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Observation Deck: Through a wider lens

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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. 

Through a wider lens

Steve Johnson, CFA, Senior Portfolio Manager

Investors often focus narrowly on things that only just transpired. In behavioral finance, that’s called recency bias — overemphasizing what occurred most recently while downplaying “older” factors and data. Although this tendency can be chalked up to human nature, it underscores the importance of stepping back periodically to consider the broader picture. That can be especially helpful when setting strategy and making critical investment decisions.

With that in mind, how exactly, did we get to this junction? After a period of consistent monetary tightening, the Federal Reserve made a quick pivot in the first quarter, shifting their tightening bias to one of patience and data dependency. The swing to a more dovish policy stance was abrupt, and was soon followed by a March Federal Open Market Committee (FOMC) meeting at which the committee shifted their median projection to reflect no further rate hikes in 2019. Although the Fed maintained the status quo in March, shortly after that meeting, FOMC Vice Chair Richard Clarida mentioned “insurance cuts” in a historical sense during an April interview. This got the market thinking that the Fed’s next move could theoretically be an interest rate cut if the data warranted. Fast forward to today, and the market is now 100 percent certain the Federal Reserve will deliver some sort of rate cut, according to fed funds futures. This reflects the nagging trade war-uncertainty, sub-target inflation and fears of slowing global growth. The market is convinced the question has now become when, not if, a rate cut will come. Participants are asking themselves at which upcoming FOMC meeting would this occur, and if it does, would it be 25 or 50 basis points (bps) of easing?

For clues around magnitude, it might be wise to consider past precedents. Looking over the past 30 years of Fed policy, there have been five “first cuts” where the preceding period resembles the policy environment of today. In other words, there have been five similar periods where the first fed funds cut occurred after either a rate-hiking cycle or after an extended period of on-hold policy had elapsed.1 In two of the five cases, the first cut was 25 bps (1995 and 1998). In three other instances, the first move was a 50-bps cut (2001, 2002 and 2007). 1995 and 1998 were mid-cycle cuts, in other words not preceding or reacting to a full blown recession, while 2001, 2002 and 2007 were. What does all this mean? It seems that history gives us some conflicting data: The most recent three “first cuts” were 50 bps; however, the two mid-cycle moves were only 25 bps to start, even if they were followed by further cuts. So depending on your view of the economic trajectory, and assessment of recessionary probabilities, past precedent helps but doesn’t make clear which way the committee could be leaning today.

Digging a little deeper, did the most recent Fed meeting on June 19th tell us anything? The Fed’s dot-plot — a graphic tool that the Fed uses to communicate and project future interest rates — showed that eight of the 17 Fed governors and presidents believe that some reduction in the fed funds rate will be appropriate this year. Of those who projected a rate cut, seven believe that a total of 50 bps lower in policy rates is the correct action, whereas one indicated preference for just a 25-bps cut. Importantly, Fed Chair Jerome Powell acknowledged in his press conference that “though some participants wrote down policy cuts and others did not…a number of those who wrote down a flat rate path agree that the case for additional accommodation has strengthened.” Again, the takeaway suggests that interest rate cuts are most likely coming, but the timing and size have yet to be decided.

So what could the timing and magnitude depend on? And why cut interest rates on the heels of a robust expansion? These valid questions spur us to look at the key inputs that could shape the Fed’s decision — those factors that will affect the timing and size of future policy decisions. Chairman Powell’s June press conference and recent commentary seem to be focused on three such themes: The domestic economy, the abundant ‘crosscurrents’ that have increased economic uncertainty and inflation (or the lack thereof).

Indeed, the domestic economy appears healthy for all intents and purposes. Unemployment is hovering near a 50-year low, first quarter 2019 GDP has held above 3.0 percent, and consumer spending remains at a high yet softening level. Despite this, a recent string of weak manufacturing data along with the weaker May employment report have muddied the picture. In his press conference, Chairman Powell explained, “While the baseline outlook remains favorable… many FOMC participants now see that the case for somewhat more accommodative policy has strengthened.” At the same time, slowing growth overseas, along with continued trade-war uncertainty have added ‘crosscurrents’ to the committee’s baseline outlook for the domestic economy, increasing the risk of a less favorable future economic outcome. Further, while the Fed remains firmly committed to its 2.0 percent inflation objective, it acknowledged stubbornly low inflation persists in today’s economy. Powell conceded that inflation weakness that persists, even in a healthy economy, could precipitate a difficult-to-arrest downward drift in longer-run inflation expectations.

