April 16, 2019Institutional Investment Management

Economic Overview 

Our theme for the first quarter was: “Things are Slowing Down” which turned out to be the case.  Many economic indicators in Europe have pointed to a slowdown this year. The Purchasing Manager’s Index (PMI) peaked in the Eurozone in December 2017 and had fallen below 50 recently.  A reading below 50 is worrisome as it means activity is no longer expanding, it is contracting.  Global trade volumes have also been declining.  A very bad winter in much of the U.S. will undoubtedly result in a weak Q1.  GDP NOW is predicting GDP will increase 1.7% although the trend has been slowly moving higher.  The next move by the Fed is expected to be a rate CUT which is in stark contrast to the view three months ago.  Oddly, the U.S. equity market had the best 1st quarter performance in over 20 years! Equity markets tend to be forward-looking so maybe we get a rebound in the 2nd quarter? 

"The next move by the Fed is expected to be a rate CUT which is in stark contrast to the view three months ago."

We think a slight rebound in the 2nd quarter is going to occur.  GDP could easily increase 2.5% - 3.0%.  There will be an unexpected increase in spending due to many areas of the country rebuilding after flooding has stopped.  In addition, springtime is traditionally a time when spending increases due to warmer weather.  People can temporarily delay spending but when unemployment is low, but they will not delay spending indefinitely.  The decline in interest rates which began in November should also boost housing which tends to be a very interest rate sensitive sector.  Autos are also interest rate sensitive, but the macro data is pointing to a slight increase in loan delinquencies. Not likely to be much of a boost from the auto sector.  The consumer will have to come through for the economy and a low rate of unemployment increases the odds that they will do just that.

Last quarter we argued that the likelihood of a near-term recession this year is very low.  We stand by that prediction.  Unemployment remains very low, wages are rising slowly, and interest rates will act as a catalyst for more spending.  Measures of consumer confidence remain very strong and inflation has been stable at a very low level. The Fed is also on hold (although some are arguing for an immediate rate cut).  Equity markets are making savers fell better-off.  The changing shape of the yield curve is something to be watched.  While not inverted, it is moving in that direction.  Europe is noticeably weaker.  So, while the data is not uniformly positive, the conclusion we draw today is that the economy will rebound in the 2nd quarter.


Chasing a little extra yield offered through securities containing call features is a mistake we have seen over and over again.  Why give someone else the right to call your portfolio (or at least a portion of it) when it benefits them the most and you the least?  The reinvestment of proceeds from bonds getting called typically occurs at an inopportune time.  Recent history may provide a perfect example.  The Federal Farm Credit Bank (FFCB) issued a 5-year security callable in 3 months in mid-November.  The yield was 3.625%.  At the time a 5-year agency bullet traded at 3.05%.  The difference is what motivates some investors to buy the callable bond.  Interest rates fell and this bond was called in February.  The new coupon on a 5-year FFCB callable was 2.80%.  If rates don’t change much, this bond will also be called in 3 months.  The smart investor has locked-in the 3.05% for the full 5 years.  The callable buyer is at the mercy of the markets and the issuer.  Over the 5-year life of the callable agency, given the path laid out above, the best weighted average yield of the holding is roughly 2.84% (3 months at 3.625% and 57 months at 2.8%).  Assuming rates stay static and the new callable agency yields roughly 2.75%, the weighted average yield of the callable bonds drops to approximately 2.80% (3 months at 3.63=25, 3 months at 2.8% and 54 months at 2.75%).  In either case it is an unappealing trade as compared to the original 3.05% bullet agency option. Sadly, it occurs again and again everyday by many investors and the recent past is a prime example of why we often avoid callable securities. 

"Why give someone else the right to call your portfolio (or at least a portion of it) when it benefits them the most and you the least?"

If we eschew callable securities, what do we currently find attractive?   While we have frequently recommended buying longer term municipals the relative value isn’t very compelling right now.  Our advice is to be patient and wait for a more attractive relative value opportunity.  The low loan balance 15-year MBS and the agency CMBS (e.g. Freddie Ks) which have been favorites of ours still have decent value.  Neither is as compelling as it once was because interest rates have declined so much.  It’d difficult to reprogram the mind into thinking a yield of 2.60% is compelling when the same security traded at 3.30% a few months ago.  What hasn’t changed is the excellent call protection both security types offer.  We have frequently discussed the privately-issued MBS (RMMBS) and continue to believe both the yield and yield spread are attractive versus agency-backed MBS.  Remember that the RMBS should be a relatively small percentage of the portfolio…something approaching 10% for example.

