SVB Asset Management's monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy.
2018 - Much of the same but expect more volatility
Ninh Chung, Head of Investment Strategy and Portfolio Management
- The U.S. economy should expand to around three percent while global expansion is expected to be firmly in place
- On average, core inflation will continue to fall short of the Federal Open Market Committee’s (FOMC) two percent target
- Expect the Fed to carry on its tightening policy, both with rates and slow-down of asset purchases
- Fixed income investors will benefit from short versus long duration strategies
- Expect the yield curve to continue to flatten
- Despite the maturing business cycle in the U.S., we expect credit spreads to remain range bound in 2018
For much of 2017, investors rode on the tailwinds of a transparent and accommodative Fed, below target inflation, synchronized global economic growth, and benign market volatility. Even fixed income investors; challenged by a seventy-five basis point increase to the federal funds rates, squeezed out positive total returns as reinvestment income largely offset negative price performance. Aiding this performance was the continuation of credit spread compression throughout the year and across most security types. Furthermore, duration defensive portfolios consistently outperformed their respective benchmarks as reinvestment rates reset higher while the yield curve flattened on each rate hike.
This year, we expect fixed income returns to largely resemble that of 2017 with the major central banks continuing to dictate the direction of interest rates.
Last year, most economists underestimated global growth as real GDP is expected to have grown between 3.5 - 3.7 percent versus expectations for approximately 3.2 percent gain. In the Eurozone, 2018 economic growth is expected to mirror 2017’s output at 2.5 percent with inflation expectations near one percent. Unlike the FOMC, the European Central Bank (ECB) is not expected to lift their benchmark rate. Instead the market will focus on the slowdown of their asset purchase program. In China, the focus will likely be the controlling of financial excess from prior years. As we mentioned in previous writings, the rally in commodities will have a spillover effect on China’s inflation in 2018 where it could challenge the 2.5 - 3.0 percent range. China’s 2017 inflation is expected to report in at approximately 1.5 percent. In the UK, 2018 economic growth is less clear given the lack of clarity on the UK separation from the EU. Should the UK strike a BREXIT deal in early 2018, consumer and business confidence should follow, thus leading to increased spending and private investments. Another interesting situation to keep a close eye on in this region is the above target inflation rate of three percent, which was largely driven by rising import prices due to the depreciation of the sterling.
In the U.S., 2017 GDP growth is expected to report in at approximately 2.5 percent, surpassing its current long-term trend of 2.2 percent. This inertia will bode well for 2018 should consumer and business confidence continue to shrug off domestic political debates and geopolitical war of words. We look for headline employment rate to challenge the three percent handle, which is currently at 4.1 percent. Should growth exceed three percent for the year, inflation could surprise to the upside to meet the Fed’s medium term inflation target of two percent. This scenario will bode well for short duration strategies.
Credit Vista: Seismic shifts in the media landscape
Daeyoung Choi, CFA, Credit Research Analyst
The internet has disrupted countless industries, and media businesses have not been spared. In fact, the ubiquitous access to digital information has sent shock waves through content creators and publishers of all sorts, from print media to music, video and beyond. Right now the moment seems particularly fateful for traditional TV media.
There are two noteworthy forces that are exerting pressure on traditional TV media. One is the growing popularity of over-the-top content distributors, which has enabled true on-demand consumption of movies and TV shows and has put the old-fashioned linear TV programming on a path to certain demise as “cord-cutting” accelerates. The other is the increasing dominance of social media, which is eating into the public’s screen time and intensifying competition for advertising dollars.
These forces are part of a larger trend shaping our daily lives – the convergence of media, telecom and technology. The lines that used to separate these industries are blurring as telecom companies want access to exclusive media content, media companies want technology solutions to enable better monetization of content, and technology companies want to upend the incumbents in both media and telecom businesses.
It grabbed everyone’s attention when Comcast, the cable behemoth, purchased a majority stake in NBC Universal in 2011, and subsequently assumed the full ownership in 2013. Verizon then bought Yahoo, a pioneering name of the dot-com boom that popularized consumer internet. AT&T, meanwhile, acquired DirecTV to become the largest pay-TV provider in the U.S., then announced the acquisition of Time Warner, though the deal still faces an uncertain regulatory outcome. Netflix and Amazon have been in the content-creation business competing with legacy media companies for creative talent for years. Now, Google and Apple are getting into that business as well. Given the sheer size of these companies, and the reach they have to virtually all consumers in the U.S., the implications of these changes are profound.
The latest tectonic shift in media landscape involves Disney, the last remaining old media giant. With its proposed purchase of the majority of 21st Century Fox, it will add to its already world-leading intellectual property portfolio. Given Disney’s vast and highly effective apparatus to monetize these assets, to which it is also planning to add direct-to-consumer streaming services, the resulting combination will have a lasting consequence in the landscape that spans all the technology, media and telecom industries.
