The U.S. economy chugs along at a 2.0% pace (GDP) with a quarterly range between 1% and 3%. Recall GDP advanced 3.1% in the 1st quarter and the 2nd quarter was reported at 2.0%. Expectations for the 3rd quarter are centered around 1.5% to 2.0%. Global growth appears to be bottoming although the Purchasing Manager’s Index (PMI) data out of Germany is troubling. The PMI follows both the services industry as well as the manufacturing sector. While the services indicator remains above 50 (expansionary) the manufacturing indicator has fallen from 60 at the beginning of 2018 to 41 currently. Germany’s GDP was negative in the 2nd quarter. A reading in the low 40s in the U.S. would almost certainly coincide with a recession. Ongoing trade issues with China lead to supply chain disruptions. Markets hate uncertainty. CEOs and CFOs hate uncertainty. This leads to delays in investment spending which has shown up in the quarterly GDP reports. How the China trade dispute plays out remains to be seen. Do the Chinese stall in order to see who might win the 2020 election or do they give the President a small “win?” Whatever the outcome, the Chinese should be thinking about all the manufacturing that is moving to Vietnam and other low-cost producers. It won’t likely come back. They may be miscalculating the risk of the waiting game strategy. The impeachment circus probably weakens the President’s hand in their eyes, which is an incentive to play hardball a while longer.
Closer to home the impact from a slower global economy has pushed interest lower but the equity markets have had three quarters of positive returns. The U.S. Treasury yield curve flattened in the 3rd quarter. The 30-year Treasury bond yield declined 45 basis points while the yield on the 2-year maturity Treasury note fell 24 basis points. Inflation remains very low (core PCE index is rising at a 1.5% annual rate). The slowing global economy, ongoing trade disputes and pressure from the bond market prompted the Fed to lower the fed funds rate by 25 basis points in July and September. Odds of at least one more rate cut this year are very high. The fed funds target range is currently 1.75% to 2.00%. The short end of the Treasury yield curve is trading near 1.50%. The market seems to think two rate cuts are needed.
The bright spot in the U.S. economy is the consumer. Consumer spending increased 4.6% last quarter while the economy grew at 2.0%. As we mentioned above, investment spending declined 6.3% in the 2nd quarter which was the lowest level in many quarters. Low unemployment, rising wages and strong equity markets make the consumer feel optimistic about their finances. One other area of strength in the U.S. is the housing market. Low interest rates have allowed many to refinance and lower their monthly mortgage payment. Existing home sales have increased from a 5.0 million annual rate to a 5.5 million annual rate. We all know when you buy a different house, your spending increases at Home Depot, Costco, Room and Board etc. This is the engine that is keeping GDP at 2.0%. With rates at very low levels, there is an expectation this can and will continue.
As we look ahead to the 4th quarter it’s likely that GDP rebounds slightly to 2.5% - 2.8%. The drag from investment spending isn’t likely to be as great as last quarter. Unemployment will remain under 4.0% and inflation won’t be a concern. The Fed should give the equity markets a small boost. The S&P 500 is 20.6% higher than at the end of 2018. A phenomenal year by all accounts. Valuations are slightly above average but a far cry from overvalued. We don’t expect a sharp sell-off like last year. The holiday season should be very good looking at all the variables at this time. We believe 2019 will end on a positive note, politics aside.
"We believe 2019 will end on a positive note, politics aside."
While interest rates have fallen sharply this year, it isn’t time to panic. When I say sharply the numeric definition is 1.0%. Making the mental adjustment to a lower rate environment is difficult but you have to play the hand you are dealt. Who knows, rates might fall even further. Given that as a backdrop what should fixed-income investors buy now?
We have frequently discussed agency-backed CMBS but we now find good old agency single-family passthroughs very compelling. Here is a recent example. FHLMC pool FG C91095 is a 20-year maturity pool seasoned 36 months. Using a prepayment speed of 9 CPR the average life is 5.67 years, the yield is 2.35% and the yield spread is a very generous 87 basis points. Not that long ago the yield spread would have been in the low 50s. If we use 12 CPR as the prepayment speed the average life falls to 4.9 years, the yield to 2.25% and the spread is 80 basis points. We feel this is a very good option for financial institutions. For someone who is premium averse (the 20-year pool trades slightly above $103) a 15-year 2.5% coupon pool sells for $101, has 4 – 5 year average life, a yield of 2.22% and a spread is 66 basis points. Obviously, the amortization schedule for the 15-year pool provides more annual cashflow.
