December 2017 – Monthly Commentary
While the team at Halyard evaluates the economic and market backdrop on a daily basis, we like to commit those thoughts to paper periodically, and especially so as we kick off the new year. Our starting premise this year is that the United States economy closed out 2017 with unmitigated strength. From a sector by sector perspective, we’re delighted to find the strength was broad based and not concentrated in any one sector or industry.
While too early to tally the result of the just ended holiday selling season, it’s seems likely that retail sales set a record with internet sales clogging the delivery channels late in December. Holiday shopping seems to have been forever changed, as the madness of black Friday has decidedly been replaced by cyber Monday which really was more like cyber December. Many of the individuals with whom we spoke said they happily avoided visiting the mall altogether this year. Nonetheless, sales were strong and UPS, FedEx, Amazon, and Walmart took an outsized share of the spoils. The very high level of consumer confidence and the robust jobs market were directly responsible for the success of the season as consumers felt confident about their prospects for job retention and wage growth.
Consumer confidence also benefited the housing market as new home sales sold at a pace not seen since pre-crisis. Despite the uptick in sales, new home construction is still well below the peak rate registered in 2005, which should be supportive of further industry gains. Moreover, the builders have carefully managed inventory to avoid a repeat of the oversupply witnessed during the peak. Similarly, the inventory of existing home sales continues to dwindle as sales outpace offerings. With the relative tightness of inventory, home prices, as measured by the Case Shiller index, closed the year with a 6.3% annual rise in price. The phantom wealth gain of rising home prices is contributing to a virtuous circle of ebullient consumer confidence and their propensity to spend.
Manufacturing continued its renaissance as the sector continued to grow, adding 79,000 new employees in the fourth quarter and registered employment gains in every month of 2017 save one. That’s a pleasant change from the month after month job cuts witnessed in the 2000’s.
With the backdrop of full employment and strong consumer confidence we believe the economy will continue to expand at least at a moderate pace. Moreover, as the Trump tax cuts work their way through the economy, the potential exists that the moderate growth could expand into a consistently greater than 3% annualized GDP growth. That’s a scenario that we believe would alarm the Federal Open Market Committee and perhaps cause them to consider more aggressive tightening. For the foreseeable future, however, we expect they will continue on the path of slow and steady rate hikes with three or four hikes in the coming year. Similarly, we expect that their bond purchase tapering will continue at the stated pace. One nuance that could be changed is the mix of asset purchases related to the recent flattening of the yield curve. Much talk has focused on the yield curve flattening as portending a recession or at best resulting in a drag on the financial sector. In thinking about the flattening, it’s important to keep in mind that it’s a direct result of the Fed’s manipulation of interest rates in the open market. It’s also important to remember that the Fed has an open dialogue with the money center bankers and considers their concerns when developing monetary policy. Given those considerations, we would not be shocked if the Fed decided to buy less of the longer maturities and allow that rate to drift higher, thereby steepening the yield curve. The challenge they face, should they decide to follow that course of action would be the size of the reduction and to what level they would like to see the yield curve move.
As for our portfolio construction, we continue to be of the mind that interest rates are too low and long duration exposure should be avoided. Currently we’re keeping maturities under three years and focusing heavily on floating rate notes. With the expectation that the Fed will continue to tighten, floaters will perform well as their coupon adjusts higher with each rate hike, thereby anchoring their price at close to par. Finally, given the relative expensiveness of riskier assets, we are limiting our exposure to investment grade corporate and municipal issuers while avoiding European banks, emerging market debt, and high yield issuers.