Market Review 2Q 2018
Updated: Jan 26
The US economy is exhibiting late-cycle tendencies, including full employment, rising inflation, greater corporate leverage, and tightening monetary policy. During the quarter the US reported positive GDP growth, strong employment, rising USD currency while international markets had soft economic results.
The unemployment rate ticked up in June from 3.8% to 4% which is attributed to the increased number of people seeking job seekers previously discouraged from looking. U.S. nonfarm payrolls rose a seasonally adjusted 213,000 in June. Wages increased modestly in June.
The large fiscal stimulus from the tax cuts enacted by Congress provided huge corporate tax cuts and individual tax reductions while still increasing spending at the peak of the economic cycle. The robust jobs market and solid consumer spending are expected to cause the economy to continue to post reasonable growth numbers.
Core Personal Consumption Expenditures (Core PCE), the Federal Reserve’s (Fed) preferred measure of inflation, rose by 2.0% year-over-year which met the Fed’s 2.0% inflation target and modestly beat expectations for growth of 1.9%
The Federal Reserve has tracked a long period of positive GDP growth and now at full employment, it is raising interest rates and unwinding its balance sheet. The Fed Chair Powell made
similar comments at the mid-June Federal Reserve meeting.
The Fed raised the Fed Funds rate by 25 bps in mid-June to 2%. The Federal Reserve signaled it will raise rates to 2.5 percent in 2018, 3.0 percent in 2019, and 3.5 percent in 2020. It is expected to make 2 more rate hikes of 25 bps each in 2018, barring any geopolitical concerns or exacerbation of the trade war.
The U.S. economy remains resilient, so the Fed is expected to continue raising rates gradually. Inflation is still moderate and wage growth has improved. Raising rates from ultra-low levels and quantitative easing is difficult. With rising Fed Funds rates, longer-term rates have not risen steepening the yield curve. Instead, the market is seeing the yield curve flattening with long-term rates remaining unchanged or declining. Some of the demand for long term Treasuries is from Liability Driven Investments by pensions, foreign buying, and flight to quality when geopolitical fears increase.
There are some concerns about the flatter yield curve. Typically, an inverted curve may be signaling an impending recession and a possible bear market. Flat yield curves can exist for long periods without inverting.
US economic momentum remains strong while acceleration in the rest of the world has eased. Short-term interest rate differentials, strong economic momentum and its value as a safe haven currency should support the US dollar. The dollar began to appreciate relative to most developed and emerging market currencies at the start of 2018, when the US economy started to pick up steam and accelerating economic activity in other countries began to ease.
US economic outperformance relative to the rest of the world is likely to continue, which supports the case for additional Fed tightening and higher short-term interest rates, increasing the attractiveness of holding US dollars.
Eventually the Fed will reach a neutral rate and pause, likely at a time when the European Central Bank (ECB) and possibly the Bank of Japan (BoJ) will begin to remove monetary accommodation and slowly raise policy rates.
ECB and BOJ
Mario Draghi, head of the ECB, indicated that the ECB would unwind its quantitative easing program by tapering bond purchases in December, 2018. Policy rates are expected to remain unchanged until mid-2019.
This policy change may lead to greater global market volatility as multiple central banks remove their accommodative policies. The increase in populist movements in Europe and heightened geopolitical risks may undermine market sentiment.
The European Central Bank (ECB) and the Bank of Japan (BoJ) are not expected to adjust policy rates in the near future. Momentum in the US economy relative to the rest of the world should keep the Fed on its current path to higher short-term interest rates, while other developed market central banks will generally remain more accommodative.
Tighter US monetary policy may increase the USD that is gaining against all of the trading partner currencies. Both the Euro and Chinese Yuan have fallen 5% in 2Q2018. Some of the Emerging Market currencies have fallen precipitously ranging from 15% - 25%.
The Trump administration has begun a trade battle through tariffs which in turn has spurred retaliatory tariffs. The administration cancelled the Trans Pacific Partnership, wants to restructure NAFTA (North American Free Trade Agreement), and trade agreements with the EU and China.
