The deep winter freeze in Q1 eventually gave way to what seemed like a long and slow spring thaw in Q2, resembling the arduously slow economic recovery. The weather related economic impact was more numbing than early estimates had indicated, with revised Q1 GDP down to a very surprising -2.9%. Meanwhile, a number of ongoing global geopolitical issues, not to mention rates rallying, gave us a sense of déjà vu, all over again. Russia made a foray into Ukraine, leading to the U.S. threatening severe sanctions and potentially other unknown consequences, drawing parallels to the tension and uneasiness of the Cold War. Adding to geopolitical tail risks, various factions in Iraq once again hailed the call to arms. There are rising questions as to whether the U.S. would intervene with military force within the country (a third time) and if so, to what extent. These events combined with a complacent Fed all serve as reminders that despite interest rates being persistently rich, they may remain stubbornly low for longer.
There were some bright spots in Q2. U.S. economic growth appeared to show signs of revitalization, which we expect to continue taking hold as the year progresses. European peripheral countries such as Italy and Spain, who just recently had serious fiscal concerns, saw their intermediate term yields pierce through the levels of U.S. Treasuries. On the corporate front, there was renewed interest in mergers and acquisitions. What is a company to do with such sluggish real growth in the economy? Well, buy growth of course. The rate of M&A year-to-date at the end of June is far outpacing that of 2013, with larger companies gobbling up smaller ones that promise future growth potential. This strategy is particularly appealing for the stash of cash being held overseas and away from the reach of Uncle Sam through inversion transactions. Fortunately for credit investors, many of these transactions have proven to be credit neutral and even positive in some instances.
Despite what we now know was a poor start to the year in the first quarter, we continue to expect a bounce back through the rest of the year and a resynchronization of global growth as the recovery in developed markets begins to filter through to emerging markets. We have, however, ratcheted down our overall expectations for U.S. and global growth for 2014, as has the Fed. The decrease in our expectations for 2014 growth is more a reflection of a challenging first quarter than serious concerns about long term potential growth. Economic indicators already suggest a rebound is underway, particularly in the United States. Inflation in the U.S. has been trending higher and the labor market has shown signs of post-winter revitalization that together will set the stage for the Fed to conclude its tapering plan and begin raising rates in 2015, as scheduled. Investors should begin thinking about the implications of the Fed’s Quantitative Easing (QE) exit for the various segments of the bond market. Investors latched onto the good news over the quarter, and may even be a bit too complacent with risks still present in the markets.