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Observation Deck: Patience is a Virtue

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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. 

Patience is a virtue

Eric Souza, Senior Portfolio Manager

After the Federal Reserve’s December Federal Open Market Committee (FOMC) meeting, there was one word that seemed to be trending in many speeches from Fed officials: patient. So, it should be no surprise that at the January FOMC meeting, the Committee added the word “patient” to their statement saying “In light of global economic and financial developments and muted inflation pressures, the Committee will be patient.” This is not surprising, considering the Fed is constantly analyzing the economic headwinds, including the potential for slowing global growth, continuing trade turmoil, uncertainties surrounding the Brexit negotiations and the ramifications of a US government shutdown. Of course, it is wise for the Fed to be patient in order to get more clarity before acting on future rate hikes.

Still, sometimes it feels like the Fed is trying the markets’ patience, especially when it comes to interpreting comments from Fed officials. Fed-watchers (and the markets) may have gotten whiplash given the mixed messages delivered over the past several months as the Fed strives to engineer a soft landing.

For example, recent quotes from Fed Chair Powell illustrate the balance the Fed is trying to achieve between normalizing interest rates and getting ahead of the next downturn:

October 3, 2018
“We may go past neutral, but we're a long way from neutral at this point, probably.” In the Q&A section of a speech, the markets were left wondering what “a long way from neutral” really meant. The markets interpreted this as a hawkish statement, which subsequently led to a sharp decline in the S&P 500 Index of more than 10 percent. Investors were worried that the Fed would overshoot its target and implement too many rate increases, which might even push the US economy toward a recession.
November 28, 2018
Interest rates remain “just below the broad range of estimates of the level that would be neutral for the economy.” Previously Fed Chair Powell said that we were a long way away from neutral, but in November we were suddenly “just below” neutral. This caused a risk-on tone in the markets with equity indexes rallying over two percent and front-end Treasury yields rallying.
December 18, 2018
At the FOMC press conference, there was a question regarding the balance sheet normalization and whether there was any insight on what might lead the FOMC to alter its normalization of interest rates in 2019. Powell suggested the Committee’s preference to “effectively have the balance sheet runoff on automatic pilot and use monetary policy, rate policy, to adjust to incoming data.” The market was once again confused and wondered if tightening financial conditions would continue on autopilot regardless.
January 4, 2019
After the market backlash from the auto pilot comment, Powell shifted his tone again, saying the Fed “wouldn't hesitate” to tweak its balance sheet reduction if it were to cause problems. He also remarked that the Fed is “always prepared to shift the stance of policy and to shift it significantly” to achieve its dual mandate of full employment and stable prices. This is when the Fed began reiterating that “we will be patient as we watch to see how the economy evolves.”
January 10, 2019
Yet in another speech, Chairman Powell said the central bank’s balance sheet will be “substantially smaller,” thereby indicating continued, more quantitative tightening was to come, despite suggesting increased flexibility the previous week.

So, how are we to interpret all this back and forth? Most recently, it seems the Fed has been trying to correct any missteps and to reassure the market that it will remain flexible and data-dependent, especially considering all the uncertainties facing global markets. In addition to the external uncertainties, there also seems to be uncertainty around the Fed. However, the Fed tried to address these uncertainties at the January 30, 2019 FOMC meeting. In addition to adding patience to the statement, they removed language saying some further gradual increases in the Fed Funds rate may be warranted and issued a separate additional statement addressing flexibility regarding the balance sheet. Although the Fed’s last projections for 2019 rate increases (updated at the December FOMC meeting) were reduced from three to two, we anticipate the Fed will look to further reduce their projections. Since the fourth quarter of 2018, the market has been pricing in a low probability for a rate increase in 2019 and it is looking like the Fed is headed in that direction as well.

Economic Vista: Off to a slow start

Jose Sevilla, Senior Portfolio Manager

Coming into 2019, the US economy has gotten off to a slower start after several quarters of above trend real GDP growth. A host of factors, including declining global growth, ongoing trade tensions, stock market volatility, a flattening yield curve and Fed policy, are all conspiring to play defense on economic growth. A partial US government shutdown has also had a negative impact as federal workers are missing paychecks and routine services are disrupted. President Trump finally agreed to reopen the government after 35 days, but the reprieve could be temporary as the short-term spending bill only funds the government through February 15. So, while it’s back to the negotiating table for the Trump administration and Congress, there’s no denying that economic growth took a hit in January.

