SVB Asset Management's monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy.
Considering the Tails
Paula Solanes, Senior Portfolio Manager
This spring marks the 10-year anniversary of when the Federal Reserve cut the Fed Funds rate by 300 basis points over the course of three months in an effort to combat the financial crisis that began the prior year and to avoid the risk of sending the global economy into a tailspin. The U.S. economy has come a long way from those dark days of the financial crisis and has been expanding for over nine years. Recently, however, there has been growing awareness of a potential recession given the natural business cycle and the relatively flat yield curve. Although the U.S. economy appears to be on firm ground, reflecting back on the global financial crisis offers important lessons in preparedness and planning for tail risk.
For the moment, the economy is chugging along and data continues to impress. The unemployment rate is hovering at a 17-year low; more than two million jobs were added to the U.S. economy over the last few years; and GDP was over 2 percent last year thanks to a strong consumer, good earnings and general price stability. In addition, the tax package delivered toward the end of 2017 is expected to stimulate further growth and possibly generate upward pressure on wages. In turn, this could trigger a rise in inflation and tilt the scales toward a fourth interest rate increase in 2018. And looking beyond the U.S., synchronized global growth and improvements in other developed economies are prompting some leading foreign central banks to consider raising their interest rates.
Despite the economic tailwinds, plenty of risks remain. In February, the possibility of mounting inflation pressures, prompted by an unexpected increase in hourly wages, sparked volatility to levels not seen in three years. And more recently, changes in U.S. trade policy prompted concerns over a global trade war, which has added uncertainty to the markets and created a flight to quality.
While we cannot predict with exact certainty if and when the U.S. economy will turn for the worst, we can structure a portfolio strategy that considers the current economic backdrop and the potential for tail risks. However, just because tail events are uncommon and difficult to foresee, it’s prudent that companies manage their cash with them in mind. In some scenarios, a company’s corporate cash management will call for more of a segmented approach, whereby its overall cash position is divided into various strategies, each one with a unique goal and benchmark, as well as appropriate positioning in the current market landscape.
For example, current interest rate forecasts support the case for being defensive on duration and focusing on the front end of the yield curve to allow for reinvestment opportunities in a rising interest rate environment. However, when structuring a portfolio strategy, it is important to take into account the cash profile of a company, along with its investment horizon and business priorities, to create a holistic strategy. This could necessitate segmenting cash into a few different categories, such as for current operations, reserves or strategic. Each category has its own purpose, but in unison they meet the needs of a growing company in a dynamic market. This also means being proactive to defend against any tail risk.
By segmenting cash into different strategies, an investor can seek to optimize the portfolio based on a certain time horizon and the intended use of the cash. In addition, choosing the appropriate benchmark and then incorporating the market and interest rate outlook can create a portfolio that is better positioned to take appropriate opportunities.
Credit Vista: What a relief!
Nilani Murthy, Senior Credit Risk & Research Officer
On March 14, 2018, the Senate passed the Economic Growth, Regulatory Relief, and Consumer Protection Act. This significant piece of regulatory reform aims to help smaller financial institutions deal with some of the post-financial crisis legislation targeted at the largest institutions that were once deemed “too big to fail”. A key component of this bill increases the asset threshold for a bank to be designated as a systemically important financial institution (SIFI) to $250 billion of consolidated assets, up from $50 billion, which was the threshold defined in the Dodd-Frank Act (DFA) of 2010. This means that banks won’t receive as much regulatory scrutiny until they reach this $250 billion threshold.
Many banks have been bemoaning the heavy burden of meeting heightened regulatory standards, including high employee and legal costs, not to mention the large amounts of paperwork. So, it’s no surprise that a huge sigh of relief could be heard from the four banks (with less than $100 billion in assets) that are immediately exempt from enhanced prudential standards, as well as the 34 banks (with between $100 and $250 billion in assets) that may become exempt 18 months after passage of the new law.
The relaxed regulatory requirements will have numerous benefits, not the least of which will be an exemption for these smaller banks to participate in a variety of public stress tests, including the living will requirement, the DFA Stress Test (DFAST) and the Comprehensive Capital Analysis and Review (CCAR), which evaluate banks’ capital adequacy under stress scenarios. However, this will also reduce reporting transparency and is/may be considered negative from a credit assessment perspective, as banks could take this opportunity to relax risk governance and encourage more aggressive capital management.
After the 18 months passage of the bill into law, the Federal Reserve will still have the authority to apply enhanced oversight to any bank holding company with assets in the $100 to $200 billion range. This may include periodic stress tests. In the interim, it will be up to the Fed to develop a more tailored oversight regime for the banks in this asset size group.
Meanwhile, investors in these banks should remain vigilant and monitor the banks’ performance closely to ensure that key capital and liquidity metrics do not deteriorate and result in heightened investment risk. As usual, we are committed to ensuring that only the safest banks remain on our approved investment list.
In order to become law, the bill must be passed by the House of Representative and signed by the president. Currently, it appears that the bill is on track to becoming law. The Fed stress tests for 2018 will proceed as usual with submissions due April 5, and the results will be announced in June.
