SVB Asset Management's monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy.
The Fed’s Exit Strategy
Renuka Kumar, CFA, Portfolio Manager
Over five years after the Federal Reserve embarked on record stimulus measures to spur economic growth, it is clear that the U.S. economy is on firmer footing. There is still progress to be made given the slow pace of recovery, but with GDP on track for 2.5-3.0 percent growth this year, the unemployment rate at 6.3 percent and the Fed halfway through its bond purchase tapering, the focus is now shifting to the question of how and when this easy, accommodative monetary policy will end.
Not surprising, there has been quite a bit of Fed rhetoric regarding the aforementioned topic this year. This rhetoric has ranged from hawkish comments from Philadelphia Fed President Plosser saying the central bank may be forced to hike rates “sooner rather than later” to dovish comments from New York Fed President Dudley stating there will be “a considerable period of time” between the end of its asset purchases and the first rate hike. The general consensus seems to follow the latter sentiment as evidenced by the minutes from the April Federal Open Market Committee meeting where policymakers concluded there was little risk of inflation with the current stimulus. While they discussed tools for normalization of policy, nothing implied that they would act soon.
The Fed continues to be data dependent, looking for greater support for underlying strength in the economy to avoid stunting growth prematurely. Policymakers recently dropped the 6.5 percent threshold for the unemployment rate in favor of a broader range of statistics. This means that in addition to the unemployment rate, they are also factoring in metrics such as the labor force participation rate, the “quits” rate (the rate at which workers are quitting their current jobs) and wage growth. Looking at these metrics in total, there are no factors pushing for an imminent end to accommodative monetary policy.
Of course, there are risks to the unprecedented monetary policy. Even with a slower rate of bond purchases, the Fed’s balance sheet is on path to hit $4.5 trillion before year end and there is approximately $2.5 trillion of excess reserves on banks’ balance sheets, which could pose a threat to inflation. This has heightened the talk of exit strategies to mitigate potential shocks to the economy. Once bond purchases come to an end—which is expected to happen this fall—the Fed could likely implement one or a number of the following options to remove excess liquidity from the system: increase the interest paid on bank reserves (IOER), halt reinvestments on securities or engage in outright asset sales, pursue reverse repurchase agreements where they pledge collateral in exchange for cash, offer interest-bearing term deposit facilities, and of course, raise the federal funds target rate.
Upcoming economic data and projections by Fed members will be telling in determining when and how fast they will exit current policy accommodation and begin tightening. This is a major factor in determining how to position portfolios and we believe a neutral to long stance remains appropriate until we see any signs of the Fed reversing course.
Credit Vista: Easy Money Prevails
Melina Hadiwono, CFA, Head of Credit Research
Despite the Fed’s moves to taper its bond purchases, bond yields remain low and continue to support robust credit markets. According to Fitch’s report, the U.S. corporate bond market continued to show healthy issuances with financial sector leading the charge due to improving lending activity in the first quarter of 2014,. The financial sector’s issues expanded 4 percent to $1.42 trillion, while industrial issues grew by 2 percent to $3.4 trillion with refinancing continuing to represent a healthy portion of the newly originated bonds. The financial sector’s issuance volume peaked at $1.9 trillion in 2007.
Conversely, the industrial sector’s bond issuances have been steadily increasing since 2006 mostly supported by growth from the energy, technology, consumer non-cyclical, healthcare, telecommunication and utilities industries. Borrowing costs continue to contract. Floaters are making their way in with 23 percent in the financial sector and 7 percent issuances from the industrial sector. Financial sector continue to dominate in the high investment grade landscape with over 71 percent with A- or better compared to 34 percent in industrials. Banking remains the prominent segment in the short-term bond landscape with over $500 billion in maturing debt in 2014-2016 compared to $489 billion for the combined 23 industrial subsectors.
S&P 500 companies continue to retain large amounts of cash as percentage of assets. While total debt has steadily increased, the absolute amount remained at 39 percent below peak level in 2007. Net Debt to EBITDA and Total Debt to Total Assets continue to hover close to two-decade low level. The rise in debt has been offset by strong operating margins and liquidity.
Despite recovery being in the low gear, credit fundamentals should remain steady in 2014 with some divergence among sectors. Deterioration in credit quality could occur if consistently easy credit conditions and high cash balances were to lead to an increase in aggressive financial policies.
We remain comfortable of the names on our Approved List and continue to monitor and search for prudent investment opportunities for our clients.
Economic Vista: Momentum on the Horizon
Paula Solanes, Portfolio Manager
The effects of the harsh winter back east have dissipated and the U.S. economy is showing signs of improved momentum. Non-farm payrolls came in very strong increasing by 288,000, the biggest gain in close to two years. Meanwhile, the unemployment rate dropped to 6.3 percent, the lowest level since 2008. However, the unemployment rate is still driven primarily by an all-time low in the labor force participation rate.
The consumer is recovering following the cold spell that covered the East Coast this past winter. Personal income increased 0.5 percent while personal spending increased 0.9 percent. Spending on durable goods increased by 2.7 percent, the biggest increase in four years. Spending on services also increased with healthcare and utilities leading the gain, while retail sales have been fairly steady with purchases up 0.1 percent in April.
Inflation is picking up; readings show that price pressures are on the rise. The consumer price index increased by 2 percent on a year-over-year basis, putting inflation in line with the Fed’s target. Core inflation, which excludes food and fuel, increased by 1.8 percent.
Housing is at a steady place. The recent drop in mortgage rates and more stable prices is adding to home affordability. Housing starts climbed 13.2 percent to an annualized pace of 1.07 million, with gains driven by a 40 percent uptick in construction starts on multi-family homes. There has also been a notable increase in construction targeted at rental housing. Existing home sales increased 1.3 percent thanks to improved supply with the number of available properties close to a two-year high. Finally, new homes sales increased 6.4 percent, the biggest jump in six months, due to the drop in mortgage rates.
The second revision to GDP showed that the winter took a bite out of output, and it was worse than initially estimated. The good news is that winter has finally passed!
Trading Vista: Bond Market Rally
Hiroshi Ikemoto, Money Market Trader
Even with the relatively positive economic numbers in May, the bond market rallied with continuing uncertainty in the Ukraine and the dovish tone of the Fed speakers during the month. The two-year benchmark Treasury yield lost eight basis points month-over-month, while the three-year’s was down 10 basis points. The Treasury bill market is showing an even stronger bid where the yield on six-month paper is five basis points and one-year is at nine basis points. Many traders are in a holding pattern, placing their cash in the short-end while waiting for any signs from the Fed of any rate hikes. Corporate bond spreads also tightened as demand for any type of yield is driving prices higher. Two-year investment grade financial bonds are trading in a range of 45 to 70 basis points depending on the region and rating, while similar maturing industrial names range from 40 to 45 basis points. Whether they are financial or industrial names corporate bonds maturing inside of one year are trading in a much tighter range of 22 to 35 basis points.
With little profit for corporate trading inside of three years and the cost of funding rising, many dealers are starting to lower their inventories to offset higher carry cost thus easing margin compression. Going forward, we should continue to see rates tight with little volatility in bonds maturing inside of 15 months. However, with the Fed tapering projected to end this fall, we should be getting more color from Fed Chair Yellen on the Fed’s exit strategy. Hopefully.0514-0073
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.