Isn’t it ironic that the Bureau of Economic Analysis was forced to delay the release of advance fourth-quarter GDP data due to the government shutdown? Much of the other economic data has been a mixed bag. US consumer confidence fell to its lowest levels since October 2016. The University of Michigan’s preliminary January index fell to 90.7 in the mid-January reading, versus 98.3 in December. According to the report, “the loss was due to a host of issues including the partial shutdown, impact of tariffs, financial market instability, global slowdown and lack of clarity from the Fed.” The decline in confidence could sour consumers’ future economic outlook and negatively affect 2019 spending forecasts.

On the other hand, the job picture has been more optimistic. December non-farm payrolls rose by 312,000, which was above all surveyed economists’ expectations and an increase from a revised 176,000 the month prior. Wages accelerated 3.2 percent year-over-year, more than all forecasts, and increased 0.4 percent month-over-month. Although the unemployment rate rose nominally to 3.9 percent, the increase reflects greater labor force participation as more Americans went in search of work.

Inflation also looks tame according to the most recent data. December’s Consumer Price Index (CPI) was in line with expectations and showed no risk of deviating from the Fed’s 2 percent target. For the second month in a row, core CPI rose 2.2 percent year-over-year and increased 0.2 percent from November.

Investors are keen to understand just how the Fed will interpret all this data and how it will affect monetary policy in 2019. The minutes from the December FOMC meeting revealed policymakers were more cautious on future rate increases than their initial statement indicated. The Committee was focused on recent financial market volatility, thereby calling into question the timing of future rate hikes. The members also acknowledge that given the lack of inflationary pressures, the Fed could afford to be patient and take a more gradual approach. Among other comments, the Fed writes: “In general, participants agreed that risks to the outlook appeared roughly balanced, although some noted that downside risks may have increased of late.” This seems to have assured investors that the outlook for higher rates is not preordained but instead depends on the economy performing as expected.

Credit Vista: Weathering the storm

Melina Hadiwono, CFA, Head of Credit Research

For the moment, investment grade issuers appear to have weathered the market volatility that spiked in the fourth quarter. The turmoil was marked by credit spread widening, a decline in the S&P 500 and the plunging price of oil, which fell below $50 per barrel on concerns of slowing global growth and rising geopolitical risks. Despite the market volatility and tighter financing conditions, there has been no material impact on credit ratings for investment grade companies.

Based on S&P’s report, the US investment grade downgrade potential as measured by negative bias (the percentage of ratings with negative outlook or on CreditWatch with negative implication) remained unchanged at 11 percent in the fourth quarter, versus the historical average of 16 percent. S&P expects that global credit ratings will remain stable in 2019, with the positive rating bias approaching historical averages and the negative rating bias remaining well below average, which is currently the lowest level seen in 18 years. Downgrade prospects remain very low across all regions, but volatile asset prices and tightening credit conditions remain key risks for 2019.

 

 

 

Any way you look at it, corporate fundamentals are solid. S&P 500 companies continued to retain large amounts of cash, averaging approximately 11.5 percent of total assets compared to a pre-crisis level of 5.9 percent, as of June 2008. While total debt for the index constituents has increased, the absolute amount remained 21 percent below the peak reached in the fourth quarter of 2007. The rise in debt has been offset by strong operating margins and liquidity. We continue to expect credit fundamentals to hold steady in 2019. However, deterioration in credit quality could occur if high cash balances were to lead to an increase in aggressive financial policies.

Aggregate revenue and earnings growth of the S&P 500 constituents have been exceptionally strong. Revenue and earnings expanded at over 8 and 20 percent, respectively, between the first and third quarters of 2018 with all sectors contributing. Looking ahead to fourth quarter earnings season, Bloomberg consensus estimates expect more realistic growth versus historical averages with a revenue and earnings growth of 3 and 10 percent, respectively.