The Administration’s trade policies are not well defined. The specter of trade wars has dampened global growth prospects for 2018. The U.S.-China trade war began on July 6, 2018. The U.S. and China slapped levied tariffs of $34 billion of each other’s exports. China’s retaliatory tariffs were planned to hit U.S. farm products and auto makers. The initial steel and aluminum tariffs were relatively small to total imports and the overall U.S. economy.
The trade disputes are more problematic to the economy. In some cases, the benefits of the tax cuts may be offset by the tariffs. The tariffs imposed on industrial components will disrupt complex multinational supply chains.
Counter tariffs have initiated a trade war making near term business decisions uncertain. The impact of a protracted trade war would be a deceleration of global growth or possibly stagflation. The escalating trade war undertaken by the Trump
administration has been met with considerable resistance. With each retaliation the size of the impact of proposed tariffs is growing.
The additional tariff proposals could cost the U.S. $120 billion. The fiscal stimulus from the December 2017 tax bill is estimated to be about $800 billion in total.
The US economy is $19 trillion so the direct impact of tariffs is small. The real impact could be disruptions to supply chains, damage to US export competitiveness from retaliatory measures, inflationary pressures on consumer prices, and delays in investment decisions by companies waiting to see how long these trade disputes last.
Corporate earnings and profitability benefited from the tax cuts, strong demand, strong balance sheets and good fundamentals.
As multinational corporations start to repatriate cash held offshore with only a modest amount of cash is expected to be used to pay down debt. Most of the cash will be used for shareholder friendly transactions such as stock buybacks and dividends.
Bond issuance rose during the quarter to $110 billion in June causing investment grade corporate bond spreads to widen during 2Q2018. Over half of the corporate issuance has come from companies rated BBB+ or below.
Credits that were impacted were those companies engaged in M&A, exporters exposed to the strong USD. Credit spreads were impacted by the ongoing tariffs concerns. Over 50% of US industrial credits have a stable credit outlook, while 33% carry a moderately improving or outright improving outlook.
BBB-rated bonds reported the widest spread and negative returns compared to higher credit quality securities. Longer durations bonds were more adversely impacted than shorter duration securities.
Additional corporate spread widening should be minimal for the remainder of 2018. With spread widening and higher interest rates, excess returns turned negative across all credit ratings and maturities.
Banks passed their Federal Reserve stress tests in 2Q2018. As banks continue to de-lever, the underlying fundamentals and overall strength of the banks remains strong. The spreads on global financial bonds have widened in response to the perceived geopolitical risks.
The yield curve flattened this quarter with the 2–10 year spread shrinking to only 33 bps. The market expects the yield curve to continue flattening interrupted by temporary steepening. The long end of the yield curve will be impacted by the Fed’s unwinding of its balance sheet, US budget deficits, higher inflation and tighter labor conditions. The Treasury curve flattened modestly due to strong demand for safe-haven assets, with trade tensions rising between the US and China long-term yields fell and front-end yields remained steady.
Highly rated asset–backed securities are attractive as short-duration investments during a period of credit volatility. Unlike corporate bonds, ABS spreads remained unchanged during the quarter. ABS were insulated from spread widening due to credit concerns or trade wars, and geopolitical concerns.
New ABS issuance volume was in line with the past few years with most of the $18 million in new issuance coming to market in the first two weeks of the month. Trading in ABS slowed down significantly ahead of the Federal Reserve’s June meeting and the July 4th holiday week.
Mortgage Backed Securities
Mortgages have been a more attractive option this year as valuations returned to reasonable levels. Some of the changes in valuations are a result of the Fed’s balance sheet unwinding of mortgage securities. RMBS outperformed Treasuries in June with rising rates, flatter yield curve, and low volatility. Duration was a key driver of relative performance within the agency MBS universe, with high coupon securities with low duration collateral generally outperforming Treasuries. The strong returns on high coupon GNMA collateral were due to the GNMA’s action to reduce "churning" behavior of some Veterans Administration loan originators. There will be additional supply of agency MBS available as the Fed’s continues unwinding its balance sheet which creates good buying opportunities.