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Observation Deck: Transitory or Trend?

 |  September 06, 2017

SVB Asset Management's monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy.

Transitory or trend?

Eric Souza, Senior Portfolio Manager

Transitory or trend? That’s what investors want to know. Are the recent soft inflation readings more of a temporary anomaly, or a definitive long-term trend? The Federal Reserve is using a different label for what it feels is the anomaly of stubborn low growth — transitory. It’s really just a fancy way of saying "not permanent." However, we think that if you look closely at the data, this "transitory" phase is becoming more of the norm. Consider some data points:

  • The Fed’s preferred inflation gauge is Core PCE (personal consumption expenditure), which excludes volatile food and energy components. Over the past 20 years, it has been below the two percent target over three-quarters of the time.
  • Since the beginning of the year, the year-over-year reading for Core PCE has declined each month from 1.89 percent to 1.50 percent.
  • The monthly reading of Core CPI (consumer price index) has come in below monthly estimates for five consecutive months.
  • Since April of this year, Core CPI has been below two percent and remains at its lowest level since 2015.

All this indicates that inflation is, for all practical purposes, difficult to find in the current environment. The Fed has been saying the deceleration on inflationary readings is coming from two main areas: wireless contracts and health care – and more specifically, prescription drug prices. However, when you exclude these two sectors, we see that inflation is still decelerating, which supports our narrative that this is more of a trend and not really transitory.

Historically, in an economy with a tight labor market, this ultimately should lead to an increase in wages. In turn, this should boost consumer spending, which leads to an increase in consumer prices. So why, then, are prices heading lower in this economy? The answer just might be that we are in a new economy, whereby technology and globalization are leading to a change in pricing pressures and tighter margins. In this new economy, companies have two basic choices, eat their higher costs or pass them along to consumers. For now, there does not appear much appetite for higher prices.

Recently the Fed has acknowledged the soft inflation data in their July FOMC statement by removing "somewhat" below two percent for its inflation target to a definitive "below two percent." That’s just a nuanced change, but it matters. Even though most Fed members say inflation will reach the two percent objective over the medium term, Fed speeches have also been sounding more cautious. For example, New York City Fed President Dudley recently suggested that it’s going to take some time for inflation to rise to two percent.

So what does this all mean for the bond market and your fixed income portfolio? This low inflation economy should keep the Fed on its gradual pace of raising rates, which in turn should also keep rates moving directionally higher without any large spikes. Although inflation should remain tame, we acknowledge that we are in a rising rate environment and thus are still remaining defensive on duration.

Markets
Treasury Rates  
 
Total Returns:  
3-Month 0.99%
 
ML 3-Month Treasury 0.09%
6-Month 1.07%
 
ML 6-Month Treasury 0.14%
1-Year 1.22%
 
ML 12-Month Treasury 0.10%
2-Year 1.33%
 
S&P 500 0.31%
3-Year 1.43%
 
Nasdaq 1.43%
5-Year 1.70%
 

 

 
7-Year 1.94%
 

 

 
10-Year 2.12%
 

 

 

Source: Bloomberg, Silicon Valley Bank as of 08/31/17  

Credit Vista: Scandinavia’s banking trolls

Tim Lee, CFA, Senior Credit Risk & Research Officer

In Old Norse mythology, trolls were often old, giant, and strong. Ironically, these traits could also be reflective of Scandinavia’s six largest banks, which each have at least a 145 years of operating history that date back to the 1800s, as well as dominant market share. Combined, these six banking "trolls" control over 60 percent of lending in Denmark, Norway, and Sweden, and they are some of the highest rated banks in the world. With less than a handful of exceptions, these banks have a stable outlook and have been recently upgraded by the major rating agencies. Despite a low-to-negative interest rate environment that has weighed on profitability, the banking trolls have scary-good credit positioning thanks to their unfriendliness to loan losses and their adherence to hideously strict regulatory requirements.

Asset quality has been steady in the face of threats from low oil prices, a weak shipping industry, and rapid real estate price appreciation. A recent uptick in nonperforming loans was primarily from corporate loans in the energy and shipping sectors. Realized loan losses, though, remain well below set aside provisions, and some banks have even commented that some stabilization in the oil and shipping industries has helped reverse some problem loans.

Meanwhile, actual loss ratios on home mortgages remain very low, and defaults are very rare thanks to the recourse nature of most loans and the region’s comprehensive unemployment safety net. One bank reported in July 2017 that it had repossessed only 45 properties out of 370,000 real estate loans, while another bank noted that it had zero credit losses on its Swedish mortgage book, with only five basis points of loans that were greater than 60 days delinquent. Overall, the average loan loss ratio for each of these six banks was less than 20 basis points, as of June 2017.