We continue to find excellent value in seasoned 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 at a recent offering. JPMMT 2017-6 A6 was issued in 2017. The bond has a AAA credit rating, 13.9% credit support and no losses. The yield at a reasonable prepayment speed is 2.64% and the yield spread is 122 basis points. The weighted average LTV is 67% with only 5% of the balance having an LTV greater than 80%. An allocation of 5% - 10% of the portfolio seems prudent to us.
Our final recommendation is once again 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 has widened out quite a bit recently for 10 to 15-year maturities. Tax rates vary based on your tax status but for this example we will assume an S-Corp bank with a 32% tax rate. The issuer is a Minnesota City rated Aa1 and it’s a GO. Bonds maturing in 2033 were priced at a yield of 2.125%. They are callable in 2028. The grossed-up yield is 3.125%. This is a spread over a like-term treasury of 142 basis points. We prefer bonds that are not callable, especially if your balance sheet is asset sensitive. The price movement for a municipal versus a taxable is much lower due to the tax-exempt feature. This reduces the downside price risk by roughly one third.
"Our final recommendation is once again in the municipal sector."
Interest Rate Outlook
Against the backdrop of decent growth numbers, somewhere between healthy and tepid inflation readings, the lowest unemployment numbers in 50 years and continued wage growth in the U.S., it is difficult to see how a domestic recession is imminent. Remove yourself from key data points and the “noise” of the marketplace may have you thinking we are on the doorstep of economic Armageddon. The simple truth is that the U.S. consumer mostly dictates our economic path. The consumer has had real wage growth, jobs are plentiful in several industries with good wages and consumer sentiment/comfort numbers remain solid. We are confident that the start of a recession is several quarters away.
Sounds like yields should be climbing then, right? Well, as emotional and fickle as the markets are, they are an expectations-based-discounting mechanism. The recent stock market and bond yield volatility leads us to believe that political uncertainty, some sagging domestic economic metrics and economic contraction in key developed countries is beginning to weigh on the psyche of the market. On the political front, the talk of impeachment has significantly ramped up. It is difficult to see how any impeachment attempts will be successful at getting through the Senate and no matter the outcome, it is difficult to see how any variation of the impeachment scenario would be a stabilizing force on the economy. Impeachment aside, we will likely find ourselves with a President Trump, who will be unable to pass any significant legislation that may help the economy, or we will have a President Warren, who will likely be met with a conservative business investment environment. No matter the outcome, it seems we have passed the “Clint Eastwood” threshold of political disagreement (the “if I disagree with you, I’m going to burn down your house, go after your family and shoot your dog” kind of mindset). The lack of national identity and near hatred for nearly half of the country seem to be the source of political paralysis and transactional friction for quite some time.
There are genuine signs of winds of change in the U.S. economy. Although I often say the U.S. consumer goes down like Rocky Balboa, other sectors aren’t quite so resilient. Recent data on business investment spending has shown a contraction of 0.60%, after a robust first quarter (it is possible some investment was accelerated in Q1 to get ahead of tariffs). Not too unexpectedly, tariffs have weighed heavily on exports, with a decline of 5.20%. Export orders sank to the lowest point since the depths of the Great Recession. It is estimated the export related drag on domestic GDP is subtracting 0.65% from economic growth. Perhaps the economic release that shook the markets the most was the domestic ISM Manufacturing index which had a reading of 47.2, which squarely suggests the manufacturing environment in the US is contracting. Given this has been the second month of contraction, it’s possible a manufacturing recession in the U.S. has begun. It is important to know that manufacturing represents about 11% of the economy but somehow it feels different when it is in your own backyard.
"There are genuine signs of winds of change in the U.S. economy. Although I often say the U.S. consumer goes down like Rocky Balboa, other sectors aren’t quite so resilient."
The “on again, off again, on again” nature of the trade negotiations with the China are so fluid and complex that we don’t expect a resolution soon. The result will be downward pressure on global growth and a challenge to long-term growth prospects for China as south Asian countries such as Vietnam should be the big winners as a result of the unresolved tensions. We’ve said the “winner” of a trade war is the country that can best handle sacrificed growth. The upcoming trade talks and tariff threats with Europe should have a more domestically beneficial outcome. Q2 GDP in Germany (the economic engine of Europe) contracted. U.K. GDP also fell in Q2 and the October 31 Brexit is a looming source of uncertainty in both the U.K. and Europe as a whole. Italy, the third largest debtor nation on earth, saw no growth for the same quarter. The EU does not have the staying power to engage in protracted trade-stifling skirmishes. Our expectation is that a trade war with Europe doesn’t happen, but it may become a development that garners headlines during the final quarter of the year.
We have a toxic political environment that will not likely result in economic growth (no matter the result of the 2020 Presidential election). Domestic economic results appear to be more likely to see surprises to the downside and trade tensions will continue to weigh on many global economies and some aspects of both the domestic economy and broader economic segments abroad are technically in a state of contraction. It is reasonable to expect that consumer sentiment will be pulled lower in the coming quarters. It may take headlines involving layoffs to get us to the point where the U.S. consumer shouts “Adrian.” A worrisome development in our eyes is the result of a recent Quinnipiac University poll where for the first time since President Trump was elected, more voters say the economy is getting worse than say it is getting better. 31% believe the economy is improving and 37% think the economy is in decline. That may be a crucial statistic for the 2020 election but in the here and now, it suggests sentiment is sliding.
The Fed may give the market one more shot in the arm toward the end of the year in hopes that the market will respond. It may, temporarily. We expect consumer-based economic numbers will push an economic contraction into next year. The Fed doesn’t have the tools in the toolbox needed to stoke fantasies of runaway growth. As we’ve speculated, it is possible that Depression era lessons/spending habits were learned during the Great Recession. Periods of hope, that the U.S. has escaped the slowing fate of the rest of the world, may be found to be misplaced. There should be a quarter or two of transition but in the coming year we anticipate a point when the market will capitulate and we will move back to a paradigm where bad economic news is, in fact, bad news. The Fed won’t be able to talk or “wish” the market out of the slowdown.
"The Fed doesn’t have the tools in the toolbox needed to stoke fantasies of runaway growth."
Zero or Negative Yields – No Thank You
I have a great idea. How about you give me all your cash and pay me to hold it overnight. To make it easier, let’s skip moving the physical cash and electronically you give me possession of the cash and tomorrow you can have it back, less a little something for the good guy (me). That is a good approximation of how zero or negative interest rates “work” except they really don’t generally make economic sense (we’ve discussed exceptions in past editions of Insights). In fact, negative rates result in some contorted economic decision-making and if protracted, they may lead to massive challenges. You thought a flat or partially inverted yield curve resulted in “tough” decisions, wait until receiving a “safe” rate of zero in the short run holds some appeal as compared to locking your money up for a decade, or three, at an “unfair” rate of 1.00% becomes a real choice. It is a real risk and one that poses a systemic challenge for the banking system, defined benefit pensions, life insurance companies and anything that is valued using models that involve a risk-free rate.
Where negative rates over long periods of time may take a significant toll is in the banking system, life insurance companies, and defined benefit pensions. Banks and life insurance companies derive a significant portion of their profitability from the spread they can earn on money. Banks take in savings (a short-term liability) and lend it out at a higher rate (or they buy securities that earn more than they pay on savings accounts). Life insurers take in premium dollars and invest the money in a long-term diversified portfolio of return-seeking assets that hopefully out-earn the claims paid out. Both examples are very simplified, but the descriptions work for this purpose. If banks have a cost of funding that is zero (a fair number to use because even if they have a negative funding rate they have overhead costs) and they either get nothing, or pay borrowers to take loans, there isn’t much incentive to extend credit to borrowers. The bank would be better off shrinking or just closing their doors altogether. The fractional banking system involves a fair amount of leverage, so the impact of negative rates is amplified. Likewise, life insurers often have significant long-term bond investments and if they get in the position where they have to pay to “invest” in long-term bonds, their profitability will be under significant pressure (or they will have to abandon bonds and assume more risk with other asset classes to generate alternative sources of return). Seeing the forest for the trees, a real concern we have is that negative rates would act to dramatically reduce access to credit - the lifeblood of a consumer-driven economy.
According to a 2016 study by Citigroup, the top 20 Organization for Economic Cooperation and Development (OECD) countries have a combined unfunded pension liability of $78 trillion, almost double their published national debt number at the time. Pension liabilities are a big deal and the cynical side of us would say that due to smoothing allowances and other accounting niceties, the true liability is twice the number Citigroup produced. A positive and negative development at the same time is that many pensions have been reducing their return assumptions. That is good, in that it makes the stated liability more in line with reality, but it is a challenge to the sponsor of the plan because it may require increased contributions, which could otherwise be invested in future sources of growth. An avenue of relief that some public pension plans are pursuing involve cutting benefits to participants. We view this as a “soft default” on the obligations. For the international pensions that are forced to invest in sovereign debt at negative yields, we see negative rates as a “friendly” wealth transfer from the plan sponsors/taxpayers to the sovereign. We were beginning to think that with $22 trillion in outstanding debt, the U.S. had amassed an amount that could never be paid back but perhaps negative rates are the path to salvation. Given that very few domestic pensions closely match their assets to the specific composition of their liabilities, we expect there will be trying times ahead. We are in the longest economic expansion in modern U.S. history, return-seeking asset classes and bonds have had terrific returns. Empirically, valuation matters to forward-looking returns, so the plans that pursue the strategy of simply out-earning their liabilities using a diversified portfolio may see near-term volatility in their funding levels. We anticipate price shocks in many return-seeking asset classes and, over time, we expect bond yields have room to fall further. If discount rates on pensions hit zero, or turn negative, things will get interesting.
"We were beginning to think that with $22 trillion in outstanding debt, the U.S. had amassed an amount that could never be paid back but perhaps negative rates are the path to salvation."
Many aspects of the financial system should go haywire if risk-free rates go negative for extended periods of time. Trillions of dollars’ worth of securities are valued using models that are based on a risk -free (Treasury) rate. As that rate goes to zero, or turns negative, that value result will skyrocket. This challenge flows through to the pricing of most securities and efficient frontier portfolio construction. It also puts debtors in the catbird seat, temporarily. As illogical as people actually are when it comes to economic decision-making, there should be a point where those who have investment assets simply wouldn’t accept negative yields. They should desire physical assets, real assets, currency, collectables, or any number of substitutes as compared to paying to let someone else use their money. The only entity we can see that could be that irrational for extended periods of time would be governments and central banks. The treasury of various governments will continue to borrow to fund deficits and central banks will be the buyers. With roughly $17 trillion in negative yielding debt and more than 14 euro-denominated “junk” borrowers with bonds at negative yields, this all feels closer than we would have imagined. Think about that for a minute (and suspend thoughts about inflation differentials or currency movements). People are paying “junk” borrowers, where the risk of lost principal is much higher than is the case with investment grade issuers, to possess their money. This must end poorly.
We are in the range we forecasted last quarter for 10-year munis (a 50-basis point range where yields may fall as low as 1.40% and we may see them reach as high as 1.90% - for AAA rated bonds). “A” rated bonds that ACG deems to be of “AA” quality in the 13-to 14-year area can be found with yields of 2.20% to 2.45%. Bonds at the higher end of that range should be bought. We would also see it as a good entry point if 10-year Treasury yields hit 1.90%. If our longer-term forecast is correct, it will have been a good decision. Expect turbulence along the way but increasingly we think people seeking a strong source of tax-efficient and reliable income will be “happy” in the long run if they are fully invested in a call-protected portfolio of bonds with an interest rate risk level that is at the long end of their comfort range.
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