Friday, July 14, 2017

Economic Review 2Q 2017

Nicholas Zaiko, CIMA
Senior Consultant
Bridgebay Financial, Inc.

The US economy continues to grow at slow but steady pace.  As of June, the expansion entered its ninth year, making it the third longest expansion since 1900. Growth slowed again in 1Q2017 following a disappointing fourth quarter, continuing the more recent trend of slow expansion constrained by a lack of cyclical boosts.

Slow growth is expected to continue through 2017, but growth may accelerate and stabilize into 2018, reflecting a pick-up in exports, inventories and government spending. Stronger investment spending and an improving global economy should be tailwinds, though the prospect of significant fiscal stimulus has diminished, thanks to low unemployment and political turmoil. Regardless, weak productivity and labor force dynamics should prevent any sustained rise in growth above 3.0%.

Labor Market
The June US jobs report was mixed, as the unemployment rate was 4.4% with a higher participation rate of 62.8%.  Non-farm payrolls of 222,000 beating market consensus, while average hourly earnings were a bit weaker than expected.

While the economy maintains a slow-but-steady pace of growth, the labor market has continued to tighten. This reflects two key trends: Low productivity growth, which implies most GDP growth has come from employing more workers, and low labor force growth, which means that much of the job growth has come from re-employing the unemployed rather than new workers entering the labor market.

Solid GDP growth in 2017 and 2018 is expected to reduce the unemployment rate further, potentially falling to 4% by the end of 2017 and 3.5% by the end of 2018. While wage growth has been stalled for years, there are some indications that wages may have already started to rise.  As unemployment falls and competition for workers increases, the Fed hopes to see upward pressure on wages and prices.

The Federal Reserve
The Federal Reserve has been deliberately cautious in raising interest rates so far, with one rate hike 2016 and two hikes so far in 2017. The Fed has indicated that it is comfortable with the current economic variables. The global economy is generating fewer concerns than in recent years and the U.S. is approaching or at many long-term targets, like unemployment and inflation, making it clear that interest rates are still too low. 

The market expects one further rate hike in 2017, most likely in December.  Chair Yellen’s testimony on July 12, 2017 was seen by many as opening the door to a more gradual rise in rates, but the Fed is clear that they would like to return rates to a normalized level.

The decision to increase rates in June reflected the Fed’s view of the economy, and barring any significant negative shocks or fiscal stimulus, many anticipate the Fed to further raise rates by 0.25% at each press conference meeting through 2018. The Fed’s June outline of future balance sheet reduction shows that the central bank is committed to raising interest rates across the yield curve.  The Fed is expected to begin normalizing the size and composition of its balance sheet by 4Q2017.

Fed Balance Sheet
The Fed’s balance sheet has grown from less than $900bn before the financial crisis to $4.5 trillion today. Agency MBS owned by the Fed now total $1.75 trillion. As the Fed continues to normalize interest rate policy, there is renewed focus on the Fed’s process to normalize its balance sheet and the impact on bonds.

There is now a higher conviction that there will be a September announcement and October implementation of the wind down of the Fed’s Treasury and MBS portfolio. The Fed’s guidance indicates that there would be a roll off of $12 billion in MBS securities in 4Q2017 based on $4 billion/month October through December.  In 2018 the roll off would be approximately $160 billion or10% of the MBS holdings.  The Fed also clarified that once the balance sheet roll off is launched it will continue and not be reversed unless there is a dramatic material deterioration in the economic outlook.  

As the Fed normalizes the size and composition of its balance sheet, it is expected that the phase out of US Treasury and MBS reinvestments will continue to have a negative impact on MBS valuations.  Current coupon MBS spreads have widened and are expected to widen as the Fed reduces its balance sheet.

Fed Stress Tests
Big U.S. banks won approval from the Federal Reserve to return money to shareholders, suggesting regulators believe they are healthy enough to stop stockpiling capital.

All 34 firms tested by the Federal Reserve got approval for their capital-return plans in the second part of the annual "stress tests" designed to gauge the soundness of the nation's financial system.

The companies include big banks such as J.P. Morgan Chase, midsize lenders such as Regions Financial and credit-card companies including American Express.

The outcome could bolster industry arguments that the banking system is safe enough to allow for cutting back some regulations. It was the third straight year the initial results showed all big banks meeting the Fed's definition of good health.

US inflation has surprised to the downside since April.  The CPI remained soft in June rising 1.7% and core inflation dropped below 2% in April.  After showing signs of strength early in the year, a fall in oil prices and heavy competition amongst consumer cellular services prices has put downward pressure on CPI, both headline and core. However, many economists expect this weakness to be temporary and inflation to edge up through 2018, helped by a weaker dollar and tightening labor and housing markets.

Additionally, inflation calculated by the personal consumption deflator continues to approach the Federal Reserve’s 2% target in 2017, which helped to justify the interest rate hikes in March and June, 2017.

Interest Rates
Long-term interest rates remain very low, especially compared to historical averages. As the Fed continues to raise short-term interest rates and reduce its balance sheet, 10-year U.S. Treasury yields should gradually increase. This back-up in rates may result in weak total returns on Treasuries and some high-quality corporate bonds, suggesting that fixed income investors may consider investing in other fixed income sectors, like structured products and high-yield debt.  Shape of yield curve flattened with short-term rates rising in response to the Fed rate increase and long-term rates falling.

Investment Grade Corporates
New Issuance of investment grade bonds reached $691 billion by quarter end.  With the continued demand for quality bonds, credit spreads continue to tighten.  This year, corporate credit has been supported by a stable economic environment, investor demand for yield and low volatility.  Corporate earnings should remain strong.  With over 40% of S&P 500 revenues coming from abroad, a weaker dollar will boost foreign sales, particularly later this year and into 2018.

High Yield Bonds
Recent high yield bonds are being issued with weaker covenants than in the past and are being called “covenant light” bonds.  Lower quality investment grade BBB credit and high yield bonds have performed well in 2017. 

Today’s bond issuers tend to have higher levels of leverage than in the past.  Strong corporate earnings and a generally positive economic outlook continues to drive an overall positive outlook for fixed income.  Credit spreads remain tight with ongoing demand from institutional investors. 

Weak bond covenants are not as important to investors in a strong economic environment as they are during an economic slowdown when an issuer’s credit may deteriorate.  

In an economic downturn, high yield defaults and breaches in bond covenants may be delayed due to the weaker bond covenants.  This delay may cause an issuer’s credit to deteriorate further by the time the issuer breaches the covenants than if they had stronger covenants in place.  This would lead to lower recovery rates than anticipated based on historical average and bonds may take longer to recover than historical data would indicate.    

Global Economy
After two years of very mediocre growth, the global economy started to show signs of life at the end of 2016. So far, it does not appear that things will cool off, with the global aggregate manufacturing purchasing managers’ index reaching six-year highs in the first half of 2017.

The Eurozone is growing particularly fast, thanks primarily to a weak currency, rising confidence and considerable pent-up demand.  Other developed markets like Japan, Canada and the U.S. continue to accelerate as well.  The recent rebound in demand for commodities continues to be a positive for Latin America, Canada and Australia, while Chinese contribution to global growth has declined slightly in recent months as the government tries to restrain financial speculation.

United Kingdom
The UK appears to be weathering the impact of the Brexit vote better than many had feared, thanks to more competitive exports on a weaker currency.

On June 28, 2017, the pound rallied after Bank of England Governor Mark Carney said interest rates in the U.K. may need to rise if the economy continues to be strong, despite weak consumer spending.  

Speaking at the European Central Bank's forum on central banking in Portugal, Carney said the U.K. central bank's tolerance of above-target inflation is wearing thin as unemployment continues to fall.

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.