SVB Asset Management's monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy.
Guard Against that Incoming Interest Rate Jab
Ninh Chung, Head of Portfolio Management
Rocky IV (1985):
Rocky Balboa vs. Drago—Round 1
Duke (trainer): What’s happening out there?
Rocky: He's winning... I see three of him out there!
Paulie (trainer and confidant): Hit the one in the middle.
Duke: Right! Hit the one in the middle.
Moviegoers will undoubtedly remember the above scene where the fictitious American boxing icon, Rocky Balboa, suffered the first series of many body blows by his artificially enhanced Russian opponent, Drago. As you may recall, Rocky came from the humble streets of Philadelphia and was barely making ends meet until he discovered the ring. Although his early struggle in the sport was trying and painful, his relentlessness, pure determination, and perseverance more than compensated for his lack of natural talent.
The year that Rocky IV was released coincided, not surprisingly, with the beginning of the Mikhail Gorbachev and Ronald Reagan Cold War period. A period marked with global uncertainty and mutual fear. That movie and specifically the above scene reminded me of the long struggle the global economy has endured due to the financial crisis. As Rocky demonstrated with his skillful movements and beautiful counterpunches during the grueling match against his apparently insurmountable opponent, the series of unprecedented actions taken by central banks have us poised for a sustainable rebound—although the timing and pace of recovery will differ regionally. As the global economy continue to gain momentum, investors, particularly fixed-income investors, must be mindful to not over reach and to keep their guards up.
The Opening Bell
The recent global financial crisis landed quite a combination of stiff jabs, right and left crosses, and even some vicious uppercuts and left the global economy staggering to this day. A 2013 research paper released by the Dallas Federal Reserve conservatively estimated that 40–90 percent of one year’s output was foregone due to the 2007–2009 recession. That is equivalent to $50,000 to $120,000 for every household. Furthermore, as a result of the global financial crisis, unemployment increased from 7 million in December 2007 to 16 million by October 2010, the broad unemployment rate spiked from 7 percent to 18 percent, foreclosures of over a million homeowners transpired, and a weakened labor market ensued. Scarier is that 1 in 7 Americans continue to live at or below the poverty line.
In Europe the pain experienced was initially less penetrating but appears to be longer lasting. The euro zone unemployment as reported by Eurostat was 7 percent in 2007, but has been hovering around 12 percent since 2011 where it currently stands at 11.7 percent. Another sign of this unabating trend is the euro zone’s staggering youth (25 years old and under) unemployment rate of 24 percent.
To slow the charging financial storm, central bankers around the world countered with the largest and most radical set of global monetary policies of our lifetime. These unconventional tools such as long term zero interest rate commitments, large scale asset purchases, and debt guarantees were instrumental in sidestepping a possible global depression. While the majority of developed economies are just starting to warm up, a select few are at the beginning stages of policy reversal. Highlighted below are current central policies of select economies and how their actions will affect investment performance.
One Step Back and Two Steps Forward
One of the brightest spots in the euro zone’s economy has been the UK where the unemployment rate reached a five-year low of 6.6 percent supported by soaring housing prices. While the UK continues to outperform its European peers, fear of an overheating economy is starting to take form. That concern was validated when Mark Carney, BOE governor and chairman of the Financial Policy Committee (FPC), stated in his speech at the Mansion House this month, “There’s already speculation about the exact timing of the first rate hike and the decision is becoming more balanced. It could happen sooner than markets currently expect.” Furthermore, markets now expect the FPC to unveil a set of measures to help curb the housing market and maintain financial stability. These measures could come in the form of: 1) stricter affordability tests that banks can use to assess a borrower’s ability to repay, 2) mortgage limits (loan-to-value or LTV), or 3) increased capital requirements on mortgages.
A similar but less speedy trend is the recovery of the U.S. economy. The unemployment rate is holding steady at around 6.5 percent while the economy has added over 200,000 new jobs per month for four consecutive months. The housing market continues to show signs of improvement as purchases of new and existing homes increased along with prices. The Janet Yellen-led Federal Reserve is marching on with a scaling back of asset purchases while reiterating its pledge to keep short-term rates low for a “considerable time” even after the completion of the asset purchase program. Should the current recovery remain on course the
Fed will inevitably embark on its exit plan of accommodative policy. The timing and tools used to remove excess liquidity brought about by six years of accommodative policies will continue to push short to intermediate rates higher. Rates jostled as investors debated on when the Fed will lift short-term rates.
As the BOE and the Fed ponder and execute exit strategies, the European Central Bank (ECB) is operating from the corners and struggling to break free from the ropes. Challenged by anemic growth of sub-1 percent, persistently high unemployment rates, and stalled economies in France, Italy, and Netherlands, the ECB announced further unconventional measures and liquidity injection with the hope of stimulating growth in the euro zone. Mario Draghi, ECB President, recently announced cutting the base rate to 0.15 percent from 0.25 percent, introduced a negative deposit rate of 0.1 percent, offered cheap loans to banks to boost lending, and left open the door to quantitative easing. Draghi recently stated, “Quantitative easing can include not only government bonds, but also private sector loans. We will discuss that when the time comes.”
