Economic Review 2Q 2017
The US economy continues to grow at slow but steady pace. As of June, the expansion entered its ninth year, making it the third longest expansion since 1900. Growth slowed again in 1Q2017 following a disappointing fourth quarter, continuing the more recent trend of slow expansion constrained by a lack of cyclical boosts.
Slow growth is expected to continue through 2017, but growth may accelerate and stabilize into 2018, reflecting a pick-up in exports, inventories and government spending. Stronger investment spending and an improving global economy should be tailwinds, though the prospect of significant fiscal stimulus has diminished, thanks to low unemployment and political turmoil. Regardless, weak productivity and labor force dynamics should prevent any sustained rise in growth above 3.0%.
The June US jobs report was mixed, as the unemployment rate was 4.4% with a higher participation rate of 62.8%. Non-farm payrolls of 222,000 beating market consensus, while average hourly earnings were a bit weaker than expected.
While the economy maintains a slow-but-steady pace of growth, the labor market has continued to tighten. This reflects two key trends: Low productivity growth, which implies most GDP growth has come from employing more workers, and low labor force growth, which means that much of the job growth has come from re-employing the unemployed rather than new workers entering the labor market.
Solid GDP growth in 2017 and 2018 is expected to reduce the unemployment rate further, potentially falling to 4% by the end of 2017 and 3.5% by the end of 2018. While wage growth has been stalled for years, there are some indications that wages may have already started to rise. As unemployment falls and competition for workers increases, the Fed hopes to see upward pressure on wages and prices.
The Federal Reserve
The Federal Reserve has been deliberately cautious in raising interest rates so far, with one rate hike 2016 and two hikes so far in 2017. The Fed has indicated that it is comfortable with the current economic variables. The global economy is generating fewer concerns than in recent years and the U.S. is approaching or at many long-term targets, like unemployment and inflation, making it clear that interest rates are still too low.
The market expects one further rate hike in 2017, most likely in December. Chair Yellen’s testimony on July 12, 2017 was seen by many as opening the door to a more gradual rise in rates, but the Fed is clear that they would like to return rates to a normalized level.
The decision to increase rates in June reflected the Fed’s view of the economy, and barring any significant negative shocks or fiscal stimulus, many anticipate the Fed to further raise rates by 0.25% at each press conference meeting through 2018. The Fed’s June outline of future balance sheet reduction shows that the central bank is committed to raising interest rates across the yield curve. The Fed is expected to begin normalizing the size and composition of its balance sheet by 4Q2017.
Fed Balance Sheet
The Fed’s balance sheet has grown from less than $900bn before the financial crisis to $4.5 trillion today. Agency MBS owned by the Fed now total $1.75 trillion. As the Fed continues to normalize interest rate policy, there is renewed focus on the Fed’s process to normalize its balance sheet and the impact on bonds.
There is now a higher conviction that there will be a September announcement and October implementation of the wind down of the Fed’s Treasury and MBS portfolio. The Fed’s guidance indicates that there would be a roll off of $12 billion in MBS securities in 4Q2017 based on $4 billion/month October through December. In 2018 the roll off would be approximately $160 billion or10% of the MBS holdings. The Fed also clarified that once the balance sheet roll off is launched it will continue and not be reversed unless there is a dramatic material deterioration in the economic outlook.
As the Fed normalizes the size and composition of its balance sheet, it is expected that the phase out of US Treasury and MBS reinvestments will continue to have a negative impact on MBS valuations. Current coupon MBS spreads have widened and are expected to widen as the Fed reduces its balance sheet.
Fed Stress Tests
Big U.S. banks won approval from the Federal Reserve to return money to shareholders, suggesting regulators believe they are healthy enough to stop stockpiling capital.
All 34 firms tested by the Federal Reserve got approval for their capital-return plans in the second part of the annual "stress tests" designed to gauge the soundness of the nation's financial system.
The companies include big banks such as J.P. Morgan Chase, midsize lenders such as Regions Financial and credit-card companies including American Express.
The outcome could bolster industry arguments that the banking system is safe enough to allow for cutting back some regulations. It was the third straight year the initial results showed all big banks meeting the Fed's definition of good health.
US inflation has surprised to the downside since April. The CPI remained soft in June rising 1.7% and core inflation dropped below 2% in April. After showing signs of strength early in the year, a fall in oil prices and heavy competition amongst consumer cellular services prices has put downward pressure on CPI, both headline and core. However, many economists expect this weakness to be temporary and inflation to edge up through 2018, helped by a weaker dollar and tightening labor and housing markets.
Additionally, inflation calculated by the personal consumption deflator continues to approach the Federal Reserve’s 2% target in 2017, which helped to justify the interest rate hikes in March and June, 2017.
Long-term interest rates remain very low, especially compared to historical averages. As the Fed continues to raise short-term interest rates and reduce its balance sheet, 10-year U.S. Treasury yields should gradually increase. This back-up in rates may result in weak total returns on Treasuries and some high-quality corporate bonds, suggesting that fixed income investors may consider investing in other fixed income sectors, like structured products and high-yield debt. Shape of yield curve flattened with short-term rates rising in response to the Fed rate increase and long-term rates falling.
Investment Grade Corporates
New Issuance of investment grade bonds reached $691 billion by quarter end. With the continued demand for quality bonds, credit spreads continue to tighten. This year, corporate credit has been supported by a stable economic environment, investor demand for yield and low volatility. Corporate earnings should remain strong. With over 40% of S&P 500 revenues coming from abroad, a weaker dollar will boost foreign sales, particularly later this year and into 2018.
High Yield Bonds
Recent high yield bonds are being issued with weaker covenants than in the past and are being called “covenant light” bonds. Lower quality investment grade BBB credit and high yield bonds have performed well in 2017.
Today’s bond issuers tend to have higher levels of leverage than in the past. Strong corporate earnings and a generally positive economic outlook continues to drive an overall positive outlook for fixed income. Credit spreads remain tight with ongoing demand from institutional investors.
Weak bond covenants are not as important to investors in a strong economic environment as they are during an economic slowdown when an issuer’s credit may deteriorate.
In an economic downturn, high yield defaults and breaches in bond covenants may be delayed due to the weaker bond covenants. This delay may cause an issuer’s credit to deteriorate further by the time the issuer breaches the covenants than if they had stronger covenants in place. This would lead to lower recovery rates than anticipated based on historical average and bonds may take longer to recover than historical data would indicate.
After two years of very mediocre growth, the global economy started to show signs of life at the end of 2016. So far, it does not appear that things will cool off, with the global aggregate manufacturing purchasing managers’ index reaching six-year highs in the first half of 2017.
The Eurozone is growing particularly fast, thanks primarily to a weak currency, rising confidence and considerable pent-up demand. Other developed markets like Japan, Canada and the U.S. continue to accelerate as well. The recent rebound in demand for commodities continues to be a positive for Latin America, Canada and Australia, while Chinese contribution to global growth has declined slightly in recent months as the government tries to restrain financial speculation.
The UK appears to be weathering the impact of the Brexit vote better than many had feared, thanks to more competitive exports on a weaker currency.
On June 28, 2017, the pound rallied after Bank of England Governor Mark Carney said interest rates in the U.K. may need to rise if the economy continues to be strong, despite weak consumer spending.
Speaking at the European Central Bank's forum on central banking in Portugal, Carney said the U.K. central bank's tolerance of above-target inflation is wearing thin as unemployment continues to fall.