- 2019: The year of the Fed pivot
- Economic Vista: Humming along
- Credit Vista: Smartphones are smart collateral
- Trading Vista: Headlines in the driver seat
Eric Souza, Senior Portfolio ManagerWhen looking back at the market events of 2019, it was largely dominated by the Federal Reserve and its responsiveness to trade policy. Coming off the famous pivot from year-end 2018 and after standing pat for much of 2019, the Fed finally began cutting rates. Ultimately, the Fed lowered its benchmark funds rate by a total of 75 basis points (bps) from July through October before pausing in December. Not surprisingly, risk assets have cheered the Fed moves, and markets rallied.
The Fed’s new direction became clear in early January when Fed Chair Jerome Powell was on a panel discussion with his two predecessors Janet Yellen and Ben Bernanke. Powell stated the Fed would be “patient” and take a watch-and-see approach on the economy, while claiming the committee “wouldn’t hesitate to make a change” on balance sheet normalization. This statement came just two weeks after the December Federal Open Market Committee (FOMC) meeting where the Fed raised rates for the fourth time in 2018 and said that balance sheet normalization (i.e., reduction) was “on auto pilot.” Indeed, this was quite the pivot.
This pivot was a result of the Fed acknowledging their hike in December was probably ill timed considering the volatility witnessed in the fourth quarter of 2018 from concerns regarding slowing global growth and equity markets selling off with the S&P falling 11 percent from the highs reached in October 2018.
Two weeks later at the January FOMC meeting, the tone turned downright dovish, as the official statement dropped the “further gradual increases” and added that the Committee would be “patient as it determines what future adjustments” are needed to the Fed Funds rate. Still, both the Fed and the market were pricing in potential rate hikes. The March FOMC confirmed the shifting policy, as the Fed reduced its expectation for 2019 rate hikes from two to zero. Although this was just a pause, the lack of any increase was, in effect, more dovish than the market was expecting. Remember, just a few months earlier the Fed was factoring in three rate hikes in 2019.
May marked the next pivotal moment. Although at the May FOMC meeting, Fed Chair Powell sounded a bit hawkish, stating that he didn’t see a strong case for a move in either direction, it was President Trump’s May 5 weekend tweet about new China tariffs that surprised markets, which had been factoring in an imminent US-China trade deal. At the May FOMC meeting, the market was pricing around a 50 percent probability of a rate cut by December 2019 or January 2020. By the beginning of June, however, the tone from Fed speakers had shifted undeniably. By the June FOMC meeting, Powell admitted the FOMC made significant changes to its statement and that “many FOMC participants now see that the case for somewhat more accommodative policy has strengthened.”
This set the stage for the July meeting when the FOMC cut rates by 25 bps for the first time since December 2008. Fed Chair Powell cited three main reasons for the cut:
- To ensure against downside risks from weak global growth
- To combat trade policy uncertainty
- To boost inflation to the symmetric 2.0 percent objective
At the October FOMC meeting, the Fed reemphasized the view that these cuts are not the beginning of a long cutting cycle and hinting toward a pause by dropping its “act as appropriate to sustain the expansion” language, while adding a promise to monitor data as it “assesses the appropriate path of the target range for the federal funds rate.” Fed Chair Powell added that it would take a “material reassessment of our outlook” to adjust policy again. The market has responded and is now pricing in no cuts until the end of 2020.
In addition to the Fed adjusting the course of monetary policy throughout the year, they also had to intervene in the plumbing of funding markets in the latter part of the year. In mid-September there were significant yield fluctuations in the repurchase agreement (repo) market due to a variety of supply and demand factors, namely: corporate tax payments, increased Treasury bill supply and the settlement of recent Treasury auctions. In addition, newer banking regulations exacerbated the impact of these temporary supply/demand dislocations. Ultimately, the Fed stepped in by directly injecting liquidity into the financial markets through its own repo program. Then in October, the Fed announced they would begin buying $60 billion of Treasury bills each month to help maintain order in these short-term funding markets. This announcement had an immediate effect on the yield curve, with a steepening of the curve, reversing the 3-month vs. 10-year spread, which had been inverted for the better part of the year.
