Market Review 2Q 2019
The US economic expansion will become the longest in history by July 2019.
Investors have begun to fear the risk of recession. Economic growth slowed in 2Q2019 due primarily to the protracted trade discussions. Tariffs and the threat of additional tariffs impeded business investment and lowered business confidence. The bond market also reflected concerns over a potential recession, as yields dropped significantly during the quarter due to a flight to quality and low inflation expectations. The yield curve inversion between three-month bills and 10-year notes also worried investors.
The economy faces some challenges that include the upcoming debt ceiling approval, growing budget deficit, protracted trade tariff negotiations, and potentially slower economic growth in 2020.
Inflation has remained steady and has been low in 2019. The Core PCE inflation was an annualized 1.6% as of June which is below the Federal Reserve’s 2% target. Inflation is not expected to rise in 2019. There are growing signs of an easing in inflation pressures across core consumer prices, producer prices, commodities, and labor. Slower U.S. growth and global economies should keep overall inflation subdued this year.
Employment slowed but averaged 151,000 monthly jobs during the quarter. April had added 224,000 new jobs. In May, employers added only 75,000 jobs which was below expectations of 182,000 new jobs. Recent job cuts in the retail industry and financial services were factors in the weak jobs growth figures. The June jobs report showed strong hiring in the professional and business services, health care, social services, government jobs, construction and manufacturing.
Wage growth remained anemic as average hourly earnings increased an annualized 3.1%. Unemployment was steady at 3.6% and the participation rate increased modestly to 62.9%.
The gross domestic product (GDP) forecast for 1Q2019 was 3.1% which was higher than the 4Q2018 annualized GDP growth of 2.2%. Concerns have been rising that the economy is showing signs of slowing as the current economic expansion may become the longest in history if it continues through the summer 2019.
The Federal Open Market Committee (FOMC) left interest rates unchanged at their June 2019 meeting and said that economic uncertainties have risen. Many of the FOMC members felt that lower rates may be needed in 2019. The Fed indicated that it was committed to sustaining the expansion.
The Federal Funds target rate remained unchanged at 2.25% to 2.50%. Many economists expect the FOMC to lower the Fed Funds rate this year in response to slowing growth. Rising risks of slowing global growth, tariffs, benign inflation and increasing geopolitical risks have made the Federal Reserve cautious. The protracted tariff and trade negotiations are influencing the global economic slowdown and pushing the Fed towards considering an easier monetary policy.
Federal Reserve Chairman Powell referenced the continuing global uncertainty stemming from protracted trade disputes, slower economic growth in China and Europe, and the prolonged uncertainty about Britain’s exit from the European Union. Low inflation and weaker global growth are also influencing the Fed’s decisions.
Fitch Ratings estimates that additional tariffs with China would reduce global economic output by 0.4% by 2020. Fears of additional disruptions, increased supply chain costs and unpredictability of trade policy are undermining business confidence and impeding meaningful business investment.
Internationally, major central banks are also moving to be more accommodative in order to counter low inflation and to extend the economic expansion. The global economic outlook has also continued to weaken due to the protracted, protectionist trade policies, economic and political uncertainties. Global rates are declining as major central banks turn more accommodative. Markets expect future rate cuts and have lowered global rates which has lowered bond yields to even more negative yields.
European Central Bank (ECB)
Mario Draghi, President, European Central Bank, changed his tone from being patient to needing to stimulate the economy. The stimulus would mean lower interest rates that are already negative. Currently 30% of the total developed markets outstanding bonds or $11.5 trillion have negative yields. An increase in negative yields is a questionable central bank response because it will increase demand for positive yielding bonds such as US bonds.
The ECB further downgraded its inflation projection to 1.6%, below its 2% target. Draghi expressed the willingness to cut rates in order to move inflation higher and extend the European expansion. The European Central Bank has also indicated a more accommodative stance.
Uncertainties about the impact of Brexit have also clouded the European economic outlook. European economies are being impacted by lower corporate confidence and slower business investment.
Low inflation expectations are the reason for the pause by the Fed and European Central Bank (ECB) this year. Economists expect the Fed and ECB to maintain their policy unchanged until upward inflationary pressures emerge.
