Silicon Valley Bank
SVB Asset Management’s monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy.
Renuka Kumar, CFA, Portfolio Manager
While the economic recovery continues to make progress domestically, geopolitical events this year have been dominating headlines and weighing on investors’ minds as to the potential impact on the markets. We have certainly seen some sell-off in the Treasury curve in response to positive economic data and Fed predictions. However, the “flight to quality” trade persists to some extent with uncertainty related to the ongoing events in Eastern Europe, the Middle East and the Gaza Strip.
Starting off in Russia and Ukraine, U.S. sanctions have been imposed on Russian firms in the financial, energy, and shipping industries (among others) and Russia has responded with its own import restrictions as well. While sanctions have been put into place, they are structured such that they do not have a detrimental impact on the global economy given the risk of harming the fragile recovery. For the U.S. in particular, Russia is a relatively minor trading partner accounting for approximately 1 percent of U.S. good imports and exports.
Despite turmoil in Iraq with regard to ISIS’ foothold and resulting U.S. air strikes, we have yet to see oil prices be significantly impacted as many anticipated (see chart below). We saw crude oil spike sharply in June to $115 per barrel as Iraqi forces battled insurgents over control of the country’s largest oil refinery, but oil prices have since come down to sub-$103 a barrel, below the one-year average of $109 a barrel. With supply concerns mostly alleviated, it appears that conflict in the Middle East is unlikely to significantly alter oil prices.
While there is no doubt the severity of this global unrest is immense, the economic impact thus far has been relatively minimal. We are not at the point where these events are affecting demand and prices and the U.S. is not imposing sanctions to the point where they would have a global economic consequence. Domestic GDP is expected to grow by 2 percent this year; many business sentiment surveys point to increased confidence on strong job growth and subdued pricing pressures; equity markets continue to hit record highs; and inflation remains below target at 1.5 percent. Furthermore, the Fed has yet to acknowledge that these events will pose a risk to growth or inflation in the coming quarters.
In the short-end of the Treasury yield curve where our focus is (inside of three years) we have seen volatility caused in part by “flight to quality” trades and by incoming economic data. For example, this year the 2-year Treasury note has ranged from a low of 30 basis points in February to a high of 56 basis points at the end of July. As part of our strategy, we continue to analyze trading ranges and resistance bands, and we trade to take advantage of these opportunities without adding undue risk to the portfolio. While the situation remains fluid, we expect these opportunities to continue to present themselves.
Credit Vista: Charging Ahead
Timothy A Lee, CFA, Senior Credit Risk & Research Officer
Consumers’ watchful spending and heightened financial sensibilities, along with hardier lending standards, are hangovers from the preceding recession that have benefitted the performance of the credit card receivables that collateralize asset-backed securities (ABS). Using Moody’s monthly credit card indices, at the depth of the recession in 2009, the charge-off rate peaked at 11.5 percent, which is more than triple the 3.2 percent low rate reached in 2006. With same measure, delinquencies peaked at 6.4 percent, almost double the 3.3 percent low rate. Since peaking, charge-offs and delinquencies have reversed and exceeded their previous low levels over the past five years.
As of June 2014, both the charge-off and delinquency rates have plummeted fourfold from their peaks to 2.8 percent and 1.5 percent, respectively. Both levels are at the lowest since the indices’ inception in 1989. The stellar credit performance is due, in part, to the current underlying credit card account holders who survived the sharp 19-month recession and proved to be excellent financial managers. Concomitantly, the recession shook out fragile borrowers who were charged-off, leaving an account pool that, today, has demonstrated its ability to be recession-proof.
Credit card performance has also benefitted from the digitization of American consumers’ lifestyle, where electronic payments increasingly displace cash. The usage of credit cards for convenience has increased the number of accounts that do not carry balances and has pushed the credit card payment rate to historical highs. The current payment rate is materially higher than at any time before the last recession, as an increasing number of credit card users who can afford their spending choose to use credit cards as handy cash alternatives to make internet payments, and who are influenced by incentives such as frequent flier miles and loyalty rewards. The high payment rate, in particular, reduces the risk that credit card ABS could miss its targeted maturity date.
Concern is rising about the sustainability of credit card receivables’stellar performance due to recent additions of post-recession originated accounts into some credit card pools backing ABS. Such accounts lack the experience of surviving a recession and the growth of lending to lower credit quality borrowers may impinge on the credit quality of the credit card pools. However, Moody’s notes that elevated lending standards, improved personal balance sheets, and a robust job market have created smaller delinquency differences between high and low credit score borrowers. In addition, with delinquencies expected to maintain their low levels, near term charge-off rates should remain steady, and any deterioration in credit card performance will, at worse, be at a marginal pace.
Economic Vista: All Eyes on the Fed
Jose Sevilla, Senior Portfolio Manager
This past month indicated that U.S. job growth has been consistent, but wage growth remains flat. U.S. employers added more than 200,000 jobs for a sixth straight month in July. The 209,000 increase was followed by a 298,000 gain in June. Consumer spending, which accounts for 70 percent of GDP, climbed 0.4 percent in June after gaining 0.3 percent in May. Gains in consumption and business investment helped the U.S. economy grow 4.2 percent in the second quarter. Inflation data has been ticking up, but nothing to cause concern for the Fed.
In her Jackson Hole speech, Janet Yellen gave no indication to the direction of monetary policy. She acknowledged that “significant labor underutilization remains,” but there are some uncertainties to this assessment as she pointed out that a mix of cyclical and structural factors are at play in assessing the labor participation rate and job flows.
July FOMC minutes revealed that the Committee agreed that recent labor market gains have exceeded expectations, and conceded that recent data is moving “noticeably closer” to the committee’s long-run targets. However, Fed members recognize that growth and inflation have been gradual, although alluded to it but gave no overt signs of an earlier tightening campaign.
Trading Vista: Moving with the Headlines
Hiroshi Ikemoto, Fixed Income Trader
As stated in our main article, last month investors took on flight to quality trades as geopolitical events in Eastern Europe, the Gaza Strip and the Middle East heated up and temporally overshadowed economic data. With the weaker-than-expected job report at the start of the month, we saw a flight to quality trade to Treasuries, as expected. Benchmark 2’s tightened 6 basis points from 0.53 percent to 0.47 percent in one day. Despite generally positive economic data, including growth in the housing sector, rates compressed further as headlines of global unrest pushed more money into Treasuries as investors continued to take risk off their portfolios and the 2 year note hit a low of 0.409 percent. With no new global incidents hitting the tape towards the end of the month, investors turned their focus back to the U.S. economy with the release of the hawkish FMOC minutes and Janet Yellen’s Jackson Hole speech, both of which hinted of rate hikes coming sooner than later. This news sent yields back up with the 2-year note finishing the month at 0.49 percent.
Corporate spreads remained unchanged with financial issued bonds being traded at 20 to 40 basis points better than similar maturing Treasuries and 5 to 15 basis points for bonds being issued by industrial names. Agency spreads were also unchanged with offers about 5 basis points above similar maturing Treasuries. Treasury bills yielded in single digit basis points across the curve, as it has for quite a while now. With the combination of the U.S. economy generally improving, low inflation and global uncertainties, short-term rates should continue to trade range-bound, with the window being about 10 basis points wide.
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.