January 21, 2019Institutional Investment Management

Economic Overview - What a Difference a Quarter Makes! 

We entered the fourth quarter of 2018 with solid economic growth, interest rates near a multi-year peak and an equity market that was trading near record highs.  But things changed.  Expectations that the economy will slow increased as expectations of a global slowdown became more widespread.  Oil prices fell sharply, and the equity markets took notice.  It was swift and it was severe.  The S&P 500, after rising every year since 2008, fell sharply in the fourth quarter and posted a loss for 2018.  European equity indices fell sharply as did markets in Asia.  Interest rates fell sharply despite concrete evidence of a slowdown in the U.S.  One can point the finger in many directions but tighter monetary policy, tariff concerns, midterm elections and China’s slowing get mentioned most frequently.

The environment is materially different from three months earlier so the question becomes: What now?  What will the Fed do?  They seemed to indicate a robot-like approach to monetary policy, which would raise rates two more times in 2019 (this was revised lower as the previous dot-plot showed three rate increases).  The market did not care for the announcement.  It had hoped the Fed Chairman would have acknowledged the sell-off in equities and the widely held view the global economy was softening.  Is there a need for any more rate hikes if the slowdown persists?  From this information, we see that the Fed and the markets have different objectives.  The Fed wants full employment and price stability, whereas the market goal is to not kill the expansion.  We expect the Fed will be on pause at least until June and possibly longer if conditions warrant.

"The environment is materially different from three months earlier so the question becomes: What now?  What will the Fed do?"

The probability of a recession in 2019 is increasing but we do not expect it will occur this year.  While we admit many indicators are slowing, they are far away from recession readings.  The Institute of Supply Management (ISM) report is a great example.  It declined sharply from 59 to 54 last month but remains at a level that shows manufacturing is expanding (just not as fast as before).  The same can be said for the jobs market.  December job growth was expected to be 184,000 but came in much higher at 312,000.  Very few excesses exist which would cause a significant pullback in activity.  Housing is strong, not weak.  An inverted yield curve is a reliable indicator of recession, but it is not inverted today.   A chart of the leading economic indicators is still moving higher.  It tends to roll over prior to the beginning of a recession.  Some point to a 20% correction in the equity markets as a recession indicator.  There have been 13 corrections of this magnitude in the past 60 years and the market did not suffer a recession for 24 months six times.  There simply isn’t enough evidence currently that a recession is imminent.

Our Recommendations

Despite the fact interest rates declined sharply in the last two months of the year, we continue to believe strongly in extending duration throughout the year.  It takes time to increase the duration of a portfolio when using monthly cashflows.  If we step back for a moment, interest rates are at some of the highest levels we have seen in the past 10 years.  Focus on where we are versus the trend, not the fact we are 50 basis points below the peak.  The odds keep that we will have a recession (albeit a mild one) in 2020 so now is the time to purchase longer duration call-protected securities.

"The odds keep that we will have a recession (albeit a mild one) in 2020 so now is the time to purchase longer duration call-protected securities."

Municipal bonds maturing in 10 – 13 years continue to be one of our top recommendations.  Let’s look at a recent example of a school district carrying a AAA credit rating who issued tax exempt securities in December.  The 10-year maturity was priced at 2.75% whereas the 10-year Treasury note traded at 2.85%.  The ratio of the two is 96.5%.  Assuming a 21% tax rate, the taxable equivalent yield is 3.48%.  The yield spread versus the 10-year Treasury was 63 basis points.  A very good value considering it’s a AAA credit.

We continue to find excellent value in private mortgage backed securities or RMBS.  A perfect example is a recent offering at 99.53 to yield 3.60% and carrying a AAA credit rating.  The average life, based on historical prepayment speeds, is roughly 4 years.  The yield spread was 104 basis points.  Agency guaranteed mortgage-backed securities are offered at yield spreads of 30 to 35 basis points for the same average lives.  This security is backed by mortgage loans having a loan-to-value ratio under 70%, a very high credit score and a few delinquent loans.  Most portfolios would benefit from a 10% allocation to this type of security.

