Friday, April 21, 2017

Economic Review 1Q 2017

Nicholas Zaiko, CIMA
Senior Consultant
Bridgebay Financial, Inc.

US Economy

Since the February, 2017 FOMC meeting the labor market continued to strengthen and economic activity continued to expand at a moderate pace. The pace of job creation remained robust in February, with payrolls rising by a seasonally adjusted 235,000 new jobs per the Labor Department report. Initial ADP numbers for March showed 268,000 new jobs, dramatically beating the consensus expectation of 185,000. 

Household spending rose moderately while business fixed investment firmed. In recent quarters, inflation has increased, approaching the Fed’s 2% longer-run objective. Excluding energy and food prices, inflation was unchanged and is slightly less than the 2% target. The unemployment rate moved lower to 4.7%, as both employment and workforce participation rose. Evidence of continued health in the U.S. labor market likely cleared the way for the Federal Reserve to raise short-term interest rates at the March FOMC meeting. Labor market and wage growth has strengthened, helping to support consumer activity. 

Consumers are steadily increasing spending, while confidence levels suggest buying will continue to grow at a moderate pace. The real estate market continues to improve, with home prices rising 5% this year amid increasing demand. At the same time, inflationary pressures have remained relatively subdued, providing a positive tailwind for businesses and individuals.

US Federal Reserve 
The Fed raised the federal funds rate to 0.75%-1.0% on March 15, 2017, a move that was widely expected by the market. The Fed indicated that there will be two more rate hikes in 2017 and three more in 2018. The Fed forecast a steeper path for borrowing costs in 2017.

The Fed will keep long-term holdings on its balance sheet. It will hold Federal agencies, agency MBS and Treasuries on its balance sheet and reinvest principal payments until the Fed Funds rate reaches its normalization level. 

Core inflation (excluding food and energy costs) was 1.7% in January. The Fed’s new forecast for core inflation for 2017 is 1.9% up from 1.8% as of December, 2016.

There are numerous variables that will impact the economy in 2017 stemming from the Trump administration’s plans for infrastructure spending, tax cuts, and budgetary plans. In response, the Fed has made the tactical decision to wait to see which programs are implemented. Once the programs are approved and more clarity is available then the Fed will respond to any inflationary expectations.  

Federal Reserve Balance Sheet 
The Fed holds $4.5 trillion in bonds on the central bank balance sheet that were acquired during 3 rounds of quantitative easing (QE). The QE program was a monthly bond-buying program implemented in response to the financial crisis. The cashflows from the holdings of Treasuries and MBS have been reinvested in bonds without shrinking the balance sheet. The Fed indicated that some balance sheet reduction this year may come from stopping the reinvestment of cashflows. 

According to the FOMC minutes of the March, 2017 meeting, the Fed acknowledged that unwinding the balance sheet would itself amount to a rate hike. A change to the Committee's reinvestment policy may occur in late 2017 although there was little consensus on how the operation would be implemented.  

Central Banks 
The ECB announced on January 19, 2017 that they would leave rates unchanged and continue the accommodative asset purchasing program. Currently the plan is to taper asset purchases after April, 2017, decreasing to €60 billion per month, down from €80 billion. The ECB explained the rationale for extending the program by citing elevated levels of political uncertainty in 2017 with several contentious elections occurring throughout the year in France and Germany.  

European bonds were volatile throughout the quarter on speculation over the European Central Bank (ECB) quantitative easing (QE) plans. 

Overall, 2017 is expected to see a slowdown by global central banks in implementing additional accommodative measures to keep interest rates down. Central banks globally are reaching the limits of monetary policy and are seeing diminishing economic benefits and increasing risks with negative interest rates.  

The UK invoked Article 50 on March 30, 2017 to initiate the 2-year process of exiting the European Union. Europe has critical elections in France and Germany that are facing pressure from populist candidates. Netherlands’ elections re-buffed the populist candidate and restored the status quo.

The Netherlands election followed the re-election of Prime Minister Mark Ruttes centre-right party which defeated the populist, extreme candidate.  