We cannot find overly compelling buy recommendations in this lower interest rate environment.  Perhaps the most compelling suggestion is to sell high-grade short-term munis, where values have become so outsized that you are likely better off on an after-tax basis buying Treasuries.  We have argued for many months that extending the duration of the investment portfolio was prudent given we had the highest yields in a decade.  The Fed tossed the market a curveball and they knocked it out of the park.  In this lower interest rate environment, nothing looks “cheap”, but one thing will always be in vogue.  Call protection will never let you down and don’t fall for the poison apple-like enticement often offered by callable securities.  In the end you may regret the book yield and cashflow uncertainty it introduced to the portfolio.

Interest Rate Outlook

In the realm of central bank actions, a policy switch tends to take time – likely to preserve its most valuable currency, credibility.  A policy change that would normally have occurred over a quarter of a year or more was accomplished over the course of a few weeks.  On January 10th, Chairman Powell pivoted away from December comments, indicating additional rate hikes would be needed, to a message that a gradual and patient stance was warranted.  In a statement released on January 30th, the Fed suggested that the need for additional rate hikes had weakened and they declined to rule out a rate cut as the next move.  In the glacial speed of “normal” Fed actions, that was a head-snapping regime switch.       

As is customary, the Fed hasn’t offered the markets a roadmap of specific factors that lead to the abrupt change.  The most concrete suggestions seem to center on concerns about slowing global growth, an interest in continued signs that the domestic job environment remains strong and a move in inflation trends that are more in line with the Fed’s stated goals.  Given the slowing domestic and global growth, overshooting tightening efforts poses asymmetric risks to the economy.  One truth of this economic recovery has been that intentionally or otherwise, the Fed has been overly optimistic about telegraphed growth expectations.  At a point, their perpetual enthusiasm may have been the greatest threat to their credibility.  We think the Fed made the correct move for several reasons, but the most compelling reason may be that they have plenty of tools to fight inflation but only a small playbook to address deflationary spirals.

The three factors of concern that have been mentioned by the Fed (growth, jobs and inflation) have had, or are about to have, some measurable hiccups.  Recent weak job growth and retail sales numbers are suggesting the U.S. economy may be losing momentum.  The International Monetary Fund (IMF) has recently cut its growth expectations for both the globe and the United States.  It slashed the growth forecast for the third time in six months, reducing the global growth expectation to 3.3% in 2019, down from the 3.5% number expressed in January.  The IMF cited the impact of tariffs, risks related to Brexit, the US government shutdown and lower than expected public spending as factors that influenced their outlook.  Domestic economic growth and inflation expectations may see signs of weakness from the first quarter, yet to be released in the second quarter, based on the economic drag caused by the government shutdown, some continued trade uncertainties and the paralyzing weather that hit much of the US through much of the quarter.

The markets appeared to focus on two additional data points.  First, nervousness seems to be building from the fact that the U.S. may soon be in the longest economic expansion in history.  As fans of mean-reversion, especially in a fair/fully valued environment, we understand how markets take note once you have the best/worst/longest/shortest measurement of a particular variable.  Such a development is a reasonable cause for market “noise”, but it doesn’t seem to be enough to cause a new longer-term trend.  The second data point that may just be “noise,” for now, is the inversion of segments of the U.S. Treasury yield curve.  You simply can’t ignore the reality that since the 1960’s, every US recession was preceded by an inversion of the yield curve.  That said, correlation does not equal causality.  We will revisit the yield curve inversion shortly, but the importance of this development is its power as a “red light” signal for many market participants.          

Related to the cautionary signs the market is observing, the mixed data points we have recently seen and the ones we expect we are about to see, we think the Fed has made a prudent policy switch.  The stock market is back near all-time high prices and the bond market has seen nice price appreciation, both suggesting opposite economic paths, how is it ACG is suggesting the markets may have gotten things mostly correct?  The stock market likes as much certainty as possible.  The Fed’s recent dovish stance has just provided the equity markets with a large dose of policy certainty.  At the same time, it may have confirmed the bond market’s view that there is a short and shallow economic slowdown in our not-too-distant future.  The shape of the yield curve suggests as much.  The Fed has provided both confirmation of the possibility of a small slowdown along with near-term policy certainty.  The state of “excesses” is such that a slowdown might be shallow and short and with limited prospects for run-away growth/inflation expectations, it would be reasonable that both the stock and bond markets would be “up.”   

Our view is that the Fed’s actions will give the economic expansion the likelihood of a few more breaths of life.  Recent market pessimism has not given the proper weighting to the optimism of the US consumer.  The most current consumer sentiment, real wage growth and service economy numbers suggest that consumers are a powerful and durable source of continued economic activity.  Add to that, increasingly accommodative central bank policy and there is a significant case for both economic expectations and bond yields to surprise to the upside in the coming months.  It may be worth repeating last quarter’s call that “the consumer carries the economy, business spending moderates and government spending expands modestly.”  Beyond the near-term, we anticipate that economic expectations will slide lower in the 12 to 20-month timeframe.  We would see it as a buying environment if 10-year Treasuries hit yields of 2.8% or if we see 10-year high-quality municipal bonds at yields above 2.6% and 15-year munis at yields close to 3.0%.  We are currently well below those levels, but we are only a string of strong economic data releases away from seeing them again.