Indeed, the Fed was the story of 2019, and without question the markets cheered its various actions and pivot to a more accommodative policy. Almost every asset class has rallied this year. Within fixed income, investment grade and high-yield credit indexes outperformed, returning more than 12 and 11 percent, respectively. Meanwhile, equity indexes also powered ahead, reaching new all-time highs. And the S&P 500 Index returned approximately 25 percent through the end of November.
Where does the Fed go from here? In 2020, we believe that the Fed is likely to remain on hold for at least the first quarter and possibly through the first half of 2020. Yields should be range-bound, and we are still not forecasting a recession here in the US. However, this outlook is very much dependent upon progress with the US-China trade talks, whether the scheduled December 15 tariffs are actually implemented or not, and how geopolitical events such as Brexit are resolved, among other factors related to the general health of the US economy. If a phase-one trade deal between the US and China is signed and fears of slowing global growth continue to abate, business sentiment should improve. In turn, this should lead to increased spending and maintain the risk-on tone for markets. If a trade deal continues to be delayed or if there is an outright no-deal, we may see a risk-off tone adopted by investors, placing further rate cuts by the Fed back in play.
Within SVB Asset Management, portfolio diversification remains a key priority, and we continue to analyze sector, subsector, issuer and maturity distributions as we build and maintain portfolios. This diversification is paramount, considering all of the uncertainties that could affect markets in 2020. As ever, we strive to position our client portfolios to thrive, no matter how the coming year unfolds.
Paula Solanes, Senior Portfolio Manager
It appears that the Federal Reserve’s recent “insurance” interest rate cuts are performing as intended, sustaining the economic expansion and insulating against downside risks. The most recent data shows the economy is weathering the effects of an uncertain trade policy, and, simply put, it continues humming along.
Despite the GM strike in October, the November payroll release continues to show a tight labor market with the US economy adding another 128,000 jobs, which beats the expectations for a more modest 85,000 new jobs. In addition, payroll numbers for the prior two months were revised upward by 95,000. The unemployment rate crept up slightly to 3.6 percent, but this is not alarming, since the labor participation rate increased to 63.3 percent. Finally, year-over-year rate of growth in wages was just 3.0 percent in October, eliminating any notion that it is translating into inflation pressure.
The most recent Institute for Supply Management (ISM) data was also encouraging. The ISM non-manufacturing index increased to 54.7 and exceeded expectations, as the service side of the US economy powers on. On the other hand, the ISM manufacturing index improved modestly over the prior month at 48.3 but still missed expectations of 48.9. Any reading under 50 indicates contraction, and the fact that manufacturing remains weak is not surprising, given the challenges of the current trade turmoil.
Reflecting on growth, Q3 GDP increased slightly to 2.1 percent due to a higher build-up in inventories than initially estimated as companies attempted to manage around the uncertainties created by trade policy. Slightly better structure investment was offset by lower contributions from intellectual property and government spending.
Subdued inflation persists as month-over-month headline consumer price index (CPI) increased a modest 0.40 percent while core CPI (excluding more volatile food and gas components) increased only 0.20 percent. On a year-over-year basis, headline CPI increased to 1.8 percent, while core CPI fell nominally to 2.3 percent. Prices for apparel and electronics were down; however, higher medical care and used vehicle prices offset the drop. Core personal consumption expenditure (PCE), the Fed’s preferred measure, fell slightly to 1.6 percent, making the Fed’s 2 percent target even more elusive.
Consumer spending also remains steady, as retail sales increased 0.30 percent and surpassed expectations. Excluding auto sales, retail sales were up a more modest 0.20 percent, while the retail sales control group was in line with expectations, rising 0.30 percent.
On the housing front, existing home sales increased to 5.46 million, which is slightly below expectations but still up 1.9 percent month-over-month. Housing starts increased 3.8 percent, while building permits jumped to a decade-high of 5.0 percent. Overall, the housing market has been bolstered by a tight labor market and low mortgage rates.
So how is the Fed interpreting the most recent economic data? The FOMC minutes from the October meeting revealed that most members believe current monetary policy has been appropriate and that there would have to be a “material reassessment” to the economic outlook to warrant another rate cut. There was discussion around various monetary policy tools, such as forward guidance, balance sheet policies and negative interest rates, with the committee favoring the first two tools over negative interest rates. The committee mentioned that while negative rates have been successful in other central bank regions, they also carry potential adverse effects. In contrast, forward guidance and balance sheet recalibration have proven successful in the US in the past. In the end, we believe there is likely to be a pause before there is another move in either direction.
