- Economic Vista: See you after the elections
- Credit Vista: Financial Sector — Calm waters ahead?
- Trading Vista: Repos — It's all good
- US markets posted impressive returns in 2019, thanks in part to accommodative monetary policy.
- While we gained some clarity on trade policy and Brexit late in the year, these issues — along with the US elections — have the potential to boost volatility again in 2020.
- We expect that rates will be range bound for a good portion of 2020, as inflation remains contained and unemployment hovers near historic lows.
Turning the page on 2019
Paula Solanes, Senior Portfolio Manager
After what could only be characterized as a year fueled by accommodative monetary policy and a steady dose of market-moving geopolitical events, it’s time to turn the page on 2019. It certainly was a good year for US equities, with many of the major indexes closing at, or near, all-time highs. The Dow, S&P 500 and Nasdaq all registered eye-popping returns of approximately 22, 29 and 35 percent, respectively.
Meanwhile, the bond market also had an interesting ride and even spooked investors with a short-lived inversion. The Treasury yield curve ended the year approximately 65–105 basis points (bps) lower, depending on the point on the curve. This reflected easing monetary policy as well as ongoing demand for US paper, as it provided the most attractive value relative to many global bonds, some of which now offer negative yields.
|Level (%)||2019 1-Year Change (%)||% Change|
Source: Bloomberg, SVB Asset Management as of 12/31/2019
As we move into 2020, we will no doubt continue to experience significant market-moving events. However, two of the more recent drivers of market volatility — trade negotiations and Brexit — appear to be progressing toward some sort of resolution, while the US presidential election may eventually take their place as the chief culprit in creating economic waves.
In terms of trade policy, a “Phase One” trade deal was announced on December 13, which scuttled the next round of tariff increases that were scheduled to be implemented mid-December. In addition, the new deal agreed to halve the tariffs that were implemented back in September on $120 billion of Chinese imports. While “Phase One” was a step in the right direction, some of the more significant details of the trade negotiations are still in question and will continue to weigh on US–China relations and, presumably, the markets.
Toward the end of the year, the United States-Mexico-Canada Agreement (USMCA) passed the House, which was a significant step forward after almost a year of little progress. USMCA replaces the North American Free Trade Agreement (NAFTA), which is more than 25 years old, adding new markets and modernizing the prior agreement to incorporate technological advances. This is expected to be mutually beneficial for the US, Canada and Mexico, creating a more streamlined, equitable and growth-promoting environment.
Capital expenditures and manufacturing were areas most affected by uncertain trade policy in 2019, while the sequential rate cuts by the Federal Reserve served as a counterbalance to support growth amid escalating tensions. Despite the recent progress, trade will continue to be a recurring theme through 2020, affecting both business investment and capital expenditures, and it’s likely to be used as a political tool as well. On the bright side, the US consumer remains on firm footing and likely will continue to support growth, albeit at a slightly slower pace. Ultimately, however, if there is a clear and long-term resolution on the trade front, it will be constructive for domestic and global economic growth.
Just as the trade news turned positive late in the year, the markets also cheered Brexit developments. On December 12, Boris Johnson, the Conservative Party candidate, was elected the new British prime minister. Prime Minister Johnson is focused on a tight Brexit schedule with a January 31, 2020, deadline. This is scheduled to mark Britain’s withdrawal from the European Union, but it remains to be seen how the separation will work from a practical standpoint. It will be interesting to see if looming deadlines will be met and what the ultimate impact will be on trade and growth.
The markets may have been focused on British elections late in 2019, but they will turn their attention to the upcoming US election in 2020. This is likely to create additional uncertainty, given the diverse group of candidates, policies and priorities. Consumers, corporations and investors will be monitoring the potential outcome of the election and how policies may change in its wake. As ever, there will be a protracted period between when new policies are proposed and when they are passed and enacted. It’s also important to remember that the final outcome may vary widely from what is proposed. Healthcare, education, infrastructure spending, housing, corporate tax rates and trade policy are all subject to change. Similar to 2016, as we near the November 3 election date, volatility may rise as the market digests what the potential results mean for future economic growth.
As 2020 unfolds, the Fed will continue to monitor and adapt to our dynamic markets. While the Fed has announced that it is on hold for now, incoming data will be weighed carefully to determine if monetary policy adjustments are necessary to maintain the dual objective of price stability and maximum sustainable employment. We expect that rates will be range bound for a good portion of 2020, as inflation remains contained and the unemployment rate hovers near a historic low of 3.5 percent. However, we do think there is plenty of potential event risk for 2020, which could spur some volatility in the markets with a vacillating risk-on/risk-off dynamic throughout the year.
