SVB Asset Management's monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy.
Hiroshi Ikemoto, Fixed Income Trader
We certainly do live in interesting times, especially given the multitude of crosscurrents that investors are being forced to navigate. The Federal Reserve's tightening policy, increased Treasury bill issuance, rising LIBOR yields, along with other factors including the effects of U.S. tax reform, are all coming together to create market dynamics which help shape investment strategy on how we position our client portfolios.
Consider the near-historic issuance of new Treasury bills this year. According to the Securities Industry and Financial Markets Association (SIFMA), U.S. Treasury bill issuance at the end of March 2018 was $846 billion. To put that into perspective, since 2000 the average monthly gross issuance has been $388 billion. The abundance of supply has helped push Treasury bill yields higher and has forced corporate-issued money market instruments, like commercial paper, into higher rates to compete. This increase in short-term borrowing costs also contributed to the rise in Libor, the benchmark rate used amongst banks for pricing short-term loans. Although Libor has stabilized this month, including the commonly used three-month benchmark, the spike in March is still jarring, as the rate increased more than 30 basis points in a span of 30 days to a high of 2.31 percent. That level had not been seen since the financial crisis of 2008, and it is more than 100 basis points above the benchmark’s 2017 average. Current yields on the three-month securities are also at 10-year highs, with Treasury bills yielding 1.81 percent and three-month commercial paper rates at approximately 2.22 percent.
However, there are some technical factors that have prevented commercial paper rates from setting new highs, such as effects from the recent U.S. tax reform and events from the financial crisis of 2007-2008. Specifically, the legislation incentivizing U.S. corporations to repatriate overseas profits has impacted the supply and demand dynamics of short-term investment instruments. As companies bring cash onshore, the need to issue short-term debt to fund operating and other corporate activities diminishes; moreover, the repatriated cash is often invested in overnight vehicles such as government money market funds. In addition to impact from legislative reform, the 10-year anniversary of the financial crisis is still affecting markets today. For example, when corporations issue bonds, they are issued in varying maturity tenors, including the very popular 10-year bond. According to Bloomberg, in 2008 corporate debt issuance was approximately $711 billion, half the volume compared to 2013 through 2016. Although there is slightly less commercial paper issuance today, there’s a drastic decrease in corporate bonds maturing in 2018 and 2019. This lack of bond supply, combined with the desire to remain short in light of rising rates, has forced many short-term investors to overweight their money market holdings, which has kept yields at bay.
As always, monetary policy outlook will shape investment opportunities. With the consensus of at least two more rate hikes by the FOMC this year, we have seen markets fully price in a 25-basis-point increase in the June committee meeting. With the spike in yields this year, dealers have lightened their bond inventories to minimize their carry cost, thus placing additional supply constraints in the market; however, with Treasury supply in abundance, the long-term impact to corporate cash investors should be minimal.
How does all this affect client portfolios? With our focus on short-duration securities in this rising rate environment, the spikes in short-term rates have been beneficial in terms of boosting overall portfolio yields. At the same time, we remain cognizant of market technicals. As the Fed continues its tightening, we should see further improvement in short-term interest rates, even as these other technical factors come into play. So despite all the crosscurrents, we can capitalize on attractive near-term reinvestment opportunities in the current environment.
Credit Vista: Commodities point to rising inflationary pressure
Daeyoung Choi, CFA, Credit Research Analyst
With the Federal Reserve squarely on its path of increasing interest rates and the strength of the overall economy showing no signs of abating, there has been more talk of inflation. Since the financial crisis of 2008, inflation has remained elusive. However, it is starting to make a comeback. One area where there have been signs of increasing prices is commodities, particularly basic and precious metals. Three of the most widely used metals — iron, aluminum and copper — have all increased 50 percent or more in price since bottoming out at the end of 2015. They also have risen 20 percent or more since June of last year. For precious metals, gold and silver prices have increased more than 20 percent since the beginning of 2016 and almost 10 percent since July of last year.
However, the metals don’t hold a candle to what the oil prices have done. Brent crude oil, an international benchmark, has gone up 165 percent since dipping below $30 in January of 2016, and it rose 45 percent since June of last year, thanks to a shrinking excess stockpile and a global demand that continues to grow. More broadly, the Bloomberg Commodity Index (BCOM) — a composite of more than 20 individual commodities ranging from energy commodities such as crude oil, gasoline and natural gas to metals such as copper, silver, nickel and zinc to agricultural commodities such as live cattle, sugar, soybean and cotton — has gained 15 percent since the beginning of 2016 and seven percent since moderately dipping in December 2017. Meanwhile, the U.S. dollar, the currency in which the majority of commodities are priced, has declined, falling 11 percent since the beginning of 2017.
Against the backdrop of a global economic growth that remains fairly robust — some areas, such as the Eurozone, are not growing as fast as once thought, and the U.S. economy appears to continue to chip away at excess capacity, leading to tighter economic conditions — the rise in commodity prices is likely to persist, especially if geopolitical tension levels, which can send gyrations in prices of certain commodities sensitive to supply shocks, remain elevated. This is bad news for industries that are heavy users of commodities, such as several consumer staples producers, though the reverse is true for commodity producers. While it is far from clear whether the so-called “commodities supercycle” is coming back, commodity prices collectively will remain a key indicator of inflation that may be making a comeback after eluding the central bankers for so long.