An idea we discussed last quarter is “low loan balance” agency MBS.  These are pools that have limits on how large the largest mortgage in the pool can be.   Some pools cannot have an individual mortgage greater than $85,000 while others have limits of $110,000 or $150,000.  The benefit to the investor is this:  Lower balance mortgage pools tend to prepay more slowly than pools with higher balance mortgages.  The savings from refinancing are greater on a mortgage with a high balance than on one with a low balance.  Low balance pools have built-in prepayment protection.  The investor won’t see prepayment speeds spike as rates decline resulting in a much slower decline in the balance and the interest income.  In a falling interest rate environment, the cost to acquire these types of pools increases sharply.  Protect your book yield by buying low loan balance MBS pools before interest rates decline.

"Low balance pools have built-in prepayment protection."

As we move into 2019 the economy appears to be slowing, the global economy is also slowing but the Fed has recently taken on a more dovish tone.  We do not expect a recession in 2019.  If, in fact, the economy slows the Fed might not raise rates at all (our official forecast written a few months ago had two rate hikes by the Fed).  If that happens there won’t be much pressure on rates but they will trade in a narrow range.  We stick by our recommendation to extend the duration of your portfolio this year.

Interest Rate Outlook – The Details

If “don’t fight the fed” was the investment theme for 2018, the phrase “regime switch” may be the call for 2019.  Our use of the term “regime switch” has to do with a “toggled” view of the expected future.  A common analytical flaw is extrapolating experience and data.  Combine that shortcoming with the idea that people almost always think we are heading toward something, and you can see why markets (mostly made up of people) often overshoot to both the positive and the negative.  It is possible that we can see this behavior through looking at a histogram of the steepness of the US Treasury curve over the past 20 years.  We observe a fair number of data points that show a steep yield curve (which may suggest economic growth) and a good number of data points in a flat yield curve environment (suggesting that growth is expected to slow), but we see a veritable wasteland of observations near the lower side of average levels of yield curve steepness.  It may suggest that although the market generally thinks the US economic outlook is for growth, the psyche of the market is that we are either growing or we are moving toward a shrinking economy. 

Since early November, we have seen regime switches on several fronts.  First, the market view for the growth prospects in the US have soured.  Some of the change may be related to political posturing, the economic impact of the government shut-down, diminished domestic growth seen in a handful of variables and additional data that shows that China and Europe are seeing moderating to tepid growth.  The important distinction is that the key word in all of this still involves growth.  As mentioned earlier, the economic engine can run at less than full speed without grinding to a stop. 

"...the economic engine can run at less than full speed without grinding to a stop."

Another “toggle” that has flipped is volatility.  Although credit risk spreads and the VIX (a widely used measure of volatility) have retreated from the spikes we saw over the past month, we are still a bit above the average levels we have seen for the past year.  Since the Fed posture is somewhere between a neutral stance and a slightly restrictive position, we expect bouts of volatility will become more common as the market vacillates between being “sure” we are heading toward recession and then “knowing” we are going to resume healthy levels of economic growth. 

The Fed itself has engaged in a switch.  We believed to get the last couple of Fed Funds rate hikes through, they would need to reintroduce language that suggested they would increasingly become data dependent for subsequent moves.  Following the December hike, Fed Chairman Powell quickly pivoted from comments that suggested the market noise was of little concern, to assuaging the markets that they would consider the impact slowing growth may have on the domestic economy.  In the span of two weeks, Chairman Powell changed his position from suggesting that we would likely have two rate hikes in 2019 and the unwind of the balance sheet expansion was moving ahead as planned (shrinking by $50 billion a month) , to saying on January 4th that there was the possibility of a pause in the rate hiking efforts and that it may alter the balance sheet plans in response to the downside risks investors perceive to the economy.  What was the market’s response to all of this?  As you might expect the question moved from “when will they raise rates next” to “how soon will they have to cut rates?”  The answer: one metric suggested at the start of January that the first cut would be in early 2020. 

