July 15, 2019Institutional Investment Management

Economic Overview

The expectation of a rebound in Q2 GDP is not likely going to happen.  The 3.1% we experienced in Q1 looks like it will fall to the low 1% area for Q2.  The lag in GDP reporting explains why we discuss it here briefly.  Third quarter GDP is expected to be 1.5% to 2.5%.  We don’t expect a strong rebound as we move closer to the end of the year, due to continued global slowing and nagging tariff issues.

The Fed’s favorite measure of inflation is the Core Personal Consumption Expenditures or PCE.  Their target level is 2.0%.  No one knows the magic behind why they chose 2.0% but here we stand.  For much of the past ten years this indicator has been below the 2.0% target.  A market-based measure of inflation that looks at Treasury Inflation Protected Securities (TIPS) shows that even for a 30-year maturity the inflation rate is expected to remain below 2.0%.  Not to get too technical but the five year forward breakeven inflation rate, another measure favored by the Fed, is near the low end of the three-year trading range.  More traditional measures like the CPI and core CPI have been moving sideways since 2012.  Will a rate cut help?  Historically rates cuts have led to LOWER inflation.  Maybe this time is different but maybe it isn’t, and we will be discussing deflation in the future.

"Will a rate cut help?  Historically rates cuts have led to LOWER inflation."

The Institute of Supply Management (ISM) indicator has been weakening domestically, and much more abroad, for months.  Recall this was referred to as the Purchasing Manager’s Survey but the name was changed.  It measures production levels but also has a New Orders component which identifies possible expansion or contraction in the future.  A reading below 50 means production is contracting, above 50, it’s expanding.  The New Orders component of the ISM has fallen from 70 in December to 50 currently.  The Prices Paid subset is at 48, down from 80.  The broader ISM has dropped from 62 to 52 during the same period.  All the components are at or approaching a level that indicates a slowing.  Europe is ahead of the U.S. in that regard, with Germany currently at 45.

GDP should rebound to 2-3 percent for the 3rd quarter.  Lower interest rates, an accommodative Fed and a consumer that has a job, with a higher 401k balance, are reasons to be optimistic.  Weather also plays an important role in economic activity.  Flooding we saw last quarter seems to have abated.  Rebuilding the damage will give activity a small boost.  Summer travel is in full swing and we tend to spend more while on vacation.  Auto sales are running at a 17 – 18 million annual rate which is very good.  The housing market remains very strong, maybe too strong as some potential buyers have given up due to homes selling with multiple bids above the listing price. It’s very plausible to see an increase in GDP in the 3rd quarter.

The likelihood of a near-term recession this year is very low.  Unemployment remains very low, wages are rising slowly, and interest rates will act as a catalyst for more spending.  Measures of consumer confidence generally remain strong and inflation has been stable at a very low level.  Unless we get some sort of exogenous shock, we don’t see a recession for some time.


Our theme for the second quarter was: “The Global Slowdown Has Begun” which turned out to be accurate.  This resulted in interest rates falling by roughly 40 basis points for the quarter. We also discussed our avoidance of callable agency bonds as they get called when you want to keep them and don’t get called at the point at which you wish you had never bought them.  While it’s true the investor gets a higher yield versus a like maturity security that isn’t callable, the incremental yield seems to never be enough, especially when the final maturity is long and the call feature short.

"Our theme for the second quarter was: “The Global Slowdown Has Begun” which turned out to be accurate.  This resulted in interest rates falling by roughly 40 basis points for the quarter."

We recently have revisited a type of agency backed Commercial Mortgage Backed Security (CMBS) known as a Fannie Mae DUS (delegated underwriting and servicing).  Most of the issuance involves a 10-year maturity and a 30-year amortization schedule.  The lender who originated the loan is responsible for one third of any losses.  One unique feature is Yield Maintenance.  Since many deals are backed by one multi-family loan, the investor wants protection is case the loan gets refinanced or what’s more likely, the property gets sold.  Yield maintenance is a form of prepayment penalty which makes the bondholder whole in the event the loan gets paid off prior to maturity.  The penalty is relatively easy to calculate and there are instances where the bondholder is made more than whole if the loan prepays.  Additionally, if the bond has a low coupon and rates rise and the loan prepays the bondholder can reinvest the proceeds into a security with a higher yield.  Cash flow during the life of the bond is minimal due to the 30-year amortization schedule.  The key is to do your homework and look for ones that are likely to prepay, especially if they have a low coupon.