Bank of Japan (BOJ)
Governor Kuroda, Bank of Japan, stated that its economy continues to expand moderately, and inflation may increase gradually to 2%. The BOJ has followed a stimulus program for the last six years, yet Governor Kuroda stated that if the economy loses momentum, BOJ would consider implementing additional stimulative measures to sustain its economic growth.
The ongoing trade/tariff disputes continue to impede efficient global trade and erode business confidence. The slower economic growth in China has also contributed to weakness in Europe and Asia.
The People’s Bank of China (PBOC) has taken a series of steps to implement supportive policies to stabilize the downward drift in its economy. China’s economy continues to slow despite the policy response. Unresolved trade disputes are a key risk to the Chinese economy and global growth. China is an important factor in global growth with European and emerging Asian economies being largely dependent on Chinese demand. China’s economy may stabilize as the policy steps take effect.
Although economic growth in China has slowed, the government has initiated policies over the past few quarters that have offset some of the weakening economic indicators. The Central Bank may need to take continued action as the trade disputes continue over a longer term.
The market had anticipated a US-China trade deal in the next few months until the Trump Administration started expanding tariff threats against the EU and threatening to exponentially increase tariffs on China. With trade talks between US and China currently stalled, markets no longer expect a complete resolution of trade disputes until 2020.
The ongoing trade/tariff disputes with China, Mexico and Europe is negatively impacting global trade activity, business confidence and capital expenditures. Although not specifically targeted with tariffs, Japan, Korea, and Taiwan have also been impacted by the trade tensions causing a fall in global trade and a deterioration in manufacturing activity. The businesses most impacted are those with global supply chains and trading markets, which is a primary factor in the economic slowdown.
Treasury Yield Curve
Rates continued to decline, driven by the expectation that the FOMC stated its goals in sustaining the current expansion and which encouraged investor expectations for rate cuts in 2019. Parts of the US Treasury yield curve steepened slightly. At quarter end, the US Treasury yield curve was inverted as measured by the spread between the 10-year Treasury note and 3-month Treasury bill.
Investment Grade Corporates
Corporate credit spreads tightened during the quarter. Risk-on investments were driven by the expectations for lower rates, as indicated by comments from the US Fed and ECB and the perception of easing trade tensions.
Investment grade spreads tightened, and excess returns were positive across sectors, credit ratings, and durations. Industrials outperformed financial and utility credits. The highest returns were generated by BBBs and longer maturities.
Modest growth, low inflation, and the Federal Reserve’s dovish tone and lower interest rates globally caused US bonds to rally, yields to fall and spreads to compress on most bonds.
Credit spreads narrowed in 1Q2019 and continued to compress during 2Q2019. Expectations are that spreads may continue to tighten this year as rates decline.
Corporate debt levels continue to be at record highs as a percentage of revenue and GDP. Companies that have used the tax cuts for M&A and share repurchase transactions are now rethinking their use of cash. High-quality companies continue to use their strong cash flows to repay debt used for recent acquisitions. With continued ratings downgrades the share of BBB-rated credits has increased.
Asset Backed Securities (ABS)
The spreads on AAA-rated ABS narrowed modestly in June. There was $18.4 billion in new ABS issuance comprised of 52% auto-related ABS. As of June 30, 2019, ABS issuance totaled $119.6 billion which is slightly less than $125 billion in 2018.
ABS benefited from strong consumer data and good collateral performance in private student loans and auto loans. The performance of consumer installment loans continued to improve. Charge-offs in credit card ABS trusts decreased slightly over the quarter. Default rates continue to remain stable across major ABS asset classes.
Residential Mortgage Backed Securities (RMBS)
RMBS underperformed credit as spreads widened at quarter end. The 30-year mortgage rate continues to track Treasury yields as they declined 25 bps in June 2019. Yields are now 1% lower than November 2018. The decline in mortgage rates impacts prepayment speeds on outstanding mortgages. Over half of outstanding mortgages can refinance to lower rates which increases the prepayment speeds on RMBS. RMBS supply is expected to increase in the near term as refinancing and home purchases rise and housing conditions continue to be stable.