Clearly, many voting members are becoming worried about risks to the economic outlook. In turn, they seem to have signaled to the market that a rate cut could be coming in hopes of preventing a weakening outlook from becoming a persistent or deteriorating reality. At least that’s how the market seems to be interpreting all the data and Fed-speak. However, as the Fed has admitted, everything is data dependent, and this requires investors to be vigilant. Upcoming July economic data thus becomes a potential road map to discover not only the timing, but magnitude of any upcoming policy decisions. The next two-day FOMC meeting on July 30 and 31 will soon be upon us, at which point everyone will have more clarity. Amid the uncertainty, our focus on capital preservation and liquidity remains unchanged. On the margin, we’ve increased the credit quality of portfolios and have been extending portfolio duration versus benchmarks to adapt to the changing environment. 

1Source: Morgan Stanley & Co. LLC (May 2019). Matthew Hornback, Robert Rosener: “The First Cut is the Deepest.”

Economic Vista: Fed gets the green light

Jose Sevilla, Senior Portfolio Manager

As some Federal Reserve watchers parse through the FOMC statement and dot plot, others prefer to focus on the data. And though the domestic economy has been on an epic run, some cracks have finally appeared. In fact, a number of recent economic releases seem to be giving the Fed cover to move ahead with interest rate cuts. How soon and how much seem to be the real questions as discussed above.

One worrisome sign has been US manufacturing production, which appears to be cooling. The Institute for Supply Management (ISM) Manufacturing Index came in at 51.7 after a 52.1 print in June. The print came in slightly better as economists were calling for a reading of 51.0. While the current print is still above 50 and in expansion mode, this reading has been consistent with weakness in global manufacturing. New orders declined to 50.0 signaling for potential softening in business investment. Meanwhile production and employment indices both increased to 54.1 and 54.5 respectively.  

The May jobs report also disappointed, as US employers added only 75,000 jobs, which was far fewer than economists’ estimates of 175,000. This was a sudden drop from April, which was revised lower to 224,000 new jobs. That brings the three-month average to 151,000. The weakness in the report was broadly based as the manufacturing, construction and professional and retail sectors all showed a slower pace of job growth. The unemployment rate did not budge at 3.6 percent; however, it is still at a 49-year low. The labor participation rate also held steady at 62.8 percent. Another downside was wages as they came in less than projected, climbing 3.1 percent year-over-year. This report highlights the growing downside risks associated with slowing global growth and trade disputes.

Despite a less-than-stellar wage number, consumers are still spending. May retail sales rose 0.5 percent, only slightly below estimates of a 0.6 percent increase. But April’s reading was revised to the upside (0.3 percent growth versus a decline of 0.2 percent). The strength in spending was broadly based and shows the consumers’ willingness to spend, which is supported by tight labor markets and solid wages. This trend suggests that consumer spending will contribute solidly to overall GDP growth in the second quarter.

In terms of overall economic growth, the final print of first-quarter GDP showed the US economy grew at 3.1 percent, year-over-year, which is unchanged from last month and up from the 2.2 percent growth in the fourth quarter of 2018. Overall, US economic growth in the first quarter of 2019 was fueled by stronger business investment and exports driving down the trade deficit, thus offsetting any slowdown in consumer spending. The report also had slightly better news on consumption as core Personal Consumption Expenditures (PCE) rose 1.2 percent, revised up from 1.0 percent. However, signs are mounting that US growth might get stymied due to a slowing global economy and uncertainty around the US and China trade dispute, which has opened the door for rate cuts by the Fed this year.