Private Mortgage Backed Securities, which we have recommended before, remain one of our favorite options.  Credit quality is excellent, and most have credit support that increases every month.  Yields can easily be well above 3.00% with an average life of 4-6 years. Liquidity is also very good.  These cannot be pledged by banks, but the risk-weight is 20% for AAA rated bonds.

Our final recommendation is in the municipal sector.  A measure of relative value is calculated by dividing the municipal yield by the like term Treasury yield.  This number changes over time but it was widened out quite a bit recently for a 10-year maturity.  Tax rates vary but taxable equivalent yields in 10 years can top 3.00% (based on an S-Corp bank at a tax rate of 35%).  That’s not bad considering the 10-year T note yields 2.0%.  This implies a AAA rated bank qualified security.  AA rated bonds will have a higher yield with minimal increase in credit risk.  Look for bonds that are not callable, especially if your balance sheet is asset sensitive.

Interest Rate Outlook

Now that the markets have adjusted to the rapid regime switch regarding Fed policy, market participants and pundits are trying to mine history and soul-search for what this means for the economy and investment assets.  In short order, the talk changed from how many Fed rate hikes could the market digest, to the length of time it would take for the markets to accept a policy change and now some market participants are wondering if the Fed will cut rates 50 basis points in July.  Clearly the mindset of the market has changed.  The new market obsessions are centered on the twists and turns of trade negotiations, Fed comments and each “negative” economic datapoint that is released.

It is important to view information through the current lens of the market, where bad news is good news, because it reinforces the prospects that the Fed will bring the “easy money” punch bowl back to the economic party.  Just so you understand the current rules, a lack of bad news is bad, good news is really bad and bad news is good.  There may be a real basis for this orientation.  As we often say, credit is the lifeblood of this economy.  Access to cheap money/credit and the desire on the part of consumers to use it are important to sustaining current consumption levels.  The velocity of money during long periods of this recovery has been downright stubborn, the Fed has generally been unable to get inflation to its target levels and they likely know the risks and consequences of choking-off this tepid recovery.  Although job numbers and wage growth measures continue to be good, there are several areas of the economy that are seeing a deceleration in growth or even some signs of contraction. 

"It is important to view information through the current lens of the market, where bad news is good news, because it reinforces the prospects that the Fed will bring the “easy money” punch bowl back to the economic party. ";

As evidenced by recent Fed comments, there is a significant focus on the lack of inflation – which would tend to call for increased accommodation.  As tariffs result in higher consumer prices, it is a wonder if any measured whiffs of inflation are merely picking up transitory signs of economic “health.”  Could it lead to a misdiagnosis and a longer policy pause than the market will accept?  Using a tariff to renegotiate trade terms (or political challenges) is a bit like using a hammer to address all household tool needs.  It comes with consequences.  Farmers are impacted greatly by this course of negotiation.  A few numbers tell the story.  According to the Minneapolis Federal Reserve Bank in 2018, farmer bankruptcies were up 30% in the six Midwestern states they cover.  Farmer incomes are down 11% since 2010 and expenses are 31% higher.  So far this year, personal income for farmers is down 25%.  This is a war with casualties.  To the positive, the dialogue between the U.S. and China has resumed and President Trump has eased the ban on U.S. companies that are suppliers to Chinese tech giant, Huawei.  Given that the U.S. and China will be jockeying for the distinction of being the world’s largest economy for the foreseeable future, we may see times of truce and peace at the surface, but this trade war will likely be the unending war of our lifetime.        

Currently, the market anticipates a near certain rate cut at the end of July, followed by another one in the fall and a final cut in the first quarter of 2020.  Fed comments have seemingly solidified this cut and it is priced into the market.  The comments that follow the meeting will likely be what propels the equity markets higher and affords the U.S. Treasury yield curve more steepness.  Comments that lead the market to expect a bias toward accommodation will impact the market as expected.  Suggestions that future accommodation will be sparse could cause the equity markets to dip and the bond market may see larger segments of the yield curve invert.  That is not the environment the Fed wants.  So, for a time, the tail will wag the dog.  If the Fed is trapped under the 2% inflation goal, they need to stoke animal spirits and disappointing the market simply isn’t going to give them what they want. 

