SVB Asset Management's monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy.
- Positioned well for volatile markets
- Economic Vista: Economy shrugs off market volatility
- Credit Vista: From tailwind to headwind
- Trading Vista: Ignore the headlines
Positioned well for volatile markets
Eric Souza, Senior Portfolio Manager
Given the number of questions I get from non-market participants (including family, friends and even my softball teammates), everyone is well aware of, and maybe even a little unsettled about, the recent equity market volatility that has been ongoing since the beginning of the fourth quarter. This prompted us to step back and ask: Is this something that might portend a recession? While the current environment bears close watching, we aren’t too concerned about the economy. Moreover, having a disciplined investment process helps us manage risk and position our portfolios for volatile markets.
Looking back, it’s interesting that corporate bond spreads initially were not affected by the market turmoil. Within the first few weeks of October, the S&P 500 Index was down more than 6 percent, while corporate bond spreads were little changed. The Bloomberg Barclays U.S. Credit Bond Index, which covers 1- to 30-year bonds, was 3 basis points (bps) wider, while the Bloomberg Barclays U.S. 1-3 Year Credit Bond Index was only 1 basis point wider. In fact, the Barclays Short-Term U.S. Credit Index was actually 1 basis point tighter.
But then things started to get more interesting. By the end of October, credit spreads began to widen further, which should not have been much of a surprise given that corporate bond spreads typically follow the movement of the equity market (as opposed to Treasury yields, which are typically inversely correlated to stocks). As of 11/30/18, The Bloomberg Barclays Credit Index has widened 29 bps since the end of September, 23 bps for the 1-3 Year Credit Index and 29 bps for the Short-Term (1 year and less). Meanwhile, the S&P improved at the end of November. It was down more than 9 percent heading into the last week of November; then rallied to close down just over 5 percent or 154 bps.
There have been many possible culprits for the recent sell off in risk-assets. These include: Fed tightening, worries about global growth, increasing trade tensions, Brexit uncertainty and the declining price of oil. Despite the perceived headwinds, we do not view the recent spread widening as a significant deterioration of economic fundamentals. Rather, we continue to be comfortable investing in credits on two fronts:
- Fundamentals: Since we have a highly selective approved issuer list of only 120 issuers out of an investment grade universe of more than 3,000, we have in-depth knowledge on the fundaments of every credit. Thus, we can actively monitor risk on a bond-by-bond basis. This ability to dive deep into each issuer, in addition to the ongoing surveillance we maintain, gives us confidence in the credit quality of the names in which we invest.
- Curve Positioning: One of our current investment themes is being defensive on duration in light of the Fed’s plan to continue raising rates gradually. Concentrating on front-end bonds gives us portfolio flexibility if markets change quickly and we want to shift our sector allocations.
Looking ahead, we expect to get more input on monetary policy from the Fed at their December Federal Open Market Committee (FOMC) meeting. The market is expecting the Fed to possibly reduce the number of 2019 Fed Fund rate increases due to the recent dovish tone from Fed Chair Jerome Powell. In addition, we received some positive news on the US and China trade negotiations with a 90-day delay in the planned tariff increase on Chinese goods. These recent events should be positive for risk assets heading into year end. However, we have positioned our clients’ portfolios to benefit in a variety of outcomes from a continued rising rate environment or if credit spreads widen further. We remain comfortable in this environment given our disciplined investment process and current market outlook.
Economic Vista: Economy shrugs off market volatility
Steve Johnson, CFA, Senior Portfolio Manager
Despite the renewed market volatility and an array of potential headwinds – including rising interest rates, ongoing trade tensions and various geopolitical hotspots – the US economy appears unfazed. The recent data points that most pundits tend to watch have been largely encouraging. Perhaps not as strong as in recent months, but there is little debate that the domestic economy appears healthy even in the face of higher equity market volatility.
Certainly that must have been the conclusion of the Federal Reserve. The FOMC left rates unchanged at its most recent meeting but reiterated the need for further gradual rate increases in its target range. Moreover, the FOMC’s commentary proved to be a very short statement with no surprises, thereby quietly illustrating the underlying confidence it has in the economy.
Headlining the recent data was the October non-farm payroll employment report, which showed that employment rose by 250,000 while the unemployment rate was unchanged at 3.7 percent. Notably, average hourly earnings increased 3.1 percent year-over-year after having been stuck around 2 percent for most of this long economic expansion. In particular, the renewed wage growth underscores the strength of the recent jobs data.
The University of Michigan Final Consumer Sentiment for November came in at 97.5, which is slightly lower than consensus expectations and down from October’s data. Although this marked the second consecutive monthly decline, it’s important to remember that this index continues to hover at elevated levels near the 14-year high it achieved in March. Similarly, the Conference Board’s index of consumer confidence also edged slightly lower in November, albeit from the 18-year high hit in October, but remains at historically strong levels consistent with very solid consumer sentiment.
Another bit of good news was a surprising surge in retail sales, which increased 0.8 percent in October, compared to consensus expectations for just 0.5 percent growth. This reverses a trend of declines in recent months. Excluding autos, sales were up 0.7 percent and driven by a strong gain in sales at gasoline stations. Although this can sometimes undermine spending in other segments of the economy, gas prices have recently retreated. Lower gas prices, coupled with the strong labor trends, should bode well for robust holiday spending in the weeks ahead.
If there was any area of concern, economists might point to durable goods. The U.S. Department of Commerce reported that spending on durable goods declined by 4.4 percent in October. This was softer data than expected, and the September figures were also revised downward. This report might suggest that business investment activity was restrained at the start of fourth quarter, after investment rose just 0.8 percent annualized in the third quarter and equipment investment rose just 0.4 percent, also annualized.