On the inflation front, US consumer prices in May, as shown by the Consumer Price Index (CPI), rose a less-than-expected 1.8 percent annually, down from 2.0 percent in the previous month. The drop was due to a decline in used car, gas and energy prices. Excluding food and energy, core inflation increased by 0.1 percent in May, which was below expectations of 0.2 percent. It was the fourth consecutive monthly reading of 0.1 percent, thereby pushing the year-over-year rate down to 2.0 percent from 2.1 percent in April.    

As expected, the FOMC kept rates unchanged at their June meeting. However, the Fed’s statement emphasized the increased economic uncertainty, and committee members are now weighing rate cuts in response to the uncertain outlook. According to Fed Chairman Jerome Powell, he “agrees that the case for additional accommodation has strengthened since the May meeting.” The summary of economic projections shows roughly half of the FOMC members are forecasting 50 bps of rate cuts, while the other half say “no cuts” in 2019. In the statement accompanying the meeting, the committee downgraded US growth from solid to moderate and noted that business investment was soft, inflation expectations have declined, and that uncertainties have increased. The committee remains committed to act “as appropriate to sustain the expansion,” suggesting that they may cut interest rates if the situation is warranted. The most recent string of data may give the Fed the green light to do so.

Credit Vista: Weathering interest rate change

Tim Lee, CFA, Senior Credit Risk and Research Officer

Much talk has been made of the potential interest rate cuts by the Federal Reserve later this year. Will the Fed cut interest rates at the next meeting in July or in the fall? Will it be 25 or 50 bps? Will it be one or a series of cuts? In some ways, this all seems like old news to the US banking industry. Ever since the Fed pivoted to a more accommodative policy six months ago, US banks have been feeling the pressure of interest rate changes.

Beginning in the first week of January, London Inter-Bank Offered Rates (LIBOR) have been declining steadily, with 3-month LIBOR, a common benchmark interest for commercial loans and other bank earning assets, falling 48 bps through the end of the second quarter. Loan rates have also been compressed by stiff competition, to the delight of borrowers of course. Long-term rates have also been sliding, with the current coupon on the Fannie Mae 30-year mortgage-backed security dropping approximately 75 bps by the end of June. To the contrary, funding costs have been creeping higher as investors have been shifting non-interest bearing deposits into money market funds, CDs or any savings account that pays rates higher than zero. This falling and rising rates environment is combining to halt a multi-year run higher in net interest margin (NIM), which historically has been a key contributor to strong bank earnings.

While the current backdrop is challenging, falling interest rates won’t be a washout for banks. Even as assets reset and adjust to earning lower rates, volume growth in deposits and loans, as well as deceleration in funding costs, should partially cushion any fall in NIM. In fact, NIMs may not fall dramatically if the Fed does indeed cut interest rates, as NIM already has been at subdued levels ever since the end of the last recession. According to data from Moody’s Investor Service, NIM has only risen 32 bps from the fourth quarter of 2016 through the first quarter of 2019, a period that spans eight interest rate hikes. NIM could be also be cushioned by a rate cut if it causes the yield curve to bull steepen, which would lower the cost of short term funds bank use to invest in longer dated assets.

Pressure from lower rates will also be countered by falling efficiency ratios, as new digital initiatives, the rationalization of physical bank branches and staff restructuring have combined to help drive down expenses. Additional cost savings may be achieved by lower FDIC fees that kicked in this year. Finally, many banks have been focused on expanding their fee-generating businesses since the last recession, and this revenue stream is largely immune to interest rate changes. 

Most importantly, changing interest rates will not directly affect the solid asset quality and capital levels that are underpinning the credit stability of most US banks. A low jobless rate has helped keep a lid on consumer loan delinquencies, while rising home prices have contributed to good mortgage performance. Moreover, commercial and industrial loans should continue to benefit from policies that help prop up macroeconomic conditions. Thus, even if losses do rise eventually, banks appear to be well equipped to handle them as falling interest rates this year have not stopped internal capital generation from absorbing losses and keeping capital ratios steady. So, from our perspective, the domestic banking industry appears ready to weather whatever interest rate path the Fed decides.

Trading Vista: FOMC takes center stage

Jason Graveley, Fixed Income Trader

Grab your seat and get ready. The FOMC is stealing the show in this market, and their upcoming meeting dates have become must-watch events. All market participants are firmly focused on the Fed, and they want to know about upcoming monetary policy changes, and the pace and direction of future interest rate moves.