Another area that may be ripe for a binary focus of its importance is the deficit, the debt (and don’t forget all of those unfunded liabilities) and the impact a nearly endless supply of newly minted Treasuries may have on the cost of borrowing.  During periods of robust relative economic growth, it would seem that investors may not be as concerned about the level of debt in the US.  During economic contractions, it seems more likely over time that slowing economic growth may not be met with reduced borrowing costs as we have enjoyed in the past.  It could be a bit circular in that slower growth could result in higher borrowing costs which could necessitate more borrowing.  Not exactly the Economics 101 version, but at a point chronic deficit spending and “can kicking” could result in a deflationary spiral.  One famous bond manager has mentioned the supply of debt as a primary concern, but it would seem he is not alone.  There has been a steep decline in demand at Treasury auctions.  Last year, of the $2.4 trillion of notes and bonds the Treasury Department offered, investors submitted bids for 2.6 times that amount, the lowest “bid-to-cover ratio” since 2008.  It may just be the case that the large number of notes and bonds being sold may mean that the ratio will be lower than historical averages.  With trillion-dollar deficits forecasted for the foreseeable future, perhaps a lower bid-to-cover will become comfortable – until it isn’t.     

All of this is to say that we think 2019 will be a noisy and emotional year.  In the end, our expectation is that the market will whip between thoughts of domestic economic stagnation and a resumption of growth at acceptable levels.  Job numbers are strong, many workers are seeing wage growth above the pace of inflation and since 70% of the economy is consumer-driven, momentum derived from consumers pushes the prospects of a recession out to the end of 2019 and more likely into 2020.  There won’t be a tax cut 2.0, reduced regulation is not likely so a large infrastructure spend might be one of the only palatable, politically feasible fiscal efforts that might prolong one of the longest economic expansions in history.  So, the consumer carries the economy, business spending moderates and government spending expands modestly.  Voilá, no recession but plenty of scares as consumers, markets and the economy navigate a slowing growth environment and a newly unknown Fed policy path.  If the Fed resumes tightening in the face of slowing global growth and while the yield curve is flat, the probability of a slow-down increases greatly.

The Fed has two break pedals, the one we can all see in the light of day (tightening the Fed Funds Rate) and one that is more hidden from view (unwinding their bond holdings amassed in the Quantitative Easing Program).  It seems that there will be a pause with the break we can see, and they will continue pressing the “hidden” break pedal. Since we are somewhere between a neutral Fed stance and a slightly restrictive position, combined with the human mind’s need to switch from a view of growth or contraction, market volatility may become the new near-term normal.  We suggest investors use the “dips” as yet another opportunity to lock in some attractive yields.

The first guideline we would suggest is to take limited amounts of credit risk and avoid the more volatile sectors, since we may be late in an economic cycle and since you are not getting much additional incremental yield for buying lower quality issues.  We recommend using the municipal bond portfolio as your place to take interest rate risk.  Interest rates are still not too far from the highest levels we’ve seen in years and the municipal bond market is enjoying an oddity that accrues to your benefit.  Between a 2-year maturity and a 10-year maturity, the U.S. Treasury curve offers only about 20 basis points of additional yield for tying your money up for an additional eight years.  In muniland, that number is more than 50 basis points.  If a slowdown becomes imminent, we expect the muni yield curve will flatten further and the opportunity to benefit from the relative “steepness” will be lost for a time.  We would encourage investors to make volatility their friend and if yields climb 20 to 30 basis points, lock in some tax efficient cashflow at yields of roughly 3%.

"We would suggest to take limited amounts of credit risk and avoid the more volatile sectors, since we may be late in an economic cycle and since you are not getting much additional incremental yield for buying lower quality issues."

If market fluctuation becomes the norm, be comfortable with the fact that the most likely near-term net scenario is no change.  We don’t always have to be “going somewhere.”