Market Review 3Q 2018
During the quarter, there was solid economic growth data, a strong employment report, an increase in hourly earnings, and favorable purchasing managers’ surveys. GDP estimates for 3Q2018 are strong. In addition, strong retail sales, firming inflation, favorable financial conditions, strong consumer confidence and robust corporate profits added to a positive economic outlook. Housing, though, due to rising mortgage rates and increased building costs remained a weak area for the economy.
The continued US economic growth may be potentially impacted by geopolitical uncertainty, trade and tariff concerns and the recent volatility in emerging markets. News of a NAFTA resolution helped calm concerns over other tariffs and trade agreements.
Inflation indicators remain close to the Federal Reserve's 2% target. PPI, CPI, and core CPI all came in below expectations. But by month’s end, consumer confidence hit an 18-year high. Personal Consumption Expenditure (PCE) Core Index averaged 1.56%, exceeding 2.0% only 8 out of 120 months, the last time being in April 2012.
The Consumer Price Index has been edging up to near 3%. U.S. inflation is expected to rise gradually as the impact of higher energy prices and tariffs on imported goods flow through the economy. University of Michigan one-year consumer inflation expectations have risen from 2016-2017 levels. Changing costs for shelter, medical and education remain key factors of core service inflation, components which are not expected to decline.
The monthly employment report of over 200,000 new jobs, the unemployment rate dropping to 3.7%, and higher average hourly earnings were all positive indicators. The labor market remains historically tight by most indicators.
The unemployment rate is expected by many to drift even lower, barring a substantial upward move in the labor force participation rate. The number of job openings exceeds the amount of job seekers for the first time, which has translated into higher wages given the limited pool of qualified applicants. The seasonally-adjusted quits rate reached 17-year highs indicating positive employee confidence which may translate into higher wages over time.
Strength of consumer spending was bolstered by the rate of wage growth and low unemployment. Consumer confidence, which is highly correlated with the stock market, continues to rise, reaching multi-decades highs. U.S. real medium household income has reached a record level. Should energy prices spike higher or tariffs begin to push prices of consumer goods up significantly, the pace of spending growth may ease.
Global growth diverged with the U.S. economy’s momentum continuing to be driven by the strong labor market and stimulative fiscal policy, whose impact is expected to slightly diminish over the next year. Many expect the pace of domestic growth to fade in 2019 but will remain in the 2.5% to 3% range, above the post-crisis average. Business and government spending assume greater importance in sustaining higher real GDP growth while the consumer spending component remains stable. The impact of tariffs, other trade-related issues and a slowdown in the housing market could weigh on the positive growth outlook. The ISM Manufacturing Index hit a new 14-year high in September.
Tariffs and domestic political issues dominated the news but appeared to have only modest impacts on the markets. The longer-run effect of trade disputes is uncertain but is generally considered potentially negative for economic growth. The impact of new tariffs poses potential problems, as prices of intermediate goods rise, and supply chains are disrupted.
As anticipated, the Federal Reserve raised the Fed funds target rate in September, 2018 by 25 bps, to 2.00%–2.25%. The Fed indicated that another rate hike in December, 2018 and three more rate hikes in 2019 are planned. The Fed also stated that monetary policy is shifting to a more neutral stance and may be more data dependent in the future. The Fed is expected to maintain a pace of one hike per quarter.
The thriving job market and rising inflation will prompt the central bank to stay the course on tightening credit. Strength in the economy and financial markets as well as firming inflation will enable the Fed to continue to unwind its balance sheet and continue its normalization program.
As the Fed’s balance sheet continues to shrink and Treasury issuance increases to fund the rising deficits, there may be increased market volatility. The US Fed is normalizing faster by raising rates than the ECB and other central banks The ECB plans to be less accommodative by winding down quantitative easing at year-end 2018 and possibly raising interest rates in mid-2019. The Bank of Japan is expected to reverse its policy on its yield control program. Brexit uncertainties will continue to cause some minor market volatility.
Continued gradual removal of monetary policy accommodation combined with stimulative fiscal policy remains positive for the U.S. dollar despite concerns about the growth in federal deficits and expected increases in Treasury note issuance.
Increased prices on imported goods could restrain growth under various tariff scenarios. The International Monetary Fund cut its outlook for global growth this week based on the impact of rising interest rates and continued trade tensions.
The agreement on NAFTA 2.0 (USMCA), which now expires in 16 years, has resulted in minor changes in the treatment of dairy production and auto parts.
Investor concern has also increased surrounding the expanding U.S.-Chinese tariff fight over China’s policy toward technology. The U.S. Treasury Department is due to release a currency report that some analysts suggest might change the official stance on China’s exchange rate policy if it is labeled a currency manipulator.
Treasury Yield Curve
The continued rise in short-term rates, increased Treasury note issuance and a flattening of the US yield curve have created strong demand for short-duration securities.
The first half of 2018 was tumultuous for fixed income and was followed by a volatile 3Q2018 due to trade tensions and geopolitical concerns. Treasury yields rose in 3Q2018 as the Fed raised rates in September and indicated another hike in December, 2018. The larger government budget deficits, higher than predicted, require a growing new issue Treasury calendar and could increase yields. The 10-year Treasury finished the quarter at 3.06%.