Economic Vista: Headlines driving markets
Eric Souza, Senior Portfolio Manager
If we have learned anything in recent weeks, it is that market sentiment still matters, no matter how encouraging the economic data appears to be. Using a strictly data-centric lens, it’s clear that we remain in a Goldilocks economy that’s neither too hot nor too cold. Yet market volatility returned with a vengeance in February and remained elevated in March, thanks largely to the news flow. Chief among the concerning headlines was the announcement of new tariffs and the subsequent resignation of President Trump's top economic advisor. Thus in March, the headlines, not the data, were the primary culprit of market turmoil.
In terms of data, the news that ultimately matters was mostly good. The March employment report was solid, though wages came in below expectations as the prior month was revised lower, and there was a large increase in new entrants into the labor force. Nonfarm payrolls increased by 313,000, which was higher than expected and represents the largest monthly gain since July 2016. Over 800,000 Americans joined the labor force – the largest one-month gain since 1983 – and the unemployment rate held steady at 4.1 percent for the fifth straight month.
Inflation has been under scrutiny ever since wage earnings spiked earlier in the year, which led to February’s first bout of market volatility reflecting concerns that the Federal Reserve would raise interest rates more aggressively than expected. For the moment, however, wage inflation seems to be measured. The most recent average hourly wages increased just 0.1 percent, which was below expectations, while the year-over-year wages increased at a slower rate of 2.6 percent. Although the economy is at or near full employment, new labor force entrants will make it unlikely that we will see any troubling inflationary wage growth in the near term.
Other inflation data has also calmed market fears. The Consumer Price Index (CPI) showed a drop in February’s reading from the previous month. Headline CPI rose 0.2 percent, while core-CPI fell slightly on a month-over-month basis and remained unchanged year-over-year at 1.8 percent for the third consecutive month.
If there was one area where the data disappointed, it was retail sales, as nearly all monthly readings were below expectations. It looks like consumers are not taking their anticipated tax cuts to retail stores. The Retail Sales Control Group – which is a direct feed into GDP – rose only 0.1 percent. Department store sales were noticeably weak, but there were some positive results as the nonretailer sector (internet shopping) increased by 1.0 percent, which is seasonally adjusted.
Despite the soft retail data, consumer sentiment from the University of Michigan came in at 102, the highest level in 14 years. This reflects how consumers assess current economic conditions and, possibly, how tax cuts may be poised to benefit lower income households.
Housing data continues to be mixed. On the sales side, housing starts, permits and new home sales were all lower than expected, while existing home sales exceeded expectations. Starts and permits were lower in the multi-family sector, declining by 26 and 15 percent, respectively, for the month (but still up 10.6 percent year-over-year). Although new or existing home sales have been underperforming this year, the hope is that rising supply will help offset any negative impact of rising mortgage rates. One interesting component of the housing market data is the continued increase in home prices despite steadily rising mortgage rates this year. The median price for new home sales increased 0.6 percent to $326,800, while the median price for existing home sales rose 0.4 percent to $241,000. On a year-over-year basis, new home prices are up 9.7 percent, while existing home sales are up 5.9 percent. The Federal Housing Finance Agency (FHFA) Home Price Index rose to a three-and-a-half year high of 7.3 percent, which largely reflects a lack of supply.
In terms of overall economic growth, the final reading for GDP came in at 2.9 percent, thanks largely to robust consumer spending that increased 4.0 percent, which is the highest reading since the Q4 of 2014. The Q1 GDP is forecasted at 2.5 percent, with consumer spending expected to drop slightly to 2.2 percent.
Trading Vista: Libor on the march
Hiroshi Ikemoto, Fixed Income Trader
The return of volatility has been an ongoing market theme, and investors have been on edge as trade war fears dominated headlines and overnight funding rates soared. A major topic of conversation on the trading desk has been the dramatic increase in Libor rates in recent weeks, with the commonly used three-month rate at 2.29 percent, the highest level since 2008. The London Interbank Offered Rate, or Libor, is a key measure for short-term interest rates that banks use to borrow from other banks. Any time Libor rates spike, some investors wonder whether it is a harbinger of troubles ahead.
It’s a fair question, but looking more closely, we believe that the increase in yields is more of a technical move as opposed to any deterioration in credit. Since February, we have seen a tremendous volume of new U.S. Treasury bills (T-bills) issued, which in turn has driven rates to their highest level in 10 years. To compound this, the U.S. tax overhaul is reducing demand for commercial paper and longer-dated bonds as companies prepare to repatriate their overseas cash. And then, of course, we also had a 25 basis point rate hike in March. All of these factors have conspired to drain demand for short-term investments; therefore, we are seeing higher yields to entice buyers back to the market. The one main headwind keeping some downward pressure on yields has been the uncertainty surrounding the extent of U.S. tariffs and trade policy. This has resulted in a flight-to-quality trade that is increasing overall demand in U.S. Treasuries for the moment.
In the credit market, we are seeing spreads widen as investors seek the relative safety of Treasuries. In a span of two months, we have seen credit spreads widen from 20 to 30 basis points across the curve as investors demand more yield-to-buy duration. Looking at money market rates, three-month T-bills increased 20 basis points month-over-month, while commercial paper has increased 30 basis points – a 10 basis point spread increase.
All the uncertainties may put some investors on edge, but we see this volatility and the increased supply as a great opportunity for our client portfolios. As we have been defensively positioning our accounts to maintain flexibility to react to rising interest rates, we have been able to invest into this spread-widening. We have seen more attractive pricing for the same highly rated investment grade issuers, and we will continue to look for opportunities.
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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