January 16, 2020Institutional Investment Management

Financial Institutions Insights

1st Quarter 2020 Strategy

“A Short-Term Rebound Followed by Economic Softening”

 

Recommendations

Interest rates declined 90 basis points in 2019.  While current levels seem low (5-year Treasury note yield at 1.60%), remember in 2012 the same Treasury had a yield 0.50%.  Unless the duration of your bond portfolio is less than 3.0 years, it’s not the time to extend duration.  2020 will be a year to maintain duration, keep the book yield as stable as possible, and use periods of higher rates to make strategic purchases.

Passthroughs maturing in 15 years offer very good value given the excellent liquidity, monthly cash flows, and low premium.  A newly issued pool with a balance exceeding $2.0 Billion sells for $101.25.  The prepayment model assumes a 14 CPR which results in a 5.0 year average life.  The yield at that prepayment speed is 2.20% and the yield spread is 60 basis points.  Half of the principal is paid back in the first four years.  The combination of an attractive yield, short average life and no credit risk makes this a conservative yet compelling option at this time.

We continue to find excellent value in private MBS.  Credit quality is excellent, and most have credit support that increases every month.  Yields spreads are north of 100 basis points with pristine credit quality on the underlying collateral. Let’s look an offering that was issued in 2019, has a AAA credit rating, 12.4% credit support and one delinquency out of 511 loans.  The yield at a reasonable prepayment speed is 2.83% and the yield spread is 127 basis points.  The weighted average LTV is 66%. The average life at 15 CPR is only 2.65 years.  The price of the security is $101.50 which minimizes negative effects from fast prepayments.  We consider this a very good value.

Longer-term (longer than 10 years) municipals are normally the best longer-term option due to the tax-exempt feature and the fact the municipal bond yield curve is historically much steeper than the Treasury yield curve.   A measure of relative value is calculated by dividing the municipal yield by the like-term Treasury yield.  This number changes over time but let’s see where it currently stands.  A county in Minnesota recently issued tax-exempt bonds maturing in 2033 that were priced to a yield of 2.00%.  A like-term Treasury trades at a yield of 1.90%.  The ratio of the muni yield divided by the Treasury yield is 105%.  We view this as munis having acceptable but modest current relative value.  This offers a yield spread over a like-term Treasury of 104 basis points.  As a comparison, this yield spread was closer to 140 basis points last quarter.  This example shows how relative value changes over time.

 

Economic & Interest Rate Outlook

Our observation last quarter was that the consumer has had real wage growth, jobs are plentiful in several industries with good wages, and consumer sentiment/comfort numbers remain solid.  As a result, we were confident that the start of a recession is several quarters away. Nothing has changed there and in fact, that is our driving investment theme for most of 2020 (5/6ths qualifies as “most”).  There will be more political distraction, a dash of geopolitical tensions, trade tiffs, and the occasional economic release that causes angst, but the consumer will carry this economy in 2020.  The most important influence to track over the next year will be the confidence and expectations of the consumer.  Their exuberance may be tested by challenges and developments both at home and abroad. 

Europe is in a manufacturing recession.  The December release of the IHS Market’s Gage of Factory Activity fell to 46.3 (a number below 50 represents contractions).  It is the 11th consecutive month below 50.  Although Germany was the worst performing country, the contractions in both the Netherlands and Italy were the worst in more than six years.  For added context, manufacturing in Germany is nearly twice as important to GDP as is the case in the US. Also, of note, the rate of job losses was the worst since early 2013. 

The International Monetary Fund (IMF) has yet again lowered global growth forecasts.  2019 is expected to come in at just 3.00% growth and the 2020 outlook is for 3.40% growth (down from an expectation of 3.60%).  Europe, and more specifically, the European Central Bank (ECB), is in a tough position.  Their negative rate experiment has resulted in INCREASED German savings rates.  So, whereas negative rates were likely designed to stimulate spending over saving, it may have been a rationale outcome for savers to save more in the face of their cash slowly eroding away, rather than earning interest on surplus assets.  Now the ECB is in the unenviable position where it seems that raising rates would stifle growth (from those using credit in order to consume) and if they make rates more negative, savers may consume less so they can save more. It seems that some other pro-growth policies are needed such as increased immigration, government spending, or incenting business investment.          

Domestically, we expect that at times consumer confidence will be shaken by signs of weakness in the manufacturing sector, increasing personal debt burdens, volatility in the market appetite for corporate credit exposure, and diminished long-term growth expectations.  In the 3rd quarter of 2019 the ISM Manufacturing Purchasing Managers Index, a measure of the manufacturing sector in the US, started showing signs of contraction.  In December the contraction deepened to a reading of 47.2 (a number below 50 suggests contraction).  Not surprisingly, in response US manufacturers expect to reduce capital spending by 2.10% in 2020, which would be the first decline in 11 years.  If you aren’t making as much as was in the case in the past, you aren’t transporting as much either.  In the 3rd quarter, US railroad carloads declined by 5.5%, the largest drop in three years.  The point being that although manufacturing is a smaller segment of the US economy, a slowdown has contagion impacts.

The consumer may, themselves, be on shaky ground.  A study by UBS recently showed that 44% of consumers are not meeting their monthly expenses.  In the three-month period that ended in June of 2019, auto loans that were 90 or more days late made up 4.6% of total balances, the highest number since 2011.  The same measure for credit cards showed 5.17% of total balances were seriously delinquent, the highest reading since 2012.  According to the New York Federal Reserve, over the past 10 years US households have amassed $803 billion in student loan debt (compared to $576 billion for autos, $493 billion for mortgages and $69 billion in credit card debt).  There is obviously a student loan crisis brewing (as is there a cost of college and a college education value proposition crisis).  The government solutions currently discussed range from unequitable and moral hazard creating to downright gross.  Specifically, there is a solution called an Income Share Agreement where either individuals, corporations, or the government get a piece of a person’s incremental wage growth in exchange for funding a portion of the student’s education.  Let the bidding begin!

We have said before that the key to a strong economy is confidence.  The Fed Chairman has made comments that suggest keeping an eye on consumer expectations and the data are starting to reflect a slide in future expected economic strength.  Chairman Powell said in testimony before the US Congress that persistently low inflation readings could lead to an “unwelcome” downward move in consumers’ inflation expectations.  In December, the University of Michigan consumer sentiment survey showed a drop in long-term inflation expectations to the lowest reading on record.  While that sounds quite dire, it is important to remember that we have been in a low inflation environment for more than a decade.  People anchor expectations based on past experience (economists call that “hysteresis” and in the field of behavioral finance it is called “decision anchoring”).  For some market participants, all they have known during their adult life is low inflation and this too will likely be an economic influence for many years.  Our interpretation is that the weak long-term expectations may be hardwired into many of the Millennials which further diminishes the risk that run-away inflation expectations may have on fixed-income investments.

Last year saw the most credit rating downgrades for US corporate debt since 2009, yet the extra yield you earn (the spread) over a comparable term Treasury for both investment grade and “junk” rated issuers is very stingy by historical standards.  Whereas “junk” spreads began 2019 around 525 basis points over Treasuries, they closed the year offering roughly 325 basis points over the Treasury.  If this relationship normalizes, we can expect some companies to have a tough time managing the increased cost of additional debt and at the same time, the market’s willingness to extend credit could dry up.  Decreasing creditworthiness and stingy yields for extending credit does not seem like it can end well.       

We have established that Europe and the ECB are in tough shape, the consumer is showing some signs of stress and long-term pessimism, corporate leverage and the cost of borrowing may be a source of turbulence and domestic manufacturing may be in the start of a recession.  How is it that it may be time to “remove the water wings” and let our economy swim on its own?  We believe the Fed may be watching the challenges of the ECB and the Bank of Japan (BOJ) and have brilliantly realized that they may have a small window to get the US economy back to being one where the markets act more on a stand-alone basis and less of being a ward of the State. Recent comments from both the Cleveland Fed President (Loretta Mester) and the Chicago Fed President (Charles Evans) have suggested that geopolitical uncertainty is, to a degree, noise, and that the US economy is fundamentally sound. The Dallas Fed President (Robert Kaplan) has said that the disappointing December manufacturing numbers and the tensions between the US and Iran don’t impact his outlook for 2020 (he expects growth of 2% to 2.25% for 2020).  Fed officials have signaled that policy is expected to stay on hold through 2020.  Chairman Powell has also said that he believes “monetary policy is in a good place.”  Kaplan has said that geopolitical tensions could result in a “repricing of risk assets” that could be healthy, but the development that would be worrisome to growth prospects would be a “severe tightening in financial conditions, particularly the availability and cost of money.”  The translation of the quotes above is that 1) the economy is sound, 2) the Fed would like to become less of a factor in the proper functioning of the economy and 3) they are going to try to let markets “work.”  That said, if corporate spreads/borrowing costs dramatically increase and credit dries up, they will jump back in to stabilize price expectations and the employment environment.  If the Fed can pull this off, and it all hinges on the durability of the consumer, it would be masterful.  If they must step in, we are headed the way of Europe and Japan. 

Where exactly do we think a masterful outcome would place domestic interest rates at the end of 2020?  The answer, sadly, is that we would see yields close to where they are at currently, with a bias toward rates being lower.  If the Fed is in a position where they must step in, our expectation is that we are dealing with lower rates and the yield curve steepness that we currently enjoy may be wiped out.  Last quarter we dove deep into the impact and challenges of negative rates (sloppy risk allocation, misallocation of resources, valuation models being thrown out the window, and complex consumer behavior patterns represent just a handful of the related headaches).  Let’s hope they pull it off and we have the luxury of dealing with positive yet low interest rates. 

A new paper by Yale professor, Paul Schmelzing, has us thinking that perhaps where we are at is not so bad after all.  The study looked at real interest rates of developed markets over the past 600 years.  The deduction seems to be that although interest rates demonstrate a reversion to the mean, the mean is declining over time (roughly 1% every 60 years).  The author’s observation is that developed markets should see negative real rates of interest about a quarter of the time.  The result seems reasonable to us because as technology and governance “improves,” the friction to moving capital should seemingly reduce the cost (or value) of capital.  Also, as sources of capital are disbursed among more people, cost/value could decline as well.  The world is awash in liquidity right now and moving/lending/investing funds is as easy as it has ever been, so it seems plausible to us that the value of capital will remain low for the near future.  Longer term, we see some imminent technological changes that should be disinflationary and that could result in more capital being concentrated.  Such technologies include quantum computing, 5G data transmission, genetic modification and nuclear fusion.

From an interest rate strategy standpoint, we are in the camp of “buy on the dips.”  The Fed has indicated that they want to be hands off for the foreseeable future and we are only a strong economic release or two away from market participants coming to the usual conclusion that the Fed is behind the curve.  If that happens while the curve has some steepness and interest rates are driven higher, we suggest jumping in with both feet.  In fact, that environment may offer another opportunity to sell short bonds and extend portfolio maturity to pick up some meaningful additional yield.  The credit spread environment is such that we would continue to focus on quality exposures.  We would start averaging into the market if the 10-year Treasury yield is above 1.95% and we would have a tough time seeing yields climb much past 2.20%.  Municipal bond yields, relative to Treasuries, are a bit underwhelming as of late and we would be a buyer as “AA” rated bond yields reach a level that is 100% of the comparable Treasury.

Taxable municipal bond spreads are attractive from an historical perspective but if the yield is a “push” on an “apples to apples” comparison with tax exempts, the edge should go to the tax-exempt security.  We expect the value of the tax exemption will increase over time as tax rates are more likely to be higher in the future.  We continue to expect 10-year munis will be stuck in a range where yields may fall as low as 1.40% and we may see them reach as high as 2.00% - for AAA rated bonds).  “A” rated bonds that ACG deems to be of “AA” quality in the 13 to 15-year area can currently be found with yields of 2.00% to 2.20%. 

The noise of the markets and the extrapolation of the expected outcome of the Presidential election will cause many waves over the course of 2020.  Use the overreactions to posture the portfolio for long-term success and stability.

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