The Fed and the markets would be concerned if the yield curve inverts. The Fed could respond by pausing its rate hike path.
Investment Grade Corporates
U.S. corporate profits have been boosted this year by the lower tax rates put in effect by tax reform. There is a growing amount of leverage in the financial system. Many industry sectors have added a considerable amount of debt, although low interest rates and tax rate cuts have kept debt more affordable.
The corporate market benefited from solid economic growth, which has produced revenue growth, higher operating margins and higher earnings. Moderate investment grade corporate bond issuance, flatter yield curve, and low bond supply contributed to the narrowing of credit spreads during the quarter.
Investment grade credit fundamentals continue to be favorable, supported by resilient U.S. economic growth yet vulnerable to event risk in industrials. Relative valuations are tight. Banking continues to show further improvement in fundamentals and reduced exposure to event risk.
Corporate debt levels are relatively high and the U.S. economic growth may be in its late stages. Should the economy slow or the impact of trade tariffs be prolonged, credit downgrades may occur. The corporate ramp up of mergers and acquisition activity, share buybacks and increased dividend payouts are shareholder friendly but not necessarily good for debt holders.
Government-sponsored enterprise (GSE) debt spreads tightened over the quarter. Fannie Mae (FNMA) reported net worth at $7.5 billion while Freddie Mac (FHLMC) recorded a net worth of $4.6 billion. Both will make a required dividend payment to the Treasury consisting of $4.5 billion by FNMA and $1.6 billion by FHLMC.
Shareholder lawsuits challenging the “net-worth sweep” of $125 billion in excess FNMA and FHLMC profits to the U.S. Treasury made some progress. In September a federal court allowed breach of implied contract claims to proceed, thus challenging the propriety of the $125 billion in FNMA and FHLMC profits having been swept and hinted that the court found the 2012 net-worth sweep to be arbitrary and unreasonable. The court case will continue.
The lack of supply in U.S. agency and GSE fixed-maturity bonds caused Agency prices to be high and spreads to tighten. New issue Agency floaters, indexed to the new Secured Overnight Financing Rate (SOFR), the future replacement for LIBOR were well accepted by the market. FNMA also issued its first SOFR floater.
Spreads on highly rated asset-backed securities (ABS) tightened in September with the seasonally light new issue calendar. The $15 billion of new issuance in September was readily absorbed by investors. Auto receivables and credit card ABS outperformed as spreads tightened and overall credit fundamentals for these securities continued to be stable.
The good ABS performance is due to the strong economy and healthy jobs market. The market’s credit concerns in the sector have shifted away from subprime auto ABS where performance is improving and underwriting standards have tightened. Credit focus is now squarely on more esoteric asset classes such as consumer loans.
Short-tenor asset-backed spreads moved tighter over 3Q2018. Spreads for AAA-rated three-year tranches of credit card, prime and subprime auto tightened from the wider spreads at 2Q2018.
Over $53 billion of new issue ABS deals came to market in 3Q2018 versus just $46 billion the same time last year. Year-to-date 2018 issuance was $179 billion compared to $164 billion issued by 3Q2017. Auto deals represented the largest segment with $79 billion, followed by credit cards at $31 billion and other subsectors at $26 billion. Other subsectors include structured settlements, insurance premium payments, aircraft leases, cell phone payment plans, whole business securitizations and timeshare deals. Floating rate securities were 16% of new issuance in 2018.
Credit card performance remains solid with charge-off and delinquency rates stable and close to all-time lows. Monthly payment rates have risen consistently since the financial crisis. The post-crisis cardholders are using credit cards as transaction-oriented rather than as a source of revolving credit.
Auto credit performance continues to show signs of stabilizing. The improving auto metrics are due to the strength of the labor market and marginally better underwriting standards for recent vintage deals.
In light of the Federal Reserve’s roll down of its balance sheet, Mortgage-Backed Securities (MBS) have become more attractively priced than corporate bonds that appear overpriced. Investors had been cautious on the mortgage sector since the financial crisis but compared with corporate bonds they offer greater yields. Seasoned AAA-rated MBS, with short weighted average lives have become more competitively priced with attractive relative yields for short-term portfolios.
Canadian Bank Bail-In Regulations
Effective September 23, 2018, eligible debt for bail-in conversion will be senior unsecured debt with an original maturity date greater than 400 days. The securities are tradable and transferable and issued by Canada’s systemically important banks (D-SIB banks). These banks include:
Bank of Montreal (BMO)
Bank of Nova Scotia (BNS)
Canadian Imperial Bank of Canada (CIBC)
Toronto-Dominion Bank (TD)
These banks will be required to issue eligible debt by November, 2021 to meet the new TLAC (Total Loss Absorbing Capacity) requirements. New issuance is expected to be concentrated in the greater than 5-year maturities. These securities are expected to be rated at least one notch lower than the bank’s current credit ratings. Total debt issuance is not expected to increase as the banks will probably offset maturing liabilities by issuing eligible debt. Any legacy securities that were issued before September 23, 2018 will continue to be non-eligible debt and not subject to the bail-in rules.