August 2018 – Monthly Commentary
The U.S. economy continues to chug along with the second quarter growing at a revised 4.2% annualized rate. That strength has carried into the third quarter with the Atlanta Federal Reserve forecasting 4.3% growth for the period. That growth seems to have emboldened equity investors as the S&P 500 posted an all-time high of 2,916.50 on August 29th. The index has since pulled back marginally, but all signs suggest that new records are likely with the release of third quarter earnings, set to begin only a few weeks from now. Despite the ebullience of equity investors, the mood of Bond investors is anything but upbeat. The 10-year and 30-year notes haven’t budged from the yield levels at which they sat in June. Granted the short end of the market has shown some life with rates approximately twenty basis points higher for the same period. With the Fed signaling two more rate hikes before year-end and a continuation of hikes in 2019, one would think that rates across the yield curve would be higher.
Especially perplexing is the lack of movement in 3-Month LIBOR. The reference rate is unchanged from the beginning of the summer and is actually three basis points lower than the recent high touched in May. To be fair, there is a material chance that LIBOR will cease to exist at some point in the future. For now, however, trillions of dollars of securities reference the LIBOR rate to determine their price, making it a critical benchmark. Historically, in a rising rate environment, LIBOR has risen at a faster rate than Treasury bