The past four months have seen capital markets adjust swiftly to the possibility of life after taper, resulting in higher yields and spreads across many fixed income assets. Fed communications have focused on preparing market participants for a reduction in quantitative eas-ing measures, potentially as early as September. However, market risks entering September are leading to some uncertainty towards the timing and magnitude of a reduction in quantitative easing. In this commentary we discuss the Fed’s policy shift, potential timing of normalization, and our capital market outlook.

Why now?Since the financial crisis and recession in 2008-2009, each calendar year has begun with the hope that economic activity would acceler-ate. However, each year’s optimism faded as the economic reality of a 2% GDP environment continued (Chart 1). The Federal Reserve, viewing the downside risks to growth, deflation, and labor markets as significant, continued with the expansion of unconventional mon-etary policy programs (QE 1, 2, & 3, etc.).

However, with a stabilizing economic backdrop, and lower perceived fiscal and policy risks, many of the conditions that led to additional unconventional monetary policy have diminished. Since April, Fed communications have focused on preparing market participants for a reduction in quantitative easing measures, potentially as early as September. The Fed reinforced this message in their June FOMC statement, “The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the Fall.”

Why TIPS underperform

TIPS have substantially underperformed in 2013. The high Trea-sury correlation and duration risk of TIPS makes them likely to underperform in a rising rate environment as the long Treasury durations overwhelm the inflation adjusted component (CPI-U) of the total return.

With average durations over six years, TIPS performance has been primarily attributable to their Treasury component12-month trailing correlation of the Barclays TIPS and 7-10 Treasury Index

Source: Barclays, as of August 30, 2013

Historical performance shows little differentiation between the total returns of TIPS and Treasuries12-month trailing total returns

Source: Barclays, as of August 30, 2013

august 2013

THE INVESTOR

NAVIGATING THE CREDIT MARKETS

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The 2008-2011 correlation was distorted by Quantitative Easing

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Chart 1: The past four years have seen an economic escape ve-locity quickly muted by macro headwinds

Source: St. Louis Fed, as of June 2013

Sept-taper?Uncertainty remains around the September 17-18th FOMC meeting regarding the timing and magnitude of a reduction in asset pur-chases. The July FOMC meeting minutes, released in August, were non-committal towards a specific date, although consensus was tapering should begin before year-end. Further, the FOMC minutes did not include a specific discussion towards the operational me-chanics of a reduction in asset purchases. The Fed is also due to up-date their GDP and inflation forecasts, of which they are expected to downgrade the outlook. Is the Fed planning to announce taper-ing at the same time they downgrade their growth and inflation outlooks?

Downside risks entering September may also adjust the timing , in-cluding; weak economic data, higher rates, potential fiscal shocks, and Middle-East tensions are all potential headwinds to tapering. The Fed’s communications since April have led to substantially higher treasury rates, impacting many rate sensitive sectors, nota-bly housing. July new home sales plunged 13% month-over-month and the housing affordability index saw a significant drop as mort-gage rates moved higher.

Congress returns on September 9th to various fiscal risks, includ-ing the potential government shutdown over a 2014 budget and the next debt ceiling debate, both with the potential to sap business and consumer confidence. Military conflict in Syria has the ability to exacerbate a risk-off environment and price shocks in oil mar-kets. Throw in the potential for an uncertain change in Fed leader-ship, and you have potential catalysts for caution from the Fed.

Capital market performanceOver the past four months, we have seen capital market perfor-mance explicitly driven by two themes. The first theme has been normalization, as investors reassess what fair value yield and spread levels should be given the potential shift in Fed policy. Quantitative easing incentivized investors to move out on the risk spectrum, putting downward pressure on risk premiums. The most significant weakness has been in those asset classes most closely associated with the global reach for yield or their sensitivi-ty to duration. Only bank loans and high yield bonds have produced positive total returns year-to-date (Table 1).

