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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. 

Decoding the curves

Renuka Kumar, CFA, Head of Portfolio Management

What does the shape of a yield curve really tell us? It seems investors everywhere have been focused on two things this year: the spread between the 2-year Treasury Note and the 10-year Treasury Note (the 2s10s) and the spread between the 3-month Treasury Bill and the 10-year Treasury Note (the 3m10y). Investors tend to focus on these curves given their correlation to economic downturns. Historically, yes, an inverted yield curve has preceded a recession. And furthermore, given the dramatic and sudden shift in sentiment from the Federal Reserve in the fourth quarter of 2018, not to mention growing global uncertainty with regard to Brexit, trade negotiations, and the resetting of growth expectations, it’s not a surprise that investors are trying to predict if the next downturn is imminent.

Notably, over the past month, we have seen a slight re-steepening in the yield curve. Both of the aforementioned yield curve spreads are currently positive with the 2s10s at a positive 21 basis points (bps), and the 3m10y at a positive 12 bps. Year-to-date, the 2s10s spread has fluctuated between +12.2 bps and +23.6 bps, while the 3m10y spread has fluctuated between -5.7 bps and +38.8 bps. Currently, some areas of the yield curve remain inverted, as can be seen in the chart below.

 

But does it matter? Historically speaking, for each of the past five US recessions, the 2s10s curve inverted anywhere from nine to 23 months prior to a recession actually occurring. This is why investors tend to follow it so closely.

But some believe “this time it’s different.” Or is it? One theory is that the predictive nature of an inverted curve has diminished, attributing the flattening of longer rates to negative term premium, unprecedented quantitative easing and stronger foreign demand for US Treasuries. Those are valid arguments. Still, it’s hard to ignore historical correlations and that an inverted yield curve does pose challenges to corporate profitability. For example, the way banks tend to borrow at short-term rates and lend at longer-term rates has the potential to affect lending practices and profitability.

Taking everything into account, the outlook is not as gloomy as it seemed earlier this year when we were recovering from the equity sell-off that occurred in the fourth quarter. At that time we were also assessing the impact of the government shutdown, hard Brexit concerns, trade negotiations and a complete shift in the Fed’s sentiment. 

For now, the Fed has taken steps to fend off further yield curve inversions (at least those driven by rising short-term rates) and an imminent recession. By lowering projections for future rate hikes and ending the balance sheet runoff, the Fed could very well be successful in achieving the elusive soft landing. Recent economic data, both domestically and globally, has also shown some improvement, albeit mixed. For example, while first quarter GDP surprised to the upside, the underlying dynamics in the report were less encouraging. For now, the Fed continues to monitor the data closely, which is consistent with its “wait and see” approach.

While we are not out of the woods with respect to a potential downturn on the horizon, a recession does not appear to be imminent, which is even more so the case with a re-steepening of the yield curve. We continue to monitor the shape of the yield curve closely along with the myriad of economic indicators to evaluate the direction of economic growth and monetary policy. From an investment strategy standpoint, we are mindful of continued market uncertainty and, hence, are taking a balanced approach with both portfolio duration and sector allocation.

Economic Vista: Rebounding like in the NBA

Eric Souza, Senior Portfolio Manager

Rebounding is key for any team that wants to go deep into the NBA playoffs. The same can be said for watchers of the economy and markets who are looking for a lasting rebound in jobs and other data. And that’s exactly what we have in the April data here in the US, most notably in nonfarm payrolls and retail sales. Although the International Monetary Fund (IMF) lowered its global growth projections, markets are nonplussed for the moment, and we have even started to see some improvement in economic data from China. This rebounding, along with dovish central banks both here and overseas, seems to be lowering the probability of a recession in the US and should continue to bode well for risk assets.

The bounce back in the March employment report confirmed that the prior month’s print (a meager 20,000 new jobs created) was a one-off event. In fact, this type of outlier is not that uncommon, as depicted in the accompanying nonfarm payrolls chart. The March reading came in above expectations with 196,000 new jobs created, and despite the very low reading in February, the three-month average of 180,000 still shows solid job creation. The unemployment rate remained unchanged at 3.8 percent, which is just above the 49-year low reached last year of 3.7 percent.