In addition to low loan losses, the credit quality of these banks is buttressed by tough regulations and strict capital requirements. While risk weights vary and have been criticized by some for not being high enough, the six banking trolls have Basel III fully applied Common Equity Tier 1 (CET1) ratios ranging from 16 to 24 percent, all of which are comfortably above minimum requirements. In general, these banks have higher capital ratios than peer banks in Europe, the U.S., Canada, and Australia, though risk weights differ.

Despite their excellent credit performance, these banks still have much to guard against, including elevated household indebtedness from high home prices and rich commercial real estate valuations, which could create high losses. Wholesale funding reliance from an international base also poses a potential risk. Still, don’t expect these trolls to turn to stone at the first sign of trouble. They are well fortified with the capacity to generate capital internally from strong earnings, and a prudent risk management culture and government support makes them intriguing from an investment perspective.

Economic Vista: Tapping the brakes?

Jose Sevilla, Senior Portfolio Manager

By and large, the recent domestic economic news has been encouraging, though we believe that persistently low inflation may give the Federal Reserve pause with regard to future rate hikes. The U.S. economy grew at a more robust rate of three percent annually in the second quarter, recovering from its sluggish start at the beginning of the year. The faster-than-expected growth was driven by strong consumer spending and business investment. This is welcome news as there was some uncertainty surrounding U.S. growth prospects after repeated failures by the White House to successfully move its legislative agenda forward. In terms of monetary policy, the growth figures should lend support to the Fed’s efforts to begin reducing its balance sheet.

U.S. Non-farm payrolls rose 209,000 in July, which was considerably stronger than the consensus estimate of 180,000. June data was revised up to 231,000 from the previously estimate of 222,000. Meanwhile, the unemployment rate declined to 4.3 percent, largely due to the expansion of the labor force as the participation rate edged higher to 62.9 percent from 62.8 percent. The pace of wage growth still stands below the cyclical high reached in December (2.9 percent), as average hourly earnings rose 0.3 percent in July keeping the year-over-year pace unchanged at 2.5 percent.

The news on the retail front has also been encouraging as July retail sales climbed 0.6 percent after a 0.3 percent advance in the prior month. Widespread gains from department stores to building materials outlets signal a healthy start to consumer spending in the third quarter. Shoppers were out in force despite the recent market volatility. That should bode well for third-quarter growth, which is riding heavily on consumption as softness abroad and a strengthening dollar weigh on other parts of the economy. Sales figures from the retail-control group, which excludes food, autos, and gas, increased 0.6 percent following a 0.1 percent gain. Overall, consumers spent more freely in July as strong hiring, limited inflation, and low interest rates are improving purchasing power.

The one key issue that seems to have the Fed’s attention is inflation. The inflation soft patch widened in July, casting doubt on whether the recent weakness can be considered "transitory." Headline and core inflation fell short of consensus expectations, both posting a 0.1 percent increase. The year-over-year rate of change for both headline and core CPI was unchanged at 1.7 percent. Policy makers are realizing that the lack of inflationary pressure may be more entrenched than anticipated, and they will likely continue debating the urgency for further interest rate hikes.

Trading Vista: Anybody home?

Jason Graveley, Trader

Slow and steady. August historically produces some of the lightest corporate bond trading volumes of the year, and 2017 was no exception. Typically, as earnings season winds down, volume tends to taper off, and many traders and investors carve out time away from work. The lack of any significant market-moving news and the anticipation of the Labor Day holiday also contributes to the calm. Consider that U.S. investment grade trading volumes have dropped over 20 percent since their February peak, and no increase is expected until after the holiday when traders return en masse.

But there’s a flip side to these quiet times. Lighter volumes can lead to higher volatility, and price swings can be exacerbated given the fewer buyers and sellers. This is especially true in times of heightened geopolitical risk. This past month, however, we witnessed rising tensions on the Korean Peninsula, but volatility did not increase materially. Domestic stock markets continued to set new record highs with the Dow Jones Industrial Average rising to over 22,000, while corporate bond spreads remained relatively unchanged.

With both volatility and trading volumes low, as well as the fading probability of an additional 2017 rate hike, we continue to emphasize selectivity and focus on duration risk. We are closely monitoring the monetary and fiscal policy outlooks, and it appears that the likelihood of meaningful reforms or significant fiscal stimulus are waning. After the failing to repeal and replace The Affordable Health Care Act, the current administration has now shifted its focus to tax reform. Whether any market-moving policies are enacted this fall remains to be seen.


 


 

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The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, 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 decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.

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SVB Asset Management, a registered investment advisor, is a non-bank affiliate of Silicon Valley Bank and member of SVB Financial Group.

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