the incoming economic slowdown. 

  Economic Outlook

 The Fed paused, but is not done

 The Fed paused in its August meeting, purely out of its worries over recent lackluster economic data. It is now the market consensus that GDP will be flat on 2.5% in the second half of 2006 and I don’t have material differences against that opinion. Therefore, now the focus is all on the inflation data, which are still within its highest territory in recent ten years. Last time we have CPI over 4% is mid-1991. Apparently high energy price contributes a lot to the CPI number but the 2.6% core CPI is not very promising either.

 The country has a low core CPI largely thanks to its enormous cheap imported goods and financial inflows from overseas. But the flip side of that is the ever-diminishing production domestic production capability and increasing reliance on foreign economies to support us. On the other hand, the consumption capability of this country keeps growing all the time. Different from 30 years or even 10 years ago, consumption power has become the sole leverage the country has over its foreign peers. One direct effect of this increasing imbalance between consumption and production power makes the correlation between inflation and economic growth much weaker than we ever witnessed before. The reason is we have lost the major control of the price of the goods that we consume everyday. Foreign goods can be cheap but that is only labor cost part. When the energy and commodity prices are now standing at their highest level in decades, foreign producers have to increase its prices to make a profit. As domestic production is no longer a viable option for this country’s manufacturers, there are only two outcomes that could be. The first is the core CPI keeps rising even when the economy recedes, which is stagflation. The second is we entice more foreign capital inflow to finance debts and sustain our economic growth and consumption level. That said, we have no way to cut or hold current rate level, and if US dollar softens more and our major trade partners like China begin its interest rates tightening cycle, the Fed will have to rise again.

In both of these two scenarios, I foresee a further rate hikes from the Fed in near future. Moreover, though both are not favorable situations for high yield bonds, the first will be even worse.