Nicholas Zaiko, CIMA
Senior Consultant
Bridgebay Financial, Inc.
www.bridgebay.com
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.
Inflation
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.