People have been studying the past for a glimpse of what this policy U-turn may look like this time.  The closest comparison seems to be the 1995-1996 rate cutting cycle.  Back then the Fed pointed to moderating price pressures, both U.S. and global growth was slowing, and the labor market was thought to be tight (and Bill Clinton was up for re-election, and my recollection was that he didn’t disparage his Fed).  Only 11 months after the conclusion of the January 1996 rate cut did then Fed Chair Alan Greenspan make the comment about the inexplicable strength of the domestic stock market, referring to the market’s “irrational exuberance.” Although it is fun to look back at history, and at times it is informational, it was nearly a quarter of a century ago when consumerism was “in” and the production of inexpensive goods from China was on the rise, resulting in a credit-driven, low-inflation period of economic growth.  Greenspan’s policy, against the backdrop of a low-inflation environment with pleasant levels of growth earned him the moniker, “The Maestro.”

Looking at the current economic landscape, it seems like our “financialized” economy will result in what John Maulden refers to as “Japanification.”  In order to build up to the crescendo it may help to offer our orientation.  Low capacity utilization metrics around the globe likely has policymakers thinking that the perfect way to address excess aggregate supply is to stimulate demand.  The stubborn demand “problem” may come from several sources.  In three of the world’s four largest economies, the labor force is shrinking.  Per capita domestic demand growth rates are near the levels seen before the global financial crisis (people are spending as much as they had in the past during good times, how do you get them to want to spend more?).  It seems that addressing the supply problem from the demand side will be difficult. Much of this demand was seemingly fueled by massive amounts of both federal and corporate borrowing.  Perhaps that debt load can wear off over time, but the likely outcome is that it won’t be unwound.  In other words, the fact that we have “financialized” our economy means that we need low interest rates to keep the cheap money flowing that is needed to sustain demand.  This debt load has positioned the U.S. and other developed economies for “Japanification” in the next recession.  The thinking is that policymakers will respond with massive (more so than the last time) fiscal and monetary stimulus which will act to further depress growth and leave us in the position Japan has been stuck in for nearly three decades.  ACG has historically said that at a point, debt is deflationary, until it isn’t.

With all of this unproductive debt sloshing around the global markets and a need for cheap financing to keep consumer demand going, what could possibly go wrong?  One might think the best solution is to grab whatever safe yield you can get for as long as you can get it.  Perhaps that may be the safe thing to do but it could be a bumpy ride along the way.  It seems the model we are working under is that central banks will socialize illiquidity and other forms of risk to the capital markets.  A risk we haven’t given much thought to is the risk that we are wrong in our economic outlook.  What if run-away growth expectations take hold of the global or domestic economy?  We model the interest rate sensitivity of the securities we buy and the portfolios we manage but the reality is that market will likely be shocked (and panic) if interest rates rose 100 or even 200 basis points.  We had glimpses of what this was like late last year.  The stock market lost a lot of value and bond market investors saw negative returns.  The reality is that with low yields for so long, the duration (a measure of interest rate risk) of many bond portfolios has increased, due in part to the impact low coupons have on interest rate risk.  As low yields have enticed/forced investors to go down the credit quality spectrum to achieve “acceptable” levels of yield, risk spreads (the amount of incremental yield you earn over a like-term Treasury bond) have become historically stingy.  If a recession becomes imminent, look for high-yield bond spreads to increase and investors will likely see a drop in the value of their junk bond holdings.   In a recession, defaults often increase and when the economy faulters as a result, investors in this space often run for the exits.  Sometimes those doors get pretty small.  We see the most likely source of pain in the bond market as coming from the high yield sector and pockets of illiquidity in certain corners of the market.

"With all of this unproductive debt sloshing around the global markets and a need for cheap financing to keep consumer demand going, what could possibly go wrong?"

The Fed needs to head deflationary pressures off at the pass.  We will see a cut in July and at least one more this year.  We anticipate that the accommodation will allow “certainty” to further drive up equity prices and bonds may modestly appreciate but that most of the movement will be the front end of the yield curve declining a bit – introducing a bit more steepness to the curve.  All will be well until the market decides that bad news is, in fact, bad news (or worse yet, that the Fed is no Maestro and they have stimulated the economy too little and too late).  Hopefully they will have moved the 2% goal post to give them an opaquer measure of meeting their mandates.     

Ten-year Treasury yields began the quarter at 2.40% and ended at 2.00%.  Many taxable bond indexes saw returns of 3% for the quarter.  ACG anticipates that bonds are in a range-bound environment with a floor on the 10-year Treasury at 1.75% and a high end of 2.25% for the next quarter.