Recognizing this shifting landscape, the Global Industry Classification Standard (GICS), the leading provider of industry classification used by the investment industry, is changing its Telecom Services sector by renaming it to Communication Services and pulling into it companies that are currently classified under the Information Technology sector and the Consumer Discretionary sector within its Media industry group. Looking ahead, 2018 will undoubtedly bring even more news on seismic changes for the media industry - not the least will be the regulatory developments around both the AT&T/Time Warner and Disney/Fox deals, and a number of other players have also positioned themselves for additional deal making, including Dish Network. Stay tuned for more to come.
Economic Vista: Stuck on repeat
Steve Johnson, Portfolio Manager
Haven’t we been here before? If the current economic backdrop looks and feels familiar, there’s a good reason for it. Both soft and hard economic data was strong during December, but also continued to be overshadowed by the notable absence of inflationary momentum in the U.S. economy. Reports on business and consumer sentiment remained near record highs, while hiring and retail sales continued to show underlying strength. However, measures of inflation like the ‘core’ PCE and CPI (controlling for the volatile food and energy categories), remained stuck below the two percent objective set by the FOMC. These core measures are below target and, in the Fed and market participants’ eyes, remain a looming question as to the long-term health of the U.S. economy.
Nonfarm payrolls continued to convey health, increasing by 228,000 versus an expectation of 195,000, while the unemployment rate held unchanged at 4.1 percent. This represents a 17-year low, down from 4.6 percent a year ago, while the labor force participation rate remained unchanged at 62.7 percent. The gain in employment during December shows a continuation of post-hurricane strength in hiring in the U.S and exceeded the average monthly gain of 174,000 seen during 2017 and the 187,000 seen during 2016.
Optimism among small businesses also surged to the highest level in 34 years and was the second highest in history, with the NFIB (a leading small business association) survey, rising by 3.7 points to 107.5, exceeding the consensus expectation of 104.0. Consumer sentiment remained strong but dipped to the lowest level since September in the final December University of Michigan report. Headline sentiment fell to 95.9 in December, down from 98.5 in November and slightly below the 2017 average of 96.8. Nevertheless, sentiment remains strong overall with the 2017 average reading 96.8, the highest yearly average since 2000. Notably inflation expectations included in the report were revised downward, with the five to 10 year estimate at 2.4 percent. This level is just above the all-time low of 2.3 percent from December 2016.
If there is one area of concern for the economy it continues to be that inflation remains below the Fed’s policy target. In December this story remained consistent, with core CPI reporting at 1.7 percent year-over-year versus 1.8 percent in the prior month, and core PCE at 1.5 percent year-over-year versus 1.4 percent in the prior month. Core PCE, the Fed’s preferred measure of inflation, continues to underwhelm and has remained below the 2 percent target since 2012. The lack of pricing pressure has been largely downplayed by the Fed in crafting monetary policy, and the committee continues to expect pricing pressure to pick up towards their target in the “medium term”, which could provide them cover to raise the Federal Funds rate during 2018.
Source: Bloomberg, Morgan Stanley, U.S. Bureau of Labor Statistics as of 12/28/17
Trading Vista: The song remains the same
Hiroshi Ikemoto, Fixed Income Trader
Once again, 2017 ended in a similar manner to prior year-ends. We witnessed a well-telegraphed December rate hike, which had little immediate effect on the Treasury curve. Yields on the two-year Treasury note, the point considered to be the most sensitive benchmark to Fed rates, remained flat after the Fed’s announcement. The encouraging economic growth and a healthy employment environment have the Fed projecting three more rate hikes in 2018. This forecast of measured, slow tightening should feel like familiar territory by now. However, persistent weak inflation readings have kept the Treasury curve flat as the spread between two-year and the ten-year notes are at lows not seen since 2007.
In the corporate bond market, spreads widened by five to 10 basis points heading into the end of the month as traders unloaded bonds to lighten their balance sheets. Again, this was expected and we have seen this widening happen in December for the past few years. Bonds traded in an orderly fashion as many investors saw the opportunity to capture additional yield. By mid-month, most firms were extremely light in inventory, and low volumes were evident in the last week of trading. Most of the excess cash that remained was invested into repurchase agreements, where yields on general collateral were in-line with Fed Funds rates.
Here at SVB Asset Management, we continue our disciplined approach to maintain target duration strategies. This approach provides us with flexibility to have available proceeds for reinvestment if rates continue to rise, while holding longer positions to anchor portfolios in an event there are economic or political events that would cause market volatility.
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