As Rocky showed in his long and gruesome 15 rounds, predicting an opponent’s tendencies positioned him well for his countermoves. For fixed income investors, the current opponent is personified by the actions of central banks. Their next moves will be key performance drivers. As each economy recovers at its own pace, investors must keep their guards up at all times and stay protected against surprise spikes in interest rate or their portfolios may feel a stiff jab.
Credit Vista: Municipals Not Taxed
Timothy Lee, CFA, Senior Credit Risk & Research Officer
Municipal financial conditions are continuing to improve, helped by climbing tax collections. State and local governments (SLGs), which derive 51 percent of their general revenue from taxes according to the U.S. Census Bureau’s latest calculations, have benefitted from rising property prices, 56 consecutive months of retail sales growth, and 33 straight months of payroll gains. In the first quarter of 2014, SLGs collected a near record level $1.46 trillion in annualized total tax receipts. Property and sales taxes reached historic highs after double digit home price increases and a 3.5 percent average gain in monthly chain store sales, while the largest number of employed people since 2008 has kept income tax proceeds near peak amounts. Reflated home prices have particularly benefitted local governments, where property taxes made up 74 percent of all taxes collected.
The notorious bankruptcy filings by Stockton and Detroit, though, expose the ineffectiveness of tax receipts as a monotherapy for structural ailments plaguing SLGs, including instable pension and retirement benefit costs and ageing infrastructure costs. Nonetheless, fiscally fit and fundamentally sound is the norm, not the exception, for SLGs. According to Moody’s data, cumulative default rate (CuDR) for municipal borrowers over a 10-year period was 0.13 percent, with the CuDR being 0.04 percent over a three-year period. For investment grade municipal borrowers, the corresponding rates were 0.08 percent and 0.02 percent. Comparatively, Moody’s data show investment grade corporate borrowers had a 10-year CuDR of 2.87 percent, while the 10-year CuDR for all corporate borrowers was 11.73 percent.
SLGs will remain financially healthy over the medium term, as firming tax receipts, sustained budget downsizing from the latest recession, and lingering austerity sentiments will afford time for political solutions to fundamental fiscal dilemmas. Any reduction in revenue from the federal government, which comprises around 25 percent of SLGs’ total revenue, should be well managed by SLGs, who have been unhurried to cut taxes or restore spending. States, for example, are proposing the smallest spending increase in four years for fiscal 2015, despite projected budget surpluses, according to the National Association of State Budget Officers. With SLGs continuing to reduce total debt outstanding, they will be well positioned financially if spending accelerates in the future.
Economic Vista: All Systems Go
Renuka Kumar, CFA, Portfolio Manager
As the Fed stated in their June FOMC meeting, growth in economic activity has rebounded in recent months with labor market indicators showing improvement. Indeed, we saw another good month of job growth with nonfarm payrolls rising 217,000 in May. This was the fourth consecutive month of 200,000+ jobs created enabling the economy to finally regain the number of jobs lost during the recession. Meanwhile, the unemployment rate remained at an almost six-year low of 6.3 percent. While payrolls are steadily increasing, we have yet to see any meaningful pickup in wage growth. Average hourly earnings rose only 0.2 percent month-over-month and 2.1 percent year-over-year.
Inflation was the other big data point this month as CPI topped both expectations and last month’s reading, coming in at +0.4 percent month-over-month and +2.1 percent year-over-year. This was the largest increase in consumer prices in over a year; however, the Fed reiterated that longer-term inflation expectations remain stable.
The consumer took a pause last month with retail sales falling short of expectations with a 0.3 percent increase. Q1 personal consumption was revised down to 1.0 percent from its earlier estimate of 3.1 percent.
The final GDP print for the first quarter showed a contraction of 2.9 percent, a larger decline than earlier estimated. Many still believe this Q1 slowdown to prove temporary as growth from the remaining quarters will drive the economy back on track to annual growth of 2.0–2.5 percent.
Trading Vista: Bond Market Volatility
Hiroshi Ikemoto, Money Market Trader
We saw some volatility in the bond market in June as stronger than expected inflation numbers fueled speculation that the Fed will raise interest rates sooner than previously anticipated. The two-year benchmark Treasury note surged to 0.482 percent on June 17, an increase of 10 basis points from May 30, and stayed in a range of 45 to 47 basis points for the rest of the month. The three-year benchmark Treasury note increased 21 basis points from May 30 to 0.988 percent on June 17 and traded in a range of 93 to 95 basis points until month-end. Corporate bonds spread tightened with the increase in benchmark yield and absolute yields increased just slightly relative to the larger curve movement. Agency bonds stayed right on top of Treasuries with spreads consistently two to four basis over similar maturing T-notes.
As the June FOMC meeting revealed almost no changes in their economic views, the trading in the bond market should remain range-bound for at least a few more months, barring any more global headlines, as we wait for guidance from the Fed.
SVB Asset Management, a registered investment advisor, is a non-bank affiliate of Silicon Valley Bank and member of SVB Financial Group. Products offered by SVB Asset Management are not FDIC insured, are not deposits or other obligations of Silicon Valley Bank, and may lose value. This material, including without limitation to the statistical information herein, is provided for informational purposes only. The material is based in part on information from third-party sources that we believe to be reliable, but which have not been independently verified by us and for this reason we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decision. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction.