July 16, 2018Institutional Investment Management

Trade Issues Take Center Stage

The Fed concluded its scheduled two-day meeting on June 13th and the new Fed Chairman announced a 2nd rate hike that was widely expected.  The U.S. economy slowed slightly in the 1st quarter but is accelerating once again.  Inflation remains very well behaved and job growth is strong. The global economy has stalled slightly, and emerging markets have had a particularly rough time.  Talks of tariffs leading to trade wars led to a spike in volatility as equity markets responded very poorly to the news.  Markets hate uncertainty and Washington is as unpredictable as ever.  Monetary policy has been consistently communicated and we look for two more rate hikes this year in September and December.

Since we expect the Fed to continue to raise short term rates, we also look for a flatter yield curve.  Accelerating GDP coupled with a slight uptick in inflation and you should expect two additional rate hikes this year.  This implies short term interest rates increase 50 basis points.  Longer term rates are NOT expected to rise by that amount.  While we do not expect a recession soon, the press as well as other market experts may telegraph that trouble is lurking just around the corner.

While it’s beginning to look as though four rate hikes is becoming a much higher probability, will this be enough to cause interest rates to rise going into the end of the year?  We think there will be a small amount of pressure at times, but nothing like we saw from October 2017 to February 2018.  Inflation is increasing but at a very modest rate.  Global growth has slowed a bit and that isn’t expected to change.  U.S. growth should moderate from the strong showing in the 2nd quarter (expected but not yet realized).  Trade policies create uncertainty which hampers growth.  Mid-term elections could create uncertainty which may postpone some economic decisions for a short while, or longer, depending on the outcome.

"While it’s beginning to look as though four rate hikes is becoming a much higher probability, will this be enough to cause interest rates to rise going into the end of the year?"

When we look at the opportunities in the fixed income markets our interest remains with longer municipals, non-agency mortgage backed securities (MBS) and low loan balance agency MBS.  Longer term municipals provide the best value in this sector.  Municipal yields as a percentage of the similar maturity Treasury are most compelling in the longest maturities.  This percentage is less attractive for the shorter maturities.  In an environment that argues for buying longer term securities and with longer term municipals having the best value it’s our opinion longer term municipals should be purchased in the coming months.  Specifically, maturities in 11 – 15 years have compelling valuations.  If we look at valuations from the standpoint of yield spreads, we find longer municipals have yield spreads that are 2-3 times the yield spread of a 5-year maturity municipal.

We continue to find excellent value in the private mortgage backed securities or RMBS.  The “R” stands for residential.  A recent offering provides a real example.  SEMT 2015-1 A6 is offered at 98.1875 to yield 3.25%.  The average life, based on historical prepayment speeds, is roughly 2.50 years.  The yield spread is 70 basis points.  Agency guaranteed mortgage backed securities are offered at yield spreads of 25 to 30 basis points for the same average lives.  This security has pristine credit metrics as well.  Loan-to-value ratios average 62%, there is 1 loan delinquent out of 284 and credit support is 20% (up from 15% originally). 

A new idea we haven’t presented before is “low loan balance” agency MBS.  These are pools that have limits on the size of the largest mortgage in the pool.   Some pools cannot have an individual mortgage greater than $85,000.  Others have limits of $110,000 or $150,000.  The benefit to the investor is that lower balance mortgage pools tend to prepay more slowly than pools with higher balance mortgages.  It’s a matter of economics.  The savings 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.  Buy them now when they are attractive.

As we move into the 3rd quarter the economy is accelerating, trade fears are unsettling investors and the yield curve is getting much flatter.  The Fed is expected to raise rates at least one more time this year.  The investing landscape hasn’t changed much from the prior quarter.  Longer maturity municipals and non-agency MBS remain very attractive in our opinion.  Low loan balance agency MBS are a new addition that may be a bit early but better than being too late.  Yield spreads for many common types of fixed income securities remain very low.  We wanted to present a few alternatives for our readers.

Interest Rate Outlook

We believe the yields obtained on intermediate and longer-term bonds in the second quarter might have seen the peak for the year.  Of course, nobody knows where rates are headed but our thinking is that the Fed’s tightening efforts, in the form of both the unwind of the quantitative easing and raising the Fed Funds rate, will take a toll on economic growth.  A strong second quarter GDP release may give investors a second bite at the yields we saw in late May, but the reality and uncertainty caused by tense trade negotiations may make that opportunity fleeting.

Our expectation is that the threat of trade wars will be the topic of focus for the third quarter, mid-term elections will dominate the fourth quarter, and that the actions of the Fed will season the conversation from now through the end of the year.  Most immediately, the rhetoric regarding tariffs and more subjective barriers to trade that are being raised are a concern.  Given we are generally operating in a global supply chain it seems difficult to inflict pain on a trading partner without causing self-inflicted harm. It appears that the US may have more growth to sacrifice in a trade war, as compared to many of our trading partners, however we don’t think that relative strength has a long life.  Europe’s growth is tepid, and the US seems to have a significant amount of leverage in the form of its funding of NATO defense spending efforts.  Europe does not have the staying power to engage in a drawn-out trade skirmish.  Although by some measures China’s growth is decelerating, the communist government may lend itself to more of a long-term view and the outcome of a trade war may have a less gratifying result for President Trump.  That said, since China imports roughly $130 billion from us, less than a third of what we import from them, China will need to resort to additional tactics to exact an equal amount of pain.  We expect the result of the trade dust ups will be some immediate gains for the US in some cases and some inconsequential “wins” in other cases.  If rapid resolution is not found, the depressed economic activity could be the cause of the next economic slowdown.

ACG thinks the primary influences on the bond markets for the balance of the year will be the Fed’s actions, waning economic fuel to drive growth, and the possibility of a flat yield curve.  In July the unwind of the Fed’s quantitative easing program will result in their balance sheet shrinking by $40 billion a month and in the fourth quarter that number jumps to $50 billion.  The Fed has suggested they expect to raise the fed Funds rate by another 50 basis points in 2018.  Combined, those actions by the Fed are applying the breaks to the economy to a meaningful degree.  As of the time of the writing of this piece, the difference in the yield between the 10-year Treasury and the 2-year Treasury was only 27 basis points.  As early as September, the yield curve may effectively be flat.  Of note, this year the San Francisco Fed released a study that concluded that an inverted yield curve has correctly predicted all nine economic recessions since 1955 and that the only false positive was in the 1960’s when an inversion was followed by an economic slowdown, but not an official recession.  The yield curve hasn’t seen this level of “flatness” since before the Great Recession.  Although flat and inverted yield curves are not likely a cause of a recession, they certainly aren’t a good sign and they tend to be a symptom of an economic state that results in a slowdown.

Lou Holtz once said that “you’re either growing or you’re dying.”  A diminishing amount of fuel to drive economic growth may result in the death of this recovery.  In April, the International Monetary Fund (IMF) may have offered a measure of the diminished fuel when they suggested that the developed global economies should “fix your roofs while the sun is shining” because they anticipate global growth will soften in the next couple of years.  Specifically, they stated “once their output gaps close, most advanced economies are poised to return to potential growth rates well-below pre-crisis averages.” The US has moved from a negative output gap of 0.16% in 2017 (when the economy is not producing at a rate as great as the theoretical maximum output) to what is likely a zero gap or a modest positive output gap in 2018 (when the economy is producing more than the theoretical maximum – which historically has been short-lived).  The last 10 recessions in the US have followed a closing of the output gap.  We see the possibility of an economic environment where we transition from using more available economic capacity to one where producers are looking to correct capacity downward is a lack of economic fuel for growth.  The uncertain demand and cost environment introduced by tariffs and trade wars seems like just the impetus needed to alter producer investments and needs.  The fact that the current nine-year economic recovery is the second longest in the post-war era, makes us squeamish about excessive optimism.  The areas that deserve the most scrutiny are commercial real estate, the growth of the Federal debt, trade negotiations gone bad and a drop in consumer demand based on workforce reductions.           

"...the International Monetary Fund (IMF) may have offered a measure of the diminished fuel when they suggested that the developed global economies should “fix your roofs while the sun is shining”

The strategy for the 3rd quarter of 2018 continues to be taking advantage of fleeting spikes in inflation expectations before the impact of trade tensions and Fed actions weigh-down growth expectations.  We continue to like the idea of averaging into this market when the yield on a 10-year Treasury is 2.8% or better, or when 10-year munis and 15-year munis hit yields of 2.70% and 3.25%, respectively.  We expect there will be times during the year when you may regret not buying when yields were at their peak however, we think by the end of the year, looking through the rear-view mirror, it will have been a good entry point.  Nimble buy/sell actions with targeted goals will be the key this year as our guiding mantra for this year continues to be, “don’t fight the Fed.”  Storm clouds may be gathering.