The second theme was fund flows, as a negative technical of record setting outflows in most bond sectors exacerbated the move higher in yields and spreads. This was in large part due to the diminished liquidity environment of corporate credit (see last month’s com-mentary for more on diminishing liquidity). These outflows were not isolated to fixed income, as in August equities saw the single largest outflow since 2011 on the back of weakening earnings, in-creasing volatility, and growing macro risks.

Table 1: Total returns are being driven by higher risk premi-ums, durations, and the technicals of negative fund flows

Index August 3-Month Year-to-dateBank Loans 0.04 0.55 3.95High Yield -0.61 -1.38 2.71Agency MBS -0.29 -1.33 -2.38Treasury -0.49 -1.69 -2.69Corporate -0.70 -2.64 -3.29Municipal -1.43 -5.06 -4.92EMD -1.96 -5.29 -7.33TIPS -1.45 -4.29 -8.07

Source: Barclays, Credit Suisse, as of August 30, 2013

Post-taperWhile we expect the Fed to indicate the beginning of tapering in September, the data over the next 3-6 months will dictate the speed and process. Regardless of the speed and amount, it is clear the Fed is seeking to begin the process of policy normalization. However, monetary policy looks to remain accommodative through the tra-ditional tools (i.e. Fed funds rate) for many years based on the cur-rent economic outlook.

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In 2013, lower downside risks have led to a shift in the Fed’s view of QE necessity

Today’s credit cycle is structurally different than any cycle seen in the past thirty years (Chart 2). An economic expansion of 2% GDP, subdued inflation, deleveraging, and potential for large scale mac-ro shocks continue to keep corporate spending and behavior con-strained. Corporate profits typically trend with GDP growth and companies understand record profits cannot be sustained indefi-nitely through operating and cost controls alone. Capital invest-ment continues to be held back by this low economic growth, lead-ing to a business cycle that remains long and low versus historic norms. For bond investors, this has led to strong corporate health metrics, an important driver of the outperformance of credit based investments year-to-date.

Chart 2: This business cycle is the weakest in the past thirty years, constraining corporate behavior

Source: Barclays, as of July 30, 2013

Since the financial crisis, central bank policies have provided a foundation for a rising tide that has lifted almost all boats. With the beginning of policy normalization on the horizon, asset class performance may be less “artificial”, and more fundamental going forward. Given this, corporate health metrics are sound and the ex-tended credit cycle continues to favor credit risk over interest rate risk in the bond market.

Pacific Asset ManagementAugust 2013

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ABOUT PACIFIC ASSET MANAGEMENTFounded in 2007, Pacific Asset Management specializes in credit oriented fixed income strategies. Pacific Asset Management is a division of Pacific Life Fund Advisors LLC, an SEC registered investment adviser and a wholly owned subsidiary of Pacific Life Insurance Company (Pacific Life). As of June 30, 2013 Pacific Asset Management managed approximately $3.7bn. Assets man-aged by Pacific Asset Management includes assets managed at Pacific Life by the investment professionals of Pacific Asset Management.

IMPORTANT NOTES AND DISCLOSURESFor Institutional Investor use only. The opinions expressed are not intended as an offer or solicitation with respect to the purchase or sale of any security. The information presented in this material has been developed internally and/or obtained from sources believed to be reliable; however Pacific Asset Management does not guarantee the accuracy, adequacy, or the complete-ness of such information. This material has been distributed for informational purposes only without regard to any particular user’s investment objectives, financial situation, or means, and Pacific Asset Management is not soliciting any action based upon such information, and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term. The information provided herein should not be construed as providing any assur-ance or guarantee as to returns that may be realized in the future from investments in any asset or asset class described herein. Bank loan, corporate securities, and high yield bonds involve risk of default on interest and principal payments or price changes due to changes in credit quality of the borrower. This material contains forward-looking statements that speak only as of the date they are made, Pacific Asset Management assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous as-sumptions, risks, and uncertainties, which change over time. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. FOR MORE INFORMATIONPacific Asset Management • 700 Newport Center Drive • Newport Beach, CA 92660 • www.pam.pacificlife.com • ContactPAM@PacificLife.com

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A weak economic outlook continues to con-strain corporate spending and investment, and is extending the credit cycle.

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