U.S. Corporate Bond Market - Feeling Good Again?

By Scott B. MacDonald

2002 was a difficult year for the U.S. corporate bond market, despite a rally in spreads in November. What made November such a good month was a number of factors - a 50 bps cut by the Fed, relatively positive economic data, a decline in tensions over Iraq, short covering and HSBC's announcement that it would purchase Household Finance. This combination of factors helped tighten spreads. Those sectors that showed the biggest rate of return were the same that were earlier the most beaten up - autos, telecoms and media/entertainment. At the same time, the new issue market reopened with strength. Following up in December, the new issue machine produced around $27 billion in new bonds.

What's next? We remain constructive about the corporate bond market through the end of the year, though we acknowledge ongoing concerns - Iraq, terrorism, the still bearish nature of the tech market, and concerns over pension funding. The less bullish revenue and earnings forecasts from the major auto companies (Ford and GM), AOLTime Warner and Disney reflect that the economy and corporate America are not completely certain of the recovery story - at least a strong and sustainable recovery. November's 6% unemployment number confirmed this. We also have to admit, with unemployment likely to remain over 5.5% through mid-2003, it will continue to feel like a recession for many Americans. In addition, it is important to watch the housing market, which is beginning to see what are the first signs of cooling. A major slump in this sector would be bad news.

Yet, the U.S. economy has not experienced a double dip recession nor do we see one on the horizon. Indeed, real GDP growth will be around 2.6% for 2002 and we are looking to 2.4-2.8% for 2003. U.S. worker productivity rebounded strongly in Q3, rising by 5.1%, compared to 1.7% in Q2 and well ahead of earlier estimates. The key strengths going into next year will be strong defense spending, other government spending measures, and a more benign regulatory environment (as the Republicans control both houses of Congress). There is already a positive undercurrent of mergers & acquisitions, asset sales, equity offerings and debt restructurings, though the stock market will remain volatile, especially in the first quarter of 2003. Equally important, the new issue market remains open. Although we expect activity in the new issue market to slow as the December holiday season begins, we would expect the market to reopen in January (barring of course a war with Iraq).

Looking into 2003, we see the following trends - a more sustainable U.S. economic recovery (though below the strong growth rates in the late 1990s), a gradual return to more predictable profitability in the corporate sector, the low point in the credit cycle in Q1, and later in the year a rise in interest rates. Probably the first quarter will be the most testing for those of us that do not see a double dip recession. This largely due to the strong possibility of a war against Iraq, mixed news from corporate Q4 results, and a hesitancy among major companies to resume capital spending until it is certain that the U.S. economy is really on track for a recovery. As for Iraq, we see the actual fighting to be short-lived and decisive, allowing markets to rebound after a temporary downturn. (We have greater concerns about what happens in a post-Saddam Iraq due to the traditional rivalries in the neighborhood.) We should add that if the war is prolonged and becomes a drain on U.S. resources, this could push the U.S. back into a recession. Nervousness about the looming Iraqi war has been a factor in mid-December for a rally in gold and oil.

Considering that 2003 is likely to see a start-up for the 2004 presidential elections, the Republicans are going to be keen on making the economy improve. President Bush wants to go into 2004 with Iraq settled and the economy in full recovery. The recent shake-up in the economic team that claimed Treasury Secretary O'Neill, White House economic advisor Lindsey and SEC head Pitt, indicates an important shifting of the gears in Washington on the economy. The new team of John Snow as Treasury Secretary (pending Senate confirmation), Bill Donaldson at the SEC, and Martin Feldstein as White House economic advisor is likely to have a better feel for Wall Street, while having a solid understanding of the non-financial side of U.S. business. Snow and Feldstein are also expected to steer a new fiscal stimulus package through Congress, with a value of somewhere between $200-400 billion and another tax cut. All of this bodes well for the U.S. corporate bond market, underlying our constructive outlook for next year, especially post-Q1.

We want to emphasize that while we are constructive on 2003 for the corporate bond market, the fisrt part of the year has the potential to be highly volatile. This is based on the uncertainty surrounding the issue of war against Iraq. When it happens, the Iraq war will have been one of the most advertised modern conflicts. Yet, the very idea of war generates a high level of uncertainty, including everything from oil prices to the potential for new terrorist attacks on mainland U.S. targets. And we do think that al-Qaeda, the Iraqi government and fellow travelers have cells in the United States and Canada. Consequently, investors are likely to hold their breath in the first part of the year. Advance with caution.