Economic Vista: This train keeps rolling
Paula Solanes, Senior Portfolio Manager
It’s status quo for the U.S. economy, and that’s a good thing. Recent data confirms the U.S. economy continues to chug along. The first significant data point released this month was non-farm payrolls, which shows the labor market remains on firm footing, despite a slowdown in hiring. In March of this year, the U.S. economy added 103,000 new jobs. This was below expectations, possibly due to the inclement weather that prolonged winter in the Northeast and across the country. However, the payroll numbers for February, which were already strong, were revised upward to 326,000 new jobs. That brought the two-month average above 200,000, which illustrates just how robust job growth has been. The unemployment rate remained unchanged for a sixth consecutive month at 4.1 percent. Meanwhile, average hourly earnings — perhaps the most anticipated labor statistic — increased 2.7 percent on a year-over-year basis, which was in line with expectations.
On the inflation front, the Consumer Price Index (CPI) met expectations at 2.4 percent and was the highest reading in 12 months. Core CPI, which excludes the two most volatile food and fuel components, increased by 2.1 percent since last month. This reflects the fading effect of cellular phone costs, which coincides with the Federal Reserve’s assessment that subdued inflation was due to transient factors. Finally, the Fed’s preferred inflation measure, core personal consumption expenditures (PCE), increased 1.9 percent. The jump was driven once again by wireless, where last year’s decline in prices finally fell from the calculation. The recent uptick in prices supports the Fed’s plan to raise interest rates two more times in 2018. However, if inflation accelerates, it might consider additional increases before year-end.
Consumer activity has also contributed a positive economic backdrop. Retail sales increased 0.6 percent in March, the biggest rise in four months, reversing course from a nominal drop last month. The Fed’s gauge of retail health, the retail control group, also increased by 0.4 percent, which was in line with expectations. The improvements in retail sales were broad based, thanks to strong auto sales, furniture, home goods, electronics and appliances. The recent improvement in retail data reaffirms the Fed’s observation that weak demand would be transitory.
Although mortgage rates have been trending higher, the housing data was mostly encouraging, thanks to a strong start to the spring buying season. Housing starts surpassed expectations and came in at a seasonally adjusted annual rate of 1.3 million, a 1.9 percent increase on a month-over-month basis. In addition, building permits increased to 1.5 million versus 1.3 million in February. And existing home sales are trending higher at 5.6 million, a 1.1 percent increase month-over-month. However, if rates continue to rise and inventories remain lean, there is a risk that existing home sales may slow in the coming months. Despite higher borrowing costs, home prices still increased as the S&P Corelogic Case-Shiller 20 City Composite Index increased 6.8 percent.
So how is all this playing out with GDP? According to the most recent data from the U.S. Department of Commerce, the domestic economy increased at an annual rate of 2.3 percent during the first quarter of 2018. This was above expectations, but it was still a decrease from the growth rate of 2.9 percent registered in the fourth quarter of 2017. Nevertheless, nobody is ringing any alarm bells. By all accounts, the economy remains on track, as many pundits expected the first quarter slowdown as a result of seasonal issues. The fact that both business and consumer optimism appear high should bode well for a second quarter uptick in growth. Ultimately, time will tell, and geopolitical risks remain elevated.
Trading Vista: Rally on
Jason Graveley, Fixed Income Trader
In the face of volatile equity markets, the corporate bond market has been resilient. Demand remains strong and investors continue to pile in, creating a purchasing depth that was lacking in the first quarter. On the back of another robust earnings season, corporate credit spreads continue to narrow. This has been particularly evident in the front end of the curve. As seen through the Barclays Credit Index levels, an index that tracks the performance of investment-grade corporate debt, investments with maturities shorter than one year have rallied significantly, compared to their one- to three-year counterparts. In total, corporate bonds in the one-year space have seen spreads tighten by almost 2.5x, compared to one- to three-year bonds.
A confluence of variables is pushing this dynamic. The most significant factors are, not surprisingly, the interest rate outlook, yield curve and supply environment. The possibility of a more hawkish Federal Reserve and a tighter monetary policy has shifted the investment focus to one of a shorter duration. As interest rates rise, managers are looking to keep investment flexibility by rolling shorter-maturing corporate bonds. A flattening yield curve is further exacerbating this, as the yield difference between one, two and three years has not been significant enough to warrant large allocations to longer-dated maturities (although smaller investments may still be prudent to manage tail risk).
As more investors focus on a narrow market segment, supply constraints have emerged, and pricing quickly reflects the new dynamic where there are many buyers and few purchase options. Some investors may be wondering why the supply is constrained. How quickly we forget. One underlying reason is the residual impact of the financial crisis. While it may seem like forever ago, it’s good to remember that it has been 10 years since that market chaos — an environment that proved difficult to issue long-dated (10-year) debt. The market stagnation that we remember from way back then is now limiting secondary purchasing options. And, oddly enough, it remains a contributing factor to the broad front-end rally that we have seen in recent weeks.
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. This 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.
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