Markets continue to watch for any softening in the US, as well as in Europe and China, and while this macro backdrop provides both risks and opportunities for investors, 2019 is setting up to be eventful for the capital markets. Given the confluence of exogenous factors, continued diligence in balancing duration risks, liquidity premium risks, and credit risks continues to be crucial in making prudent investment selections.

Trading Vista: Flip the script

Jason Graveley, Fixed Income Trader

Although December (and its historically challenging market) sits in the rearview mirror, many of the headwinds, not to mention the corresponding market volatility, remain fresh in investors’ minds. Investors are still grappling with the probability that US growth will moderate this year as the effects of fiscal stimulus wane and the prolonged government shutdown weighs on public spending and private consumption. Elevated global trade tensions are not helping matters either.

Responding to the perceived risks, the Federal Reserve has again emphasized data dependency when discussing the path of future interest rate increases. This more recent dovish posture has eased some investor concerns and helped major US indexes find their footing. Most indexes have managed to post year-to-date gains for January after seeing some of their worst declines since the financial crisis during the fourth quarter.

Credit spreads have also reacted in kind. After moving to their tightest levels of 2018 in September, spreads got significantly wider to close the year. Bloomberg Barclays Short-Term Credit Index spread levels, an index that tracks the performance of investment grade corporate debt maturing in less than one year, moved four times wider into year-end. However, January has flipped the script and has been a different story altogether. Spreads in the front end have grinded tighter, as the recent volatility has refocused investor attention in this space. Issuer funding conditions remain very favorable as well, with a light issuer maturity schedule expected through February. This dynamic should keep demand elevated and supply constrained, further compressing spreads and the benchmark three-month London Interbank Offered Rate (LIBOR) rate, which has dropped five basis points since the start of the year. As a result, issuer selectivity and duration management remain focal points in our investment approach, which should help us retain flexibility in our portfolios as headlines evolve.

Markets

Treasury Rates: Total Returns:
3-Month 2.38% ML 3-Month Treasury 0.20%
6-Month 2.45% ML 6-Month Treasury 0.22%
1-Year 2.54% ML 12-Month Treasury 0.26%
2-Year 2.46% S&P 500 8.01%
3-Year 2.43% Nasdaq 9.79%
5-Year 2.44%    
7-Year 2.52%    
10-Year 2.63%    

Source: Bloomberg, Silicon Valley Bank as of 1/31/19

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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. Views expressed are as of the date of these articles and subject to change. 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.

None of the material, nor its content, nor any copy of it, may be altered in any way, transmitted to, copied or distributed to any other party, without the prior express written permission of SVB Asset Management. 

SVB Asset Management is a registered investment advisor and nonbank affiliate of Silicon Valley Bank, and member of SVB Financial Group.

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About the Author

Eric Souza is a senior portfolio manager for SVB Asset Management (SAM) based in the San Francisco Bay Area, where he and his team are responsible for the overall strategy, security selection and risk management of client portfolios. With a keen eye for the macro-strategy side of portfolio management, Eric thinks globally and connects locally. Thriving on his face-to-face interactions with his clients, he meets regularly with company chief financial officers (CFOs), finance directors and treasury teams to review their portfolios and share market insights. Eric is also a valued communicator who is often asked to speak with the financial press on a range of topics and at industry conferences.

He has over 20 years of fixed income portfolio management and trading experience with both buy-side and sell-side firms. Prior to joining SVB in 2013, Eric served as head of fixed income trading for Natixis Global Asset Management, a fixed income portfolio manager and trader with Barclays Global Investors (currently Blackrock), a fixed income position trader specializing in MBS, CMOs and ABS with Schwab Capital Markets, and a trader at broker-dealer Stone & Youngberg. Eric earned his master’s degree from Saint Mary’s College of California and bachelor’s degree from California State University, Hayward. He holds the Financial Industry Regulatory Authority (FINRA) series 7 and 63 security licenses through our affiliated broker dealer.

As the child of parents who postponed their wedding for a Raiders playoff game, Eric’s zeal for the Oakland team was cemented well before his birth, and he’s been a diehard fan all his life. He’s also an avid dog lover and animal-rights supporter. When he’s not cheering on the Raiders or hanging out with his dogs, who of course have been named after legendary Raiders, he’s out playing softball and training for half marathons.
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