Therefore, we continue to take a flexible approach to investment strategy by positioning duration accordingly with sufficient flexibility built in. For longer portfolios, with benchmarks over nine months, we prefer a neutral stance to avoid being overextended now that the Fed is expected to remain on hold. Regardless of portfolio positioning, we expect there to be opportunities to execute on total return portfolios, thanks to expected bouts of market volatility throughout the year.
Jose Sevilla, Senior Portfolio Manager
The Federal Reserve had a very clear year-end message to the markets: “See you after the elections.” As expected, the Federal Open Market Committee (FOMC) kept the federal funds rate unchanged at a range of 1.50 to 1.75 percent in its December meeting. More importantly, however, the committee has suggested to the markets that it will, in all likelihood, remain on hold for 2020 leading up to the elections. Yes, policymakers are still concerned by low inflation and an array of global risks, but they are optimistic that downside risks have diminished. The vote was unanimous to keep rates on hold, and it was the first dissent-free meeting since May. The committee reiterated that rates will likely stay where they are, unless there is a “material” change in the economic outlook, and the most recent data seems to have provided justification for staying on the sidelines.
Inflation showed signs of picking up in the third quarter, though it remains broadly muted. The Fed’s preferred inflation measure, the Personal Consumption Expenditures (PCE) price index, excluding food and energy, rose 1.5 percent last quarter, down from 1.6 percent in the previous quarter. Despite an acceleration in headline Consumer Price Index (CPI) stemming from gas price fluctuations, this inflation indicator also remained tepid at best in November. On a year-over-year basis, headline CPI ticked up to 2.1 percent from 1.8 percent, while core CPI held steady at 2.3 percent year-over-year.
The employment picture remains solid, with over two million jobs added in 2019 and the unemployment rate at 3.5 percent. The solid labor market supports the Fed’s recent decision to keep rates on hold. Digging into the details, December non-farm payrolls rose by 145,000, modestly lower than the expected 164,000. However, November non-farm payrolls jumped 256,000, the highest reading since January 2019. November was the first full month after General Motors workers ended their strike, which helped boost payrolls by 41,300 and offset a similar drop seen in the prior month. Meanwhile, wage growth fell slightly to 2.9 percent ending lower on an overall basis for the year.
However, it wasn’t all jolly news as we ended 2019. There are signs that the ongoing trade turmoil has been a factor. For example, November durable goods orders fell 2.0 percent, following a 0.2 percent increase in the prior month. This was well below the consensus forecast that called for a 1.5 percent rise. This most recent data from November is the first monthly reading after the October China tariffs were delayed. Excluding transportation industries, orders were flat, suggesting that business investment has been sluggish in the fourth quarter, perhaps remaining cautious until there is greater clarity on a trade deal. This sluggishness may spill over into 2020. The core orders data also suggests that diminishing trade tensions and stabilizing global growth have had a limited impact on encouraging more capital expenditures.
The third estimate for third quarter 2019 GDP was unchanged at 2.1 percent, thanks largely to consumer spending that grew by more than previously reported. Personal incomes increased 4.9 percent year-over-year, which is slightly higher than the 4.5 percent growth previously reported. This has helped propel consumer spending up 3.2 percent annually. Consumers continued to be a pillar of strength for the US economy in 2019, despite the concerns of a lingering trade war, manufacturing weakness and slow business investment. This consumer strength looks to continue in the new year.
Fiona Nguyen, Senior Credit Risk & Research Officer
As the US economic expansion celebrated its 10th anniversary last year, tell-tale signs of the late credit cycle have begun to emerge. For the banking industry, 2019 was the year of a flattening yield curve (even inverting momentarily), margin compression, slower lending growth and strained profitability. All of these were provoked or exacerbated by global trade tensions. We noted in our previous Credit Vista that despite these challenges, bank earnings were resilient largely due to robust consumer strength, tight expense management and benign credit costs. With most economic forecasts now calling for no further rate cuts in 2020, pressure on net interest margin (NIM) is expected to wane. However, it will likely continue to be a factor so long as the Federal Reserve and central banks around the world commit to maintain their accommodative monetary policy, namely, lower rates for longer.
