Bond Market Volatility

Week Ending 7 July, 2023

Once again, we have witnessed bond market volatility this week and it began on Thursday with the release of the ADP employment data (“….an independent estimate of the change in US private sector employment and pay derived from actual, anonymised payroll data of client companies served by ADP….”). The latter - erroneously in my opinion - is often used as a precursor for the Nonfarm payrolls print came in at +497,000 new private sector jobs. On the back of that and other reports (such as the Challenger, Gray & Christmas report which showed layoffs falling by half in June as cuts in the tech sector began steadying even though Tech companies still led the way though with 141,516 layoffs in 1H 2023) sent bond markets gyrating. The reality is both the ADP and Nonfarm Payrolls releases are never really correlated. There have been many instances where they go different ways. The upshot is that the bullish ADP print sent Government bond prices into a tailspin as renewed & stronger rate hike expectations set in.

So, with that in mind, there were high expectations for Friday’s June US Nonfarm payrolls which was expected to come in around 240,000. The actual print was 209,000. Sending bonds into a mild reversal from the day before but still net negative. It wasn’t enough however to prevent the US 10y Treasury from falling back below 4%. It has settled at 4.06%. Parsing the data, it’s clear how tight the job market still is. The unemployment rate fell -0.1% to 3.6%. Critically, for the Fed, wages are rising 4.4% y/y, above expectations and this will be of concern in their fight to get inflation under control. June marks the slowest month for job creation. Government jobs rose 60,000, Healthcare 41,000, Social Assistance 24,000 and Construction 23,000. Leisure & Hospitality added a lower 21,000, Retail lost -11,000 and Transportation & Warehousing declined -7,000. The labour force participation rate was steady at 62.6% and remains below pre-covid levels (reflecting just how many people have left the workforce). Interestingly, the prime participation rate (those in the 25y to 54y age range) rose to 83.5%. This is the highest in 21y. It’s those above this age range that are causing the bottleneck. May was revised down -33,000 and April -77,000. Taken together, the six-month average job gains reduces to 278,000 pm (vs 399,000 in 2022) – that’s still a good number. The Quits rate (the number of [voluntary] resignations as a percentage of total employment) is still elevated. It stands at 2.5%, down from 3% in April 2022, suggesting the labour market is easing. However, top-line hiring remains strong. That’s what the ADP number is really telling us – there is a skew to those senior level roles requiring high level skills. This is the Fed’s (and other CBs’) dilemma. You can’t control what is a complex and evolving labour market with just one toolkit (rates).

Today’s print is not weak – the reality is the expectation was simply too high to begin with following Thursday’s ADP release. Each data release has its own quirks but we live in such a high-level, headline-driven, fast-moving environment that no one really pauses to analyse the detail. The devil is always in the detail - of all the most precious and rarest minerals and resources out there, time is top of the list!

The real state of play?

Consider Real estate - which has been in the doldrums for some time and has been the brunt of bad news for months. There are clear signs of life – just not visible in the traditional sense. One manager I track reported, during Q2, several multi-billion-dollar deals conducted at private valuations well above listed valuations. Prologis acquired a $3bn portfolio from Blackstone at a 4% initial cap rate. In June, D.R. Horton and Starwood each sold large single-family rental home portfolios for a total of almost $2.5bn (cap rates believed to be 4.5% to 5.0%). Extra Space Storage announced an agreement to acquire Life Storage in a $16bn deal at a sub-5% cap rate. In the storage arena, REITs are generally trading at a 0.50% to 1.00% discount to these private market transactions. The upshot is that with cap rates as attractive as 5.0% to 5.5%, buyers are sniffing around. It's not that there is no desire to transact or that there is a lack of dealflow – the issue is who blinks first! Sellers are still trying to stick to 4.0% and this is causing a gridlock. Don’t forget the agents in the middle who want their cut. Eventually there will be a coming together. If rates continue to rise, sellers will wish they sold earlier. Supply side issues remain as construction costs remain elevated. However, while the old adage “location, location, locations” still holds true, of even more importance today is “theme, them, theme”. Demand for warehousing and Retail will continue to remain strong but sub-sectors such as Life Sciences are also becoming key. Look at the chart below – with good yields and high discounts to NAVs, is this really a time to dump property altogether or to look ahead? Incidentally, it’s not just a US story. Through our South African connections, there are fantastic opportunities to be found in SA – double-digit yields and huge discounts. Treat liquidity with caution – the latest proposal in the UK is that property funds start to limit liquidity outflows and charge entry and exit fees. Suddenly, traditional world is starting to look more and more like Hedge Fund world.

There’s something else to keep an eye on – this time from the US oil sector! Despite efforts from Saudi and others to drive up prices, US production has been racing ahead. It is up 9% y/y  driven partly by improved production efficiency as well as growing output elsewhere (in the face of OPEC’s waning ability to control prices). OPEC has announced cuts of some 6% this year yet crude oil prices have fallen some -13%. It’s a double whammy – weaker-than-expected growth in China plus higher production from the likes of Brazil, Canada and Norway. Of the total cuts announced by OPEC, some two-thirds has been offset via higher production from non-OPEC! Half of this new crude is coming from the US where major producers such as ConocoPhillips, Devon Energy, Pioneer Energy and EOG delivered strong Q1 production. Production improvements since 2014 have lowered drilling and fracking costs by some -36% (source: JPM). Technological advancements have meant being able to force more water and sand into rocks thus freeing up more oil contained in fissures. As an example, ConoccoPhillips plans wells that are 14% longer vs 2022. EOG has said it has drilled over 5 miles deep and 3 miles long in South Texas. Today’s increased efficiency means EOG can earn just as much from oil priced at $42 pb today as it would from oil trading at $86 pb nine years ago. If this becomes replicated across the shale oil spectrum, it’s a game-changer!

In summary, taking just the above two examples, there are significant changes ahead. I am not even factoring in AI. At a consumer level, higher interest rates = higher deposit rates = more wealth. Plus, rising wages that are equal to if not ahead of nominal inflation. US treasuries are now yielding net positive real returns right through to the 10y end of its yield curve.

MARKET SUMMARY