Oil Prices
Oil prices rallied as several OPEC members commented about possibly extending the production freeze agreement when the group meets in May. There is a reduced outlook for inflation as oil prices have settled in the $50/barrel range in March while inventory levels and drilling rig activity increased.  

Yield Curve 
U.S. 10-year Treasury yields have fluctuated from a low yield of 1.36% in July, 2016 to 2.40% on March 31, 2017. The yield curve is expected to flatten as short-term interest rates rise and the 5-10 year portion of the yield curve remains steady. Although the expectation for the 10 year has been for it to rise to 3-3.5% by year-end 2017, demand for US fixed income securities due to the strong US dollar and shortage of high quality, global bonds may key those yields down. 

Short-term rates under 12 months rose directly in response to the increase in Fed Funds rate in March, 2017 ranging from 18 bps. to 30 bps. 3 month LIBOR is 1.15%. quarter-end. Money market funds continue to have seasonal outflows. Corporate credit spreads have continued to narrow. When rates rise, over time, higher reinvestment rates will offset the decline in bond prices, and become the primary driver of total return.

1-3 year BBB credits were the best performing investment grade fixed income sector during 1Q2017. The US economy is providing a stable footing for corporate credits. 

Accommodative monetary policy and positive economic data have provided a stable backdrop for the US corporate fixed income market. US GDP continues to grow at a slow pace. Currently, there appears to be limited capacity for credit spreads to narrow in 2017. Amid stable fundamentals, strong demand for US credit has driven spreads tighter year-to-date in the face of heavy issuance. Investment-grade supply topped $1 trillion in 2016, making it a record-setting year.

In the current low rate environment, traditional high-quality US buyers are pushing into lower-quality credits in search of additional yield. Outside the US, over a quarter of all government debt is trading in negative territory. The lack of attractive opportunities in local foreign markets is driving strong flows into US corporate bonds, Treasuries and agencies. More recently, they are increasingly finding attractive opportunities in investment-grade corporates, which have boosted returns. Additionally, corporate buying programs in the Eurozone and Japan are providing a positive technical for high-quality global bonds, including US bonds.

Friday, January 6, 2017

Economic Review 4Q 2016

Nicholas Zaiko, CIMA
Senior Consultant
Bridgebay Financial, Inc.

The U.S. economy is poised for stronger growth, higher corporate profits, improving wages, and inflation returning to normal levels. The Federal Reserve is responding by accelerating its monetary tightening and projecting that it will raise Fed Funds rates three times in 2017.  Changes in U.S. federal policies for 2017 include potentially lower personal taxes, corporate tax rate reductions, increased fiscal stimulus, and infrastructure spending should all favor growth.

U.S. Federal Reserve
On December 14, 2016, the Federal Reserve increased the Fed Funds from a target rate of 0.25% to 0.50% to a range of 0.50% to 0.75%. The last rate hike was December 16, 2015.  The FOMC cited inflation and strong labor markets as grounds for the rate increase. If labor market conditions continue to improve the unemployment rate is expected to be 4.5% in late 2017.

The Fed is reflecting its confidence that the U.S. economy is strengthening by forecasting 3 rate hikes in 2017 ending the year at 1.25% to 1.50% Fed Funds rate.  A tight labor market and firming inflation in the U.S. should allow the Federal Reserve to continue to slowly raise rates.

The Fed expects inflation to rise more than previously forecasted due to the a new fiscal stimulus program being considered by Congress under the new Trump administration.  The FOMC expressed "considerable uncertainty" about the economic impact of the Trump administration’s stimulus plans and potential increase in government debt to fund those programs. 

U.S. Interest Rates
Since the November, 2016 election and Fed Funds rate increase, yields have risen across the curve.  The long-end of the yield curve flattened slightly.  The 4th quarter was dominated by market reactions to the Trump victory which helped to sharply increase inflationary expectations, leading to a surprising rise in rates. Rising rates may lead to increased short-term volatility in fixed income markets.  Interest rates should rise in 2017 but only at a modest pace due to sluggish global growth and very cautious global central banks.  The U.S. 10-year Treasury yields rose to 2.50%–2.60% range in December, a substantial move from the low yield of 1.36% in July, 2016.