While the low-rate environment poses a continued headwind to the sector’s profitability, we can expect some revenue boost from the lingering positive effect of lower deposit costs thanks to last year’s three rate cuts. Additionally, since the last rate cut, the spread between the federal funds rate and the 10-year yield has widened and is expected to steepen further in 2020, as implied by the forward curve. Since banks lend money out at the longer end of the curve, any decent recovery in long-term rates should help asset yields expand, further easing NIM constraints. However, the magnitude of NIM defensiveness varies from bank to bank depending on their different balance sheet compositions.
Juxtaposed against an expected favorable macro backdrop in 2020, the industry has taken a cautionary stance in anticipating uncertainty ahead. With revenues slowing, major banks have relied more on efficiency to maintain profitability and maximize returns. Expense control has been the key contributor to stable earnings, but further cost cutting is constrained by the need to invest in technology to compete with emerging disruptive forces like fintech. On the technology investment front, large banks clearly hold a competitive edge over regional banks given their scale and bigger budgets. In fact, the need for scale was the key strategic rationale driving the recent merger between BB&T and SunTrust. The relative success of the deal could pave the way for smaller banks to initiate more mergers as they face slowing profits and fierce competition from non-banks and larger financial institutions.
One key area to watch for in 2020 is banks’ asset quality. As it stands, overall asset quality remains sound with nonperforming assets and net charge-offs near historical lows. Nonetheless, the lending category with above-GDP growth, such as Commercial and Industry (C&I), is worth watching. With one-third of C&I lending now being underwritten by non-banks, stiff competition from the shadow banking sector has encouraged aggressive loan growth and more lax underwriting standards. Although C&I problem loans remain low (for now), we continue to follow them closely since the unprecedented level of corporate debt, deteriorating lending standards and the widening gap between corporate debt and profit are negative signs for C&I loan performance.
Kevin Li, Fixed Income Trader
There were some unusual happenings in the overnight repurchase (repo) market in 2019, but we think it may be a little alarmist to call it a black swan event. Rather, we think the Federal Reserve is on the case and that the current situation may even provide an opportunity to pick up extra yield under certain circumstances.
In mid-September 2019, the overnight Treasury repo rate spiked significantly, thanks to a confluence of several unusual factors, including lower reserve balances, the impact of regulatory requirements on bank balance sheets, and the timing of corporate cash outflows. As an immediate response to the volatility, the New York Federal Reserve injected more than $50 billion of funding into the market to bring down rates from as high as 10 percent. The Fed also followed up with a series of overnight and term repo operations to further stabilize the repo market, which plays a significant role in providing short-term liquidity needs to banks and financial counterparties.
The volatility and actions by the Federal Reserve garnered numerous headlines around this time, most of which painted the market as strained and in need of further intervention. Given the market’s importance in extending credit and stabilizing borrowing costs, it’s understandable that investors remained weary heading into 2019 year-end, when repo rates historically trade higher due to bank capital requirements. It’s clear the Fed learned a lesson from the past and stayed one step ahead. Starting in November and operating through December, the Fed repeatedly extended overnight and term repo operations in amounts ranging from $30 billion to $120 billion. In total, the Fed provided more than $250 billion in additional funding over year-end to curb any softening in rates.
Still, we will likely see intermittent volatility. Fed Chairman Jerome Powell stated in his press conference after December’s Federal Open Market Committee (FOMC) meeting that “the purpose of monetary policy decisions isn’t to eliminate all volatility, particularly in the repo market.” But given the Fed’s ability to step in when markets dictate, a significant spike similar to what happened in September is not likely to happen again.
With regard to our trading strategy, we believe that any continued repo volatility may be more of an investment opportunity to gain extra yield for clients’ portfolios, while still maintaining the safety of Treasury collateral. As always, we continue with our disciplined approach to manage the liquidity and risk profiles of our clients while considering any opportunity from market dislocations.
|Treasury Rates:||Total Returns:|
|3-Month||1.55%||ML 3-Month Treasury||0.14%|
|6-Month||1.59%||ML 6-Month Treasury||0.16%|
|1-Year||1.58%||ML 12-Month Treasury||0.18%|
Source: Bloomberg, Silicon Valley Bank as of 12/31/19
SVB Asset Management's monthly Market Insights covers current topics on portfolio management, credit considerations and market events that influence corporate investment strategy.
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