From a manufacturing perspective, the data was also slightly less robust. Markit Manufacturing Purchasing Managers’ Index (PMI) fell slightly to 55.4 in November, which was below both expectations and recent monthly readings. In addition, the first two regional Federal Reserve manufacturing surveys for the month of November were mixed. Empire Manufacturing rose 2.2 points to 23.3, while the Philly Fed survey fell 9.3 points, to 12.9. Nevertheless, the underlying details were generally constructive in both surveys, and positive indications were seen in forward-looking capital expenditure readings.
So how has all this activity manifested itself in inflation and GDP readings? Headline Consumer Price Index (CPI) increased 0.3 percent in October and 2.5 percent year-over-year. Although the October reading is slightly higher than recent months, it was within consensus estimates. In addition, core CPI (which excludes the more volatile components of food and energy) was up approximately 2.1 percent year-over-year. This is only nominally higher than the Fed’s stated 2.0-percent target.
Meanwhile, the revised second estimate of third quarter GDP showed the US economy grew at a rate of 3.5 percent annually, which is in line with the first reading in October. The report confirms the health of the economy, and it is not likely to change the Fed’s trajectory of interest rate increases. So while market turmoil has returned to the equity market late in the year, it appears that the US economy, to this point, has taken little notice.
Credit Vista: From tailwind to headwind
Daeyoung Choi, CFA, Credit Research Analyst
After a sustained decline throughout 2017, the US dollar has made a strong comeback in 2018. Measured against a basket of currencies from major US trading partners, the nominal (unadjusted for inflation) value of the so-called “trade-weighted US dollar index” has gained 8.5 percent this year and is hovering near an all-time high. Weaknesses in a number of emerging market countries, such as Argentina, Turkey, Brazil, Russia and India, have contributed to the dollar’s strength, so has the continued normalization of the US monetary policy.
Fluctuations in foreign exchange rates pose a thorny issue as they affect various constituents differently. A strengthening US dollar, for example, increases the greenback’s purchasing power of goods and services produced overseas and priced in foreign currencies. This is generally good for US consumers who can then benefit from strong purchasing power. On the other hand, a rising US dollar hurts US-based multinational companies that earn significant revenues overseas in foreign currencies, especially if the majority of that company’s cost center is located in the US with expenses paid in US dollars.
Compared against significant foreign exchange-related benefits that multinational companies saw in 2017, the reversal of the dollar’s trend in 2018 caught some companies off guard, and has turned what used to be a tailwind into a headwind. The following are what some of the largest US corporations have said about the dollar strength in their latest earnings release conference calls:
- Apple: “We expect almost $2 billion of foreign exchange headwinds” in the December quarter.
- Microsoft: Foreign exchange will be “a 1-point headwind to full-year revenue growth.”
- Proctor & Gamble: “The foreign exchange headwind on earnings increased by $400 million after tax, $900 million in total for the fiscal year” and “forward currency rates imply pretty significant headwinds again in 2019.”
- Kimberly-Clark: “Foreign currencies were also a sizable headwind in the quarter, reducing operating profit by a high single-digit rate.”
- Coca-Cola: Experienced a “significantly stronger currency headwinds than we anticipated at the beginning of 2018.”
- Pepsi: “We expect foreign exchange translation to negatively impact both net revenue and operating profit by approximately 3 percentage points in the fourth quarter.”
Is the US dollar peaking or does it have more room to run? Nobody knows for certain, which simply highlights the need for investors to keep abreast of the fluctuations, especially when analyzing and determining the value proposition of individual credits.
Trading Vista: Ignore the headlines
Jason Graveley, Fixed Income Trader
Sometimes it’s best to tune out the news. Consider some of the popular doomsday narratives: A new era of tariffs and trade wars will derail globalization and slow global growth here and abroad; the Fed will go too far with its monetary tightening, invert the yield (2s10s Treasury) curve, and push the economy into recession. These provocative narratives might provide good fodder for debate on TV, but they simply ignore what’s really important—the underlying domestic economic indicators. Right now, there’s nothing to suggest any immediate deceleration in economic activity. Fourth quarter growth is still tracking near 2.5 percent, unemployment is hovering at just 3.7 percent, robust job growth continues and inflation readings are coming in near consensus expectations. By all appearances, the US economy remains on solid footing.
Nevertheless, recent market volatility cannot be ignored. US equity markets have struggled to find firm footing, and investment grade credit spreads have widened in recent months. The Bloomberg Barclays Short-Term Credit Index, an index that tracks the performance of investment grade corporate debt maturing in less than one year, has widened more than 30 bps from its tightest levels in September. LIBOR, the London Interbank Offered Rate, has recently reached a decade high thanks to general market volatility and foreign bank funding. Overall, yields are rising and investors are taking notice.
In credit markets, we have started to see the signs of seasonality as year-end is fast approaching. Dealers have already begun looking to reduce their balance sheets, which has put further pressure on widening spreads. This was expected, although the timing of the move has trended more into November and away from mid-December. With general market volatility pushing investors to the sideline, we have seen less demand in our space. In this environment, we are keeping a close eye on the economic outlook and we remain defensive on duration to maintain flexibility, while stressing selectivity as the market swings. The volatility creates pricing dislocations and other potential trading opportunities. And with the Fed widely expected to hike rates again in December, we don’t believe our approach will change in the coming months, even with a possible Santa Claus rally in the markets.
|Treasury Rates:||Total Returns:|
|3-Month||2.34%||ML 3-Month Treasury||0.21%|
|6-Month||2.52%||ML 6-Month Treasury||0.21%|
|1-Year||2.68%||ML 12-Month Treasury||0.21%|
Source: Bloomberg, Silicon Valley Bank as of 11/30/18