- Patience is a virtue
- Economic Vista: Off to a slow start
- Credit Vista: Weathering the storm
- Trading Vista: Flip the script
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:
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.
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.
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.
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.
|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%|
Source: Bloomberg, Silicon Valley Bank as of 1/31/19