"Our view is that the Fed’s actions will give the economic expansion the likelihood of a few more breaths of life."  

The Yield Curve (and other great conversation starters)

There is no denying there is a clear relationship between an inverted curve and recessions.  It may be misplaced faith that one leads to another.  Rather, they may be symptoms of each other at different times.  Currently, the Fed’s posture is somewhere between being neutral and slightly restrictive.  The recent curve shape occurred as the Fed moved from an extremely accommodative Fed Funds rate of roughly zero, through a series of nine rate hikes, at the same time as longer-term economic growth expectations moderated.  A key difference between past tightening cycles and this one may be that in the past the Fed was moving toward a clearly restrictive stance and this time they paused at a neutral position.  The former is for the purpose of constraining “animal spirits” of the market and once it takes hold the long end of the curve sees yields fall.  The latter seems to be a rare bird and its effect on the psyche of the market is anyone’s guess. 

What’s ACG’s guess?  As already indicated, we think the Fed’s actions may have prolonged the expansion.  Perhaps this time they got it right and possibly this time things are different (and yes, that is a very uncomfortable comment to utter).  We will borrow some comments offered by Nobel Laureate Myron Scholes (co-author of the Black-Scholes option pricing theory) to expand the discussion.  He makes a distinction between a “bear inversion” where in response to inflation concerns the Fed hikes sort-term rates to the point where they are well above the rate of inflation, making money “expensive” and a “bull inversion” where prices seem to be in check and growth expectations soften, causing the long end of the yield curve to fall.  In this current cycle, short-term rates haven’t moved materially above inflation.  Three-month T-Bill yields are only 30 basis points above core inflation.  In every recession since 1960, the three-month bill exceeded inflation by roughly 200 basis points.  On that basis, money doesn’t seem to be “expensive” and as credit and the velocity of money are the lifeblood of the economy, it appears the tepid expansion will continue.

Perhaps another piece of information that confirms the view that growth will continue in the near-term involves the credit markets.  Specifically, credit curves (the difference in incremental yield as compared to a like-term Treasury security, between short-term and long-term corporate bonds) may be suggesting that the market doesn’t expect economic difficulty or defaults in the near term.  Currently, the “credit spread” between short and long corporate bonds is roughly 120 basis points.  The average since 2000 is approximately 80 basis points.  This indicator may be suggesting two things.  First, the size of the spread may be telling us that the market expects longer-term inflation concerns or increases in expected defaults over the long run.  Second, it is likely saying that the expectations for near-term difficulties is slim.  The last time we saw an inverted credit curve, in March of 2008, was just before the Great Recession.

Counter to the rosy picture presented above, or at a minimum, influences that are making things opaque include; continued massive deficit spending supported by Modern Monetary Theory (MMT) and the legacy influence of the Fed’s Quantitative Easing (QE) program.  MMT says that since the U.S. borrows in its own currency, it can print dollars to cover its spending and we can’t go broke.  With trillion-dollar deficits and the second year in a row of trillion-dollar new Treasury issuance, we seem to be on a path to allow future generations the opportunity to see how the perpetual fun machine of MMT ends up.  Economics 101 suggests that if government spends and borrows too much, at a point it “crowds out” investment dollars, pushing borrowing costs higher.  Not nearly as fun as MMT but it seems a bit more reasonable.  The Congressional Budget Office estimates the current path will cause the U.S. debt burden as a percent of GDP to hit the levels seen just after WWII in roughly 10 years (93% of GDP).  MMT fans may point to a negative Term Premium as support for their view.  Term Premium is the extra compensation that investors need to hold long-term debt instead of successive short-term securities for the same period.  For much of the past 50 years the Term Premium has been positive but for the past few years things have turned negative.  Generally, a lower premium means lower bond yields. During the first quarter the 10-year Treasury premium was negative 72 basis points.  Likely distorting the value of the Term Premium concept is the more than $2 trillion of Treasury holdings at the Fed.  Some estimate that the Fed’s holdings reduce the premium by nearly a full percentage point.  While central banks continue to distort debt markets, it’s difficult to point to any one data point and be certain of a particular market call.  Our expectation is that excessive pessimism will give way to a short-term bout of optimism.  Longer-term we will see a slowdown in the next couple of years and we will live to worry about the debt and deficits another day.