- Navigating the pitfalls
- Credit Vista: Reigning in expectations
- Economic Vista: Art or science?
- Trading Vista: The power of patience
Jose Sevilla, Senior Portfolio Manager
Recent market volatility reminds us that it’s not easy out there. There is a wide range of risks to consider when positioning clients’ portfolios in this current cycle. For starters, how will the markets react to softness in the global economy brought on, in part, by the ongoing US-China trade war, a weakening Eurozone economy and questions surrounding a Brexit resolution? If those weren’t enough, investors are also wondering where the Federal Reserve is headed with monetary policy and what the status is with unwinding its balance sheet. Ultimately, everyone wants to know how benchmark rates will be affected. While all these issues have garnered significant attention recently, investors will have to navigate through potential pitfalls and be positioned accordingly should market dynamics shift.
Given the current macro backdrop and recent market volatility, we appear to be nearing a pivotal point in the cycle. Concerns over the global market slowdown are hovering in investors’ minds. The tit-for-tat tariff war between the US and China has disrupted manufacturing and supply chains globally, and despite a broad outline of a resolution, both sides remain far apart. German sovereign yields continue to fall due to prospects for slower growth and low inflation, despite the quantitative efforts by the European Central Bank (ECB). After peaking in 2018, global manufacturing is showing significant weakness, confirmed by a sub-50 PMI, the IHS Markit Manufacturing Purchasing Managers' Index that measures the performance of the manufacturing sector, print for the Eurozone last month. Moreover, German manufacturing levels came in well below expectations reaching their lowest level since 2012. Meanwhile, South Korean exports fell in February, providing further evidence that economic activity in East Asia has deteriorated in recent months. On the Brexit front, a lot remains up in the air on whether a timely and orderly deal can be struck. Investors are apprehensive about the possible repercussions that could affect financial markets and hinder economic stability in the Eurozone if a deal is not reached.
On the domestic front, there is also uncertainty. The Federal Open Market Committee (FOMC) left interest rates unchanged at its January meeting, and markets expect the Fed to hold rates steady in March as well. The Fed could still hike rates at least one more time in 2019, but core inflation, hovering at the Fed’s 2.0 percent target, allows the committee to be patient with additional tightening. The decision to raise rates or to hold them steady will be largely dependent on a pickup in inflation or a sustained easing of financial conditions, which hinge on a number of factors including continued job creation, trade turmoil and the global economy’s growth outlook. The January Fed minutes elaborated on their dovish shift, which reiterated that the lack of inflation was a concern, raising doubts for additional hikes this year. Also highlighted in the minutes were plans to end balance sheet tapering. Any upward pressure on yields from the balance sheet wind-down should start to cease or be priced-in during the coming quarters as the unwinding draws to a close.
So how do we position our investments at this juncture in the current market cycle? It’s important to take a balanced approach and preserve flexibility. As of now, keeping the duration relatively short and staying nimble appears to be the right strategy, given all the uncertainties and the flat yield curve. Depending on the resolution of the issues, the next move may be to extend out, though it seems to be too early to reposition portfolios. Staying flexible allows us the luxury to realign duration and asset allocation strategies accordingly, should market conditions soften. This means that staying disciplined within portfolio duration targets while maintaining a balanced allocation to high-quality credit should provide relief as we navigate through the pitfalls.
Daeyoung Choi, CFA, Credit Research Analyst
Risk assets reeled from a historic sell-off in the final quarter of 2018 amid concerns of a significant deceleration in global growth. Consequently, corporate earnings expectations also saw meaningful downward revisions after strong earnings growth in 2018. The consensus 2019 earnings estimate among Wall Street forecasters for the S&P 500 index has declined every month since last October. By the end of January, the estimate was down 6 percent from the October 2018 peak. In fact, for the first quarter of 2019, analysts are now projecting a year-over-year decline in quarterly S&P 500 earnings for the first time since the second quarter of 2016.
With the price of crude oil dropping 40 percent from a peak in October, which was the highest level since 2015, to a trough in December 2018, the energy sector led the decline with 2019 earnings estimates falling by 27 percent between October and January. Materials also saw a significant 10 percent decrease in forecasted earnings. Perhaps more surprising was the technology sector, for which analysts slashed earnings estimates by 13 percent during the same three-month span. This contrasts sharply with many of the secular tailwinds that had been propelling the tech sector higher during the current 10-year bull market run.
Looking beyond the first quarter, positive earnings growth is expected to resume, with second quarter profits projected to rise by 5 percent year-over-year. On average, analysts are projecting full-year 2019 earnings to grow by approximately 10 percent over 2018. With the Federal Reserve signaling it will be patient and likely pause its monetary tightening in light of many economic uncertainties, the corporate sector appears well-positioned to continue growing profits. In fact, earnings could surprise to the upside against the backdrop of reduced expectations this year.
Steve Johnson, CFA, Senior Portfolio Manager
Economics might be the dismal science, but economists were forced to act more like artists this past month. The delay of numerous economic releases due to the partial government shutdown has forced all of us to get creative to get an accurate pulse on the economy and gauge whether we are at risk of a further slowdown. As for the data that has been available, it’s been a mixed bag. The overall picture is a little murky at the moment, but one thing is certain: More data is coming soon.
The best news continues to be employment, which looks very strong, in spite of all the downside risk factors that could have dragged down job growth, principally the government shutdown. Nonfarm payrolls rose by 304,000 in January, beating consensus expectations by a large margin for the second month in a row. There were downward revisions to November and December, but that wasn’t nearly enough to alter the narrative of continued robust job growth.
In addition, the labor force participation rate increased one-tenth of a point to 63.2 percent, its highest rate on an unrounded basis since September of 2013. The increase in the participation rate was driven by a big jump among prime-age males (aged 25 to 54), where the participation rate rose from 89 percent to 89.4 percent, a high since June of 2010. If this move higher is sustained, it would be a significant development that would provide important support for long-term labor market growth.
Although job growth was robust, average hourly earnings were less impressive in January, rising only 0.1 percent month-over-month. But perhaps more important were the meaningful revisions to the average hourly earnings data during the fourth quarter of 2018. These revisions suggest a stronger trajectory for wage growth, and even with a softer sequential print in January, year-over-year wage growth held firm at 3.2 percent.
The encouraging employment data manifested in a stronger-than-expected rebound in consumer sentiment in February. The headline University of Michigan Consumer Sentiment Index (CSI) rose to 95.5 in February, up 4.3 points, compared to the previous month and well above consensus expectations. The rebound didn’t completely erase the 7.1-point drop in January, perhaps reflecting a lingering impact of the shutdown as well as uncertainty over a potential second shutdown. However, the report noted that the February gain reflected “a more fundamental shift in consumer expectations due to the Fed’s pause in raising interest rates.”
On the manufacturing front, the ISM Manufacturing Index unexpectedly recovered in January, rising 2.3 points to a reading of 56.6 percent from its two-year low of 54.3 percent in December. This was an upside surprise, relative to consensus expectations for a 0.3-point decline, and it confirms industrial expansion in the economy. The rebound was driven by large gains in the new orders and production indexes. New orders jumped 6.4 points, the largest month-over-month gain since 2014, while production rebounded 6.9 points to 60.5 percent, up from its lowest level since October of 2016. Other major components were softer in January.
One key piece of data that was delayed was the number of monthly retail sales, which was finally released in mid-February. Unfortunately, the number was hardly worth the wait. Total retail sales for December (the most recent month) were down 1.2 percent from the prior month, the largest drop in nine years. Excluding autos, which posted a strong gain in December, sales plummeted an even sharper 1.8 percent, the worst month-over-month reading since 2008. Meanwhile, the Personal Consumption Expenditures Price Index (PCEPI) data, the Fed’s preferred measure of inflation, was delayed until early March.
All told, the US economy grew at an annual rate of 2.6 percent during the fourth quarter of 2018, according to the initial estimates from the Bureau of Economic Analysis (BEA), which were delayed over a month. This was higher than expected, though it reflects a slowdown from the prior quarter.
Hiroshi Ikemoto, Fixed Income Trader
It’s amazing how one word can deeply influence markets. There’s no doubt that the Federal Reserve’s explicit use of the word “patience” in their last meeting pushed money market rates lower in February. The widely used 3-month London Interbank Offered Rate (LIBOR) index tightened 10 basis points (bps) to 2.64 percent as the lack of bank short-term funding needs pressured the benchmark down.
The spread between bank 6-month commercial paper and like-maturing Treasury bills was at an all-time low of 13 bps. For comparison, the spread was 50 bps back in early November of 2018, when investors were still anticipating multiple rate hikes. That has all changed as Fed Funds Futures are now showing no rate increases in 2020 and in fact, have been pricing in between a 10 percent and 30 percent chance of a rate cut at the start of 2021. This is also reflected in the inversion in the Treasury yield curve, which currently has the 12-month note at 2.55 percent, the benchmark 2-year note at 2.5 percent and the 5-year note at 2.44 percent.
In the corporate bond market, the Eurodollar Synthetic Forward Curve, the benchmark for pricing corporate bonds maturing within 13 months, has settled at 2.6 percent across the 90- to 365-day space. Credit spreads were unchanged at five to 10 bps for most high-quality names, regardless of sector. With all-in yields relatively flat in the 12-month to two-year area, we have been selectively investing in names that can generate income as well as perform during a rate-cut cycle.
In general, our duration targets remain the same, which is relatively short, but we look to extend to the higher range of the target to position accounts for the uncertainties in the direction of monetary policy this coming year. We are also turning some of our focus to Treasuries and asset-backed securities, as the announced increase in issuance should make the relative value of these securities more attractive over commercial paper, while also increasing the overall credit quality of portfolios.
|Treasury Rates:||Total Returns:|
|3-Month||2.43%||ML 3-Month Treasury||0.16%|
|6-Month||2.49%||ML 6-Month Treasury||0.16%|
|1-Year||2.54%||ML 12-Month Treasury||0.20%|
Source: Bloomberg, Silicon Valley Bank as of 2/28/19