Market Review 1Q 2018
The U.S. economy is continuing to grow slowly. It is now in the ninth year of an economic expansion. The economy has been moving very steadily, but at a slow pace for many years. Economic activity is expected to speed up slightly this year with the additional fiscal stimulus of large corporate tax cuts and government spending. Growth is expected to be 3% for 2018-2019 and may slow down in 2020 due to the low unemployment rate.
The Fed will continue to normalize monetary policy throughout 2018 and into 2019. Policy normalization will be achieved through two mechanisms: balance sheet reduction and interest rate hikes.
The U.S. Federal Reserve began to unwind its $4.5 trillion balance sheet in October 2017 at a moderate pace. The central bank will stop reinvesting all of the money it receives when its assets mature. As a result, the balance sheet will gradually shrink. The Fed is reducing its bond holdings by initially small, monthly reductions of $6 billion of Treasury debt and $4 billion of mortgage-backed securities. It will slowly increase that to a maximum of $30 billion and $20 billion, respectively. Rather than selling securities outright, the Fed will allow bonds to “roll off” and will not reinvest the principal and interest of the maturing bonds.
The Fed owns about $2.5 trillion in U.S. Treasury securities which is 18% of the U.S. government debt held by the public. Its holdings of mortgage-backed securities total about $1.8 trillion which is 25% of the MBS market. The rest of the $4.5 trillion portfolio consists of such assets as swaps with foreign central banks, overnight loans of securities and foreign currencies.
On February 5, 2018 Jerome Powell became the new Federal Reserve Chairman replacing the former Chair Janet Yellen. Powell shares similar beliefs to Yellen and wants to normalize interest rates, reduce the Fed balance sheet and is not expected to change the direction of Fed policy.
The Federal Reserve raised the federal funds rate on March 21, 2018 by 0.25% to a range of 1.50% to 1.75% and is expected to raise rates at least two more times in 2018. The Fed increased the number of rate hikes for 2019 to three with expectations of stronger economic growth.
The Fed also provided updated economic projections. Real GDP was adjusted up from 2.5% in December to 2.7% for 2018. The GDP growth forecast for 2019 was raised to 2.4% but growth is expected to moderate in 2020 at 2% and long-term at 1.8%.
The Fed’s unemployment projection was lowered to 3.8% for 2018. Inflation projected at 1.9% and interest rates forecast at 2.1% remained unchanged for 2018.
February inflation data was modest. Headline CPI rose slightly to 2.2% and core inflation (excludes food and energy) was flat at 1.8%. CPI is projected to be 1.8% and core inflation to be 1.6% this year.
Unemployment Rate and Wages
The March employment report was weaker than expected, with a payroll increase of 103,000 which was about 70,000 jobs lower than expected. The decrease was attributed to extreme seasonal weather conditions. The previous 2 months were also revised by 50,000. In spite of this perceived temporary decline there is no expectation that monetary policy will change.
The unemployment rate has fallen to 4.1% and has remained there for six consecutive months. This is comparable to the low unemployment rates during the booming 1960’s. It is a huge accomplishment given that the rate peaked at 10% during the last recession.
If there is an acceleration of growth to 3% or more that could push the unemployment rate to 3.5%. There are already starting to be labor shortages in certain parts of the country. Annual wage growth increased 2.4% for production and non-supervisory workers and total private annual wage growth figures increased 2.7% for March.
Tight labor markets may generate wage growth although businesses still wield a lot of bargaining power when it comes to labor, and that has tended to hold down wage growth. As long as this continues, wages will only increase gradually rather than spike upwards.
Fixed Income Yields
The Treasury yield curve rose by between 30 and 40 bps. across the yield curve over the quarter primarily in response to the Fed Funds rate hike. Six-month LIBOR rose by 62 bps from 1.71% in December 2017 to 2.33% in March 2018. 1-3 year credit yields rose by +46 to +66 bps over the first quarter of 2018 while 1-3 year treasuries saw a rise of +39 bps for the same period.
The scandal-plagued benchmark index for roughly $350 trillion in consumer and business loans will be phased out over the next few years. That means the London interbank offered rate (LIBOR), the rate at which banks extend short-term loans to each other, is very much relevant to thousands of consumers for the near future. And like other loans — from mortgages to credit card balances — rates are ratcheting up in 2018 thanks to rising interest rates and economic growth. The three-month LIBOR rate has basically doubled over the past year to 2.33%.
Corporate profits look favorable for 2018. Companies are benefitting from strong economic growth, a falling US dollar which is increasing international revenues, and higher oil prices leading to improving energy company revenues.
A significant factor contributing to corporate profits is the corporate tax cut that lowered the corporate tax rate from 35% to 21%. Economists expect that to be a huge boost to US businesses. Corporate profits are expected to be as high as 25% higher in 2018 versus 2017 which is uncharacteristically high. From this high level, 2018 profitability may only eke out a 2%-3% growth in corporate profitability in 2019.
Profit margins may be squeezed by higher interest rates, higher wage growth, and lower GDP growth. It is anticipated that future growth may be modest.
The recently announced trade tariffs sparked fears of a potential trade war between the US and China which upset markets and caused corporate credit spreads to widen. Increased retail bankruptcies added to concerns although those had been anticipated as retail sales have long been weakening.
Following the passage of tax reform in December, US multinational companies especially technology and pharmaceutical companies are likely to reduce holdings of short-term fixed income instruments held offshore, including corporate bonds. This reduced buying and increased selling of short-term corporate debt has caused short-term corporate debt spreads to widen sharply in 2018.
These large liquidations have impacted the total return performance of US investment-grade credit. This weakness is primarily due to supply/demand technical issues. Corporate credit fundamentals remain strong. Earnings growth is strong, leverage is stable, interest coverage ratios are good and the corporate tax cuts will be reflected in earnings in 2018.
After two years of mediocre growth and various political setbacks over the last decade, 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 moving into 2018.
The Eurozone is growing due to an undervalued euro, improving confidence and a high level of pent-up demand. Euro strength over the past year has been attributed to receding political risk, solid growth and inflows into European assets. There is uncertainty around the degree to which currency appreciation will impact inflation, with the European Central Bank (ECB) officials suggesting that the direct impact of currency rates on inflation may have lessened. Expectations are that the Euro area inflation will remain subdued due to several factors including a slack labor market and continued downward pressure on wage growth.
The UK appears to be weathering the economic impact of the Brexit vote better than had been anticipated by economists. The weaker currency has improved exports.