The 10-year Treasury is expected to be at 3.0–3.5% by year-end 2017.  The strong U.S. dollar may move higher against major currencies due to higher U.S. rates and a potential repatriation of corporate cash from offshore portfolios.

U.S. Economy
The U.S. is in economic expansion as 3% GDP growth is possible in 2017, even if job growth slows down.  December, 2016 was the 75th straight month that U.S. employers added jobs with less slack in the labor market putting upward pressure on wages. In December, 2016, average hourly earnings for private-sector workers advanced 0.39% from November. Although job creation slowed, growth in wages was the strongest since 2009 as a result of the tightening labor market. 

Nonfarm payrolls rose by a seasonally adjusted 156,000 in December from the prior month. The unemployment rate rose to 4.7% from 4.6% in November, reflecting more Americans entering the labor force. Economists expected 183,000 new jobs and a jobless rate of 4.7%. The broader measures of labor market slack are expected to remain tight in 2017.

With the years of low interest rates, consumers have repaired their financial condition and household wealth.  A personal tax cut could further add to demand in the economy.

International trade should continue to be a net drag on the U.S. economy because of a high dollar. Congress may pass some tax cuts and additional infrastructure and defense spending in 2017, further boosting an already growing budget deficit.

Stronger U.S. economic growth, inflation, increased fiscal spending and larger government deficits are negative for fixed income markets. 

Central Banks
2017 may see the end of global central bank easing and a positive normalization in interest rates and inflation. Global central banks are acknowledging that they are out of monetary policy tools. The outlook for developed markets remains modest but steady. Increasingly sound economic fundamentals supported by U.S. and European policies should help offset weakness in the United Kingdom and Japan.

Policy rates for the U.S. and the UK are projected to rise gradually.  Most developed economies are likely to struggle to consistently achieve 2% core inflation over the medium term.  Further monetary stimulus is unlikely, as the benefits are waning and, in the case of negative interest rates, can prove harmful to the economies that monetary policy attempts to stimulate. The European Central Bank and Bank of Japan each implemented additional quantitative easing in 2016 and are unlikely to raise rates this year. 

The Bank of Japan pledged on September 21, 2016 to keep 10-year Japanese Government Bond (JGB) yields near zero. The Bank of Japan has proven itself to be the boldest in pushing the boundaries of monetary policy. Although a recent pivot by the government toward fiscal policy and longer dated yield targeting implies the central bank may begin to step aside, the policy rate is expected to fall slightly deeper into negative territory.

European bonds were volatile on speculation over the European Central Bank (ECB) quantitative easing (QE) plans.  On December 8, 2016, the ECB announced that it would extend the QE bond purchase program. European rates are expected to become less negative.

Central banks across the globe have reached a critical stage and are hitting the limits of monetary policy, which is leading to diminishing benefits and increasing risks with negative interest rates.  Negative interest rates have had a damaging impact on the banking sector. Europe is experiencing slow but steady growth.  Japan is stabilizing and will curtail additional stimulus. 

The populist tide in the UK’s Brexit and the U.S. Trump win is a global phenomenon. Elections in 2017 in France and Germany may cause key economies to adopt nationalistic and trade-protectionist policies.  Developed countries may implement significant fiscal expansion plans that may increase the global amount of government debt.

Growing global debt, the rise of political populism and geopolitical threats all still highlight potential risks. Populist politics and anti-globalization sentiment have set the stage for significant policy change in 2017 and beyond.

Possible protectionist trade policies could lift consumer prices by raising the cost of imports. Rising energy prices also helped boost headline inflation. Higher inflation prospects mean that the Fed would tighten monetary policy by raising rates.

Modest rate increases in 2017 may create a more challenging environment for fixed income investing. This rate hike cycle will be more difficult than the last. Rates are rising from extraordinarily low levels and fixed income investors will not have the high interest coupons to offset potential capital depreciation as rising rates lead to falling bond prices.