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

Balancing act

Renuka Kumar, CFA, Director, Portfolio Management

There has been no lack of headlines this year which has certainly kept the financial markets and the Federal Reserve on their toes. Coming off three rate hikes over the past nine months, the Fed is now trying to balance a number of themes. Optimists see the current environment as the Goldilocks economy, one that is running not too hot and not too cold, while others are interpreting the data a little more skeptically. All this makes one wonder not only what’s next in terms of monetary policy, but also how to position investment portfolios in the near-term.

The incoming economic data has offered mixed signals. On one hand we are getting a few impressive readings. GDP in the U.S. grew by 3.1 percent in the second quarter making it the fastest growth rate in over two years. Underpinning this growth was robust consumer consumption and larger gains in business investment. The labor market is also in good shape with an unemployment rate of 4.2 percent, matching pre-recession lows. In spite of this, we have yet to see any meaningful wage pressure, which correlates to the soft inflationary data we have been witnessing. Core PCE, the Fed’s preferred inflation measure, has dropped every month this year. The current year-over-year reading of 1.3 percent is well below where it was back in January at 1.89 percent. Given the Fed’s 2 percent objective, inflation is far from running too hot.

Fiscal policy this year has been underwhelming, and there has not been any new meaningful legislation to boost growth as many had hoped. The latest push for fiscal stimulus, the long-awaited tax plan, has been put into motion and has sent equities and interest rates higher for the time being. Of course, the details and whether this proposed framework becomes law remains to be seen.

Further muddying the waters have been rising geopolitical tensions and the effects from the recent hurricanes. All this makes it clear that the Fed needs to strike the right balance with regard to monetary policy. In the latest Federal Open Market Committee meeting, members acknowledged that the recent hurricanes will likely boost inflation temporarily and otherwise distort some growth metrics in upcoming data releases. Nonetheless, Fed Chair Janet Yellen seems to be committed to normalizing monetary policy through gradual rate hikes and unwinding some of the Fed’s unprecedented $4.5 trillion balance sheet. This past month, the Fed announced that its plan to begin shrinking the balance sheet by $10 billion each month will commence in October. Given the well-telegraphed message and very gradual pace of unwinding, this did little to move markets. Markets have been more focused on future rate hike projections, which now imply one additional rate hike in 2017 and three more in 2018. For investment portfolios, we are committed to maintaining our target durations while taking advantage of attractive rates in the front end and being selective on the longer-end.

Markets
Treasury Rates  
 
Total Returns:  
3-Month 1.04%
 
ML 3-Month Treasury 0.09%
6-Month 1.19%
 
ML 6-Month Treasury 0.07%
1-Year 1.29%
 
ML 12-Month Treasury 0.02%
2-Year 1.48%
 
S&P 500 2.06%
3-Year 1.62%
 
Nasdaq 1.11%
5-Year 1.94%
 

 

 
7-Year 2.17%
 

 

 
10-Year 2.33%
 

 

 

Source: Bloomberg, Silicon Valley Bank as of 09/29/17 

Credit Vista: A whirlwind for P&C insurers, surviving the storms

Melina Hadiwono, CFA, Head of Credit Research

Hurricane season has been relentless in 2017. According to AIR Worldwide, a catastrophe modeling consulting service, this season marked the first time ever that two Category 4 or higher hurricanes came at the same time. Hurricane Irma also broke another record as the most intense tropical cyclone ever in the Atlantic Basin with 185 mph winds for 37 consecutive hours. It is also the first time ever that the U.S. has been hit by two major (Category 3 or higher) hurricanes in quick succession. All these records are noteworthy considering that the mainland U.S. had not been hit by a major hurricane in almost 11 years before this season. Such intense and record-breaking hurricane activity not only takes a heavy humanitarian toll, but also has ramifications for the insurance industry. How are property and casualty insurance companies holding up after the storms?

While total economic damages are expected to be among the costliest in U.S. history, the actual insured losses are expected to be lower. Many large Property & Casualty (P&C) insurance companies have limited exposure to Florida having largely exited this market. In fact, most U.S. homeowners are not insured against floods unless they live in a flood zone, in which case they often obtain coverage from a division of FEMA. Commercial flood coverage is optional and often subject to higher deductibles. Fitch estimates catastrophic losses for global insurance and reinsurance sectors could reach close to $190 billion on a pretax basis, which would be the highest on record in a single year. Nevertheless, we believe these estimates remain manageable compared to total statutory capital surplus of $700 billion for the P&C sector and $600 billion for reinsurance sector. It will take some time to fully determine the magnitude of insured damages, which generally peak in third quarter.

Many large P&C insurers with exposure to impacted regions are expected to incur meaningful losses, though they should be manageable relative to earnings. Catastrophic losses are part of the business risk and are inherent in the industry, and thus many of the large P&C Insurers have positioned themselves strongly over last decade. Many of the large P&C insurers appear to have capacity to absorb such losses based on strong capital bases, thanks to over a decade of benign catastrophic events, geographic diversification, adherence to strong risk management, and measured coastal exposure. Additionally, many large insurers have extensive re-insurance arrangements that may help absorb losses. Downward pricing pressure in the reinsurance sector, driven by increasing competition from alternative capital sources, has led to favorable reinsurance terms for most large P&C insurers in recent years. Nevertheless, some regional and local insurers may find themselves under stress depending on their exposures. As always, we continue to monitor the industry closely.

Economic Vista: Mixed signals

Paula Solanes, Senior Portfolio Manager

While some of the third quarter economic data has been relatively soft, especially compared to the previous quarters, we have seen occasional bright spots in the data. Looking out toward year-end, the Federal Reserve will be closely watching the numbers to determine if the soft data we have been seeing is temporary or if the outlook still supports the presumed final rate hike of the year. Moreover, this year’s catastrophic hurricanes may be a temporary drag on economic activity in the near-term, but we believe they are likely to boost growth in subsequent quarters as rebuilding efforts ramp up.

The employment data for September showed some signs of distortion due to the hurricanes, however the labor market continues to remain healthy. Payrolls fell by 33,000, the first decline in seven years. The drop in payrolls is considered temporary and was due to a reduction by more than 100,000 in the restaurant sector in addition to 1.5 million people that could not work due to extreme weather conditions. Average hourly earnings also reflected the effect of the storms by jumping 2.9 percent as more overtime was required from some workers and lower wage workers were dislocated. On a more positive note, the prior month was revised upwards to 2.7 percent from 2.5 percent. Finally, the unemployment rate fell to a 16-year low of 4.2 percent and the participation rate picked up to 63.1 percent.

The housing market also reported weaker than forecasted data. Housing starts declined by 4.8 percent, existing homes sales decreased by 1.7 percent, and new home sales fell 3.4 percent. Some of the decline can be attributed to Hurricanes Harvey and Irma, while the balance of the disappointing data reflects a combination of higher prices and supply/demand dynamics.

On a more positive note, home prices increased by 0.4 percent reflecting reduced inventory. Expectations for higher mortgage rates could cause a slowdown in demand; however, given the relatively lean inventory, home prices should continue to increase at a modest pace.

Retail sales declined slightly on a month-over-month basis, but excluding autos, retail sales actually increased 0.2 percent. Five out of 13 major retail categories reported declines in August. Gains in areas such as gasoline, food and drink were offset by decreases in apparel, electronics and autos. While the hurricanes were a partial culprit in the weak retail numbers, the prior two months were revised downward as well.

The latest estimate for second quarter GDP was 3.1 percent, stronger than the preliminary two estimates and the best reading since 2015. This also reflects a significant improvement over the 1.2 percent GDP during the first quarter. Growth was bolstered by greater investment in private inventories, increases in personal consumption expenditures and federal spending, and a deceleration in imports. Partially offsetting the gains were declines in residential fixed investment, exports, and reduced spending by state and local governments.

The Fed’s preferred inflation reading, core personal consumption expenditures, came in below expectations at 1.3 percent. Despite the lower reading, the Fed continues to view the low inflation figure as transitory and likely to be closer to its preferred target of 2.0 percent in the medium term. In the September FOMC meeting, the Fed decided to keep rates unchanged at 1 to1.25 percent; however, guidance from the meeting still suggests one additional quarter-point interest rate increase before year-end. For now the current soft patch of data does not seem to have altered the Fed’s trajectory.

Trading Vista: Back in the swing

Jason Graveley, Trader

With summer in the rearview mirror, markets are back in full swing. August, which has been traditionally known for its light volumes and slow pace, gave way to a more active September. Markets continue to digest the mix of fiscal and monetary policy headlines, as well as the continuous flow of domestic economic data. The verdict: equity indexes have responded with a fresh set of all-time highs, while front-end Treasury yields have hit some of their highest levels in close to a decade.

On the monetary policy front, the September Federal Open Market Committee confirmed that the Federal Reserve will begin to shrink its portfolio by allowing $6 billion of Treasuries and $4 billion of mortgage-backed securities to mature each month without reinvesting the proceeds. In a separate address, Fed Chair Janet Yellen reiterated the view that the central bank expects to remain on a gradual interest-rate increasing path despite inflation remaining below its 2 percent target rate. Two-year Treasury yields, considered to be the most sensitive to shifts in monetary policy, have increased over 15 basis points in the last month alone, breaking out of the range-bound levels that we saw over the past several months. These are its highest levels since 2008, which marked the beginning of the Fed's quantitative easing program.

Given rising Treasury yields, as well as the expectation of rates moving directionally higher, Treasuries have continued to be an investment focus, representing close to 30 percent of all trading in September. Moreover, Fed funds futures are pricing in more than a 75 percent chance of an additional 2017 rate hike, which compares to a less than a 40 percent probability just one month ago. Despite the broad emphasis, we have limited our exposure to December 2017 Treasuries to mitigate short-term interest-rate risk. This allows us to navigate through any legislative uncertainty (and risks) associated with the temporary debt ceiling relief, reducing overall portfolio volatility.



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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.

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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About the Author

Renuka Kumar is a Director, Portfolio Management at SVB Asset Management, and has over twelve years of experience in banking and financial services. Prior to joining SVB Asset Management, Kumar worked in the Treasury division of SVB Financial Group performing financial modeling and managing the interest rate risk position of the company. Her experience also includes interest rate risk management at Flagstar Bancorp in Troy, MI.

Kumar earned her undergraduate degree in Finance from Michigan State University and also holds the Chartered Financial Analyst (CFA) designation.
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