 

Weekly jobless claims also rebounded from a high of 244,000 in January to below 200,000 for the second week in a row in April (193,000 and 197,000, respectively). However, later in the month, jobless claims did spike above 200,000, though that was likely affected by the Easter holiday.

Retail sales registered yet another rebound in April, as sales rose 1.6 percent, coincidentally matching the decline in December. The gains in sales were broad based, with only one of the 14 subcategories making a negative print. Leading the gains were Motor Vehicle & Parts (+3.1 percent) and Gasoline Stations (+3.5 percent). Clothing and Non-Store Retailers also showed healthy gains of 2.0 percent and 1.2 percent, respectively. Eating and drinking establishments also contributed by rising 0.8 percent. This subcomponent is a good indicator on the health of the consumer, since eating out is often the first thing that is cut during difficult economic times.


  December 2018 January 2019 February 2019 March 2019
Retail Sales

(Month-over-Month %)
-1.6% +0.8% -0.2% +1.6%
Sources: Bloomberg and U.S. Census Bureau.

 

The housing market has also pitched in with rebounding as new home sales rose 4.5 percent (or went up 692,000) on an annualized rate, which is the best monthly rate since November 2017. Declining mortgage rates this year have fueled this rise, along with a drop in the average new home price. The combination of the two are making housing more affordable for many, and that bodes well for the continuing health of the sector.

So how did all this rebounding manifest in first-quarter GDP? The Federal Reserve Bank of Atlanta produces a quarterly GDP forecasting model called GDPNow. In March, it was forecasting a first-quarter GDP reading of 0.7 percent. However, with the improving data trend, the GDPNow model ratcheted up first-quarter growth estimates to 2.7 percent, as of April 25. This nowcasting model proved to be relatively accurate as the Commerce Department’s initial first-quarter estimate pegs economic growth at 3.2 percent, which is the strongest Q1 reading we’ve had in the past four years. However, this rebound might be short lived, considering the increase came from inventories and exports/imports, which tend to reverse in the quarters that follow. Consumer spending has been decreasing since the second quarter of 2018, so a solid second-quarter reading will be dependent upon a rebound in consumption.

Credit Vista: Approaching after hours?

Tim Lee, CFA, Senior Credit Risk and Research Officer

For now, the party continues. But how much longer will the good times roll? Through the first quarter of 2019, rating agencies continued to shower US investment grade, corporate issuers with more upgrades than downgrades, thanks in part to the stable financial positions of banks and energy companies. After adjusting for related entities, Moody’s had made approximately two ratings upgrades for every one downgrade, based on actions taken through the end of April. The story is similar to 2018, when upgrades by Moody’s outpaced downgrades by the same margin.

Financial issuers have been the largest beneficiaries of upgrades, with nearly four upgrades for every one downgrade over the course of 2018. A consistent streak of rising earnings, good asset quality and strong capital levels provided a backdrop for rating agencies to mark up their scorecards on banks. Of the relatively few downgrades in the financial sector last year, most were confined to insurance companies and the American units of banks based in Europe, where profitability of their parent operations have been lackluster. This year, Moody’s has yet to hand out a long-term rating downgrade to any financial issuer, while upgrades have included Citibank NA and Bank of America Corporation.

While the ratio of upgrades for US investment grade industrial issuers trailed financial issuers, they still outpaced the number of downgrades. Last year, upgrades included energy companies benefitting from a rebound in oil prices, as well as retailers such as Amazon, Dollar Tree and Costco, which have been able to reduce leverage and maintain prudent financial policies. With regard to industrial upgrades, the first quarter of 2019 has been similar to 2018, with notable upgrades in the energy and commodity sectors as well as life science companies such as Thermo Fisher Scientific. The one sector not participating in the good times has been utilities, especially those facing cash-flow challenges. One notable downgrade was the California utility company Pacific Gas and Electric (PG&E), which was lowered below investment grade. PG&E subsequently filed for bankruptcy due to idiosyncratic liabilities.

Though downgrades aren’t expected to materially increase for the rest of the year, the upgrade party may soon start to fade after raging for the better part of the last few years. The credit improvements in the financial and energy sectors have largely concluded, and industrial issuers that levered up over the past decade to fund acquisitions and repurchases will have their debt reduction proficiencies tested. Look for rating actions to become more even as 2019 wears on, with the upgrade-to-downgrade ratio falling back toward one-to-one. After all, the party must end sometime.

Trading Vista: Smooth sailing

Jason Graveley, Fixed Income Trader

After the Federal Reserve’s famous pivot late last year, it’s no surprise that low volatility has permeated the markets in recent months. Under this more accommodative monetary policy, the Fed-fueled rally has lifted equity indices across the board. Both the S&P 500 Index and Nasdaq Composite recently touched record highs, a stunning rebound after the stock market rout that closed out 2018. In fact, stocks registered their strongest first-quarter run in more than two decades. In addition to this dovish tilt, easing recessionary fears, fading geopolitical headlines, upbeat corporate earnings and healthy US economic indicators have combined to renew investor optimism. The Chicago Board Options Exchange Volatility Index (CBOE VIX), the most popular measure of near-term equity volatility and often referred to as Wall Street’s fear gauge, posted its sharpest decline in volatility in the first quarter with a 46 percent loss. Consequently, it’s been smooth sailing for stock investors, and complacency has set in. 

In the bond market, the story was all about the reversion. In other words, the yield inversion between the 3-month Treasury Bill and the 10-year Treasury Note that captured headlines and stoked recession fears last month has since normalized. Although the spread between these short- and long-dated maturities remains minimal, it still holds positive. Month-over-month, we have seen little change in credit spreads or benchmark levels as both remain range-bound. Some signs of weakness in the global economy have caused the dollar to surge, subsequently increasing the overall attractiveness of Treasuries and keeping a lid on yields. Movements in short-term credit spreads have been muted as well, with corporate supply constrained and investors continuing to re-enter the market. Declining year-over-year corporate bond issuance is also playing a role, as the lack of new issues has kept investors focused on the secondary space. In this environment, Treasuries still provide quality relative value. Yields have moved sideways in our space, but as the curve normalizes, we aim to incrementally pick up yield, add duration and increase the overall credit quality of portfolios.

Markets

Treasury Rates: Total Returns:
3-Month 2.41% ML 3-Month Treasury 0.18%
6-Month 2.44% ML 6-Month Treasury 0.19%
1-Year 2.37% ML 12-Month Treasury 0.21%
2-Year 2.27% S&P 500 2.86%
3-Year 2.24% Nasdaq 3.44%
5-Year 2.28%    
7-Year 2.39%    
10-Year 2.50%    

Source: Bloomberg, Silicon Valley Bank as of 4/30/19

0519-0022MS-043020

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

Renuka Kumar, CFA, is Head of Portfolio Management at SVB Asset Management (SAM) and is based in San Francisco. In this role, she oversees SAM's portfolio management and trading teams while also managing investment portfolios for clients. Key components of Renuka’s job include developing and executing investment strategy as well as overseeing risk management. She feels the most important part of her job, however, is to engage directly with clients to better understand their individual needs and to develop strategies that meet these needs head-on. Her direct relationships with stakeholders within the innovation economy — and being in a position to help them succeed — add meaningful dimensions to her work.

Renuka brings more than 15 years of experience in banking and investments. Before joining SAM, Renuka served as the asset liability manager for the Treasury division of SVB Financial Group. During this time, she managed the interest rate risk position of the company, working closely with the bank’s own investment portfolio. Through this experience, Renuka gained a greater appreciation of the larger balance sheet picture. Renuka holds a bachelor’s degree in finance from Michigan State University and a member of the CFA Society of San Francisco.

Renuka lives in Marin County with her husband and two children — though she says the family’s first “baby” was actually their German shorthaired pointer. In her free time, you can find her running and hiking with her dog across the summits, shorelines, fields and forests of the Bay Area.
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