Tim Lee, CFA, Senior Risk & Research Officer
In 2019, the average smartphone user will check his or her device 63 times a day and spend an average of 171 minutes per day on the phone. That user will tap, swipe and click an average of 2,617 times within a 24-hour period, according to statistics from bankmycell.com. There’s no denying that we’re having a downright love affair with our smartphones. In fact, approximately one-third of all Americans claim they can’t eat without being on their device, according to Nutrisystem. Smartphone love apparently also spans generations, as a study by Provision Living revealed that millennials and baby boomers spend comparable time on their devices each day. All this quality time with our smartphones suggests consumers will do everything possible to make their monthly payments, even if they become unemployed or economic conditions weaken.
Most consumers purchase their smartphones at full retail price, as opposed to receiving a free or significantly subsidized phone, which was common practice five to ten years ago when wireless carriers locked their customers into service contracts. Today, many carriers sell their customers smartphones via an interest-free installment payment plan, typically over a 24-month period. Carriers first purchase these phones from Apple, Samsung and other manufacturers, and while they allow customers to pay for their phones over an extended period, the carrier must pay the phone manufacturers in full up front. To finance this difference in cash flow, some carriers have turned to the asset-backed securities (ABS) market to securitize their device payment plans (DPPs).
Fixed-income investors in these smartphone-backed securities receive their interest and principal from the monthly payments made by smartphone owners. The installment payment is normally bundled into the monthly service bill that a wireless customer receives, which essentially ties the phone to the data and calling plan. According to data from an October 2019 Verizon Wireless securitization of DPPs, obligors had an average FICO score above 700, and a majority already had a five-plus year history of successfully making monthly wireless payments. Nearly 75 percent of these obligors also pay their bill automatically through a credit or debit card, or other electronic method. Also, adding to the likelihood of on-time payments is the relatively low monthly payment amount of approximately $30.
So, what does all this mean for investors in these asset-backed securities? Consumers in love with their devices are willing to do all they can to keep their hands on their smartphones. Thus, from our vantage point, smartphone consumers have been, and will continue to be, a very reliable collateral source for bond investors.
Jason Graveley, Fixed Income Trader
It’s all about the news these days, and investors had better be paying attention. It appears that bond market movements have become less correlated to the typical economic and corporate indicators — like inflation, labor statistics and earnings — than we have come to expect. And although these metrics obviously influence changes to market sentiment, the real market-mover these days is the news. It’s a headline-driven market, whether it’s a Federal Reserve speech, a Presidential tweet or some other indication of a pending trade deal.
With equities touching new highs on the back of a renewed optimism in just such a trade deal, the prospect of stalling negotiations has left bond yields range-bound. For every positive or negative headline that we see, regardless of substance, the market reacts in-kind. Benchmark yields move higher, as Treasuries sell off and a risk-on tone returns. Conversely, benchmark yields drop, as investors flock to “safe-haven” assets on a more negatively skewed narrative. Right now, we remain cautiously optimistic.
Determining what investors should expect going forward is difficult. We have seen trade negotiations taken to the cusp of a deal, only for things to deteriorate abruptly. And with the increasing expectations that the Federal Reserve will remain quiet on monetary policy, all eyes are now focused on the negotiations and possibility of a meaningful and lasting agreement. This will be especially important as economic growth projections are likely to take center stage ahead of the 2020 presidential election. From our perspective, we continue to maintain a neutral duration stance for our longer benchmarked portfolios, which provides us with the flexibility to take advantage of any shifts in market sentiment. As we’ve seen, these shifts can happen at any time. And although we are anticipating certain underlying market dynamics that will affect bond yields, such as less expected investible bond supply in 2020, it’s likely that trade headlines will remain in focus for the near future. So, don’t cancel that newspaper subscription just yet.
|Treasury Rates:||Total Returns:|
|3-Month||1.57%||ML 3-Month Treasury||0.11%|
|6-Month||1.60%||ML 6-Month Treasury||0.09%|
|1-Year||1.59%||ML 12-Month Treasury||0.06%|
Source: Bloomberg, Silicon Valley Bank as of 11/30/19