At the conclusion of the FOMC meeting on June 19, policymakers did not ease rates, but they did acknowledge increasing economic headwinds and communicated a more dovish tone. Future global growth rates appear tenuous, both in developed and developing nations. Inflation remains muted, and the global trade outlook is as murky as ever. As a result, it is now likely that the Fed will provide further policy accommodation.

In fact, the future implied probability of a rate cut in 2019 is now 100 percent, with the market pricing in this likelihood as early as next month at the July 30–31 FOMC meeting. Markets have reacted in kind to the dovish Fed signals, with equities continuing their march higher and the Treasury curve bull steepening (i.e., short-term rates falling faster than long-term rates). The 2-year note — the measure considered most sensitive to monetary policy — dropped close to 15 bps after the Fed’s June announcement, though the longer end of the Treasury curve saw little change.

In credit markets, benchmark curves have tightened, while all-in yields grind lower. This has been offset by some marginal spread widening, but it’s important to note that this widening is likely more a necessity to attract buyers than it is a reflection of deteriorating credit fundamentals. Meanwhile, benchmark curves remain inverted, and some of the highest-yielding investments are in the front end. Although given the rate outlook and forward curve, most market participants seemingly expect this to be short-lived and are positioning portfolios accordingly. We are seeing this dynamic play out, as many investors are eschewing higher short-term rates and instead electing to lock in longer-dated assets at lower yields. 

In this period of market uncertainty and shifting sentiment, we continue to prudently manage portfolio duration to mitigate increasing interest rate risks. We are also balancing out sector allocations to help further insulate portfolios should economic headwinds pick up.

Markets

Treasury Rates: Total Returns:
3-Month 2.09% ML 3-Month Treasury 0.22%
6-Month 2.09% ML 6-Month Treasury 0.27%
1-Year 1.93% ML 12-Month Treasury 0.40%
2-Year 1.76% S&P 500 7.05%
3-Year 1.71% Nasdaq 7.51%
5-Year 1.77%    
7-Year 1.88%    
10-Year 2.01%    

Source: Bloomberg, Silicon Valley Bank as of 6/30/19

0719-0058MS-063020

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

Steve Johnson, CFA, is a senior portfolio manager at SVB Asset Management (SAM) based in the San Francisco Bay Area, where he and his team are responsible for the overall strategy, security selection and risk management of client portfolios. His work combines two of his greatest passions: people and financial markets. Steve thrives on the process of getting to know each of his clients, developing a deep understanding of their unique set of financial challenges and coming up with strategies that allow them to achieve their goals.

Colleagues past and present recognize Steve as a proven communicator. Before joining SVB, he worked at Wells Fargo Asset Management as a portfolio specialist for the Montgomery Fixed Income team, a fixed income manager with an over 25-year history specializing in core fixed income, long duration credit, and short duration fixed income management. This involved distilling his team’s investment philosophy, processes, portfolio construction and portfolio positioning for current and prospective institutional clients. In this role, he worked with institutional consultants and institutional clients, including endowments and foundations, corporate defined benefit and contribution plans, and subadvisors among others. Prior to that, he worked at Morgan Stanley in an institutional fixed income sales role, covering fixed income money managers, corporate treasury groups, pension funds, endowments, and 2a7 money market funds in a sales and advisory capacity. This role involved expertise in all things fixed income from funding trades and securities lending, to outright primary and secondary market trading execution across fixed income cash, derivative and ETF products.

Steve holds a bachelor’s degree in economics from Duke University as well as a master’s degree in management studies from Duke’s Fuqua School of Business. He is a member of the CFA Society of San Francisco.

No matter where he lands, Steve finds his athletic niche. Growing up in Colorado, he enjoyed skiing, hiking and mountain biking. While at Duke, he played varsity basketball for the 2010 National Championship Duke Blue Devils and was a high jumper on the varsity track team. Now that he’s lived in California for a few years, he’s added beach volleyball, CrossFit and running to his list of pursuits. To stay in shape, he continues to play in a number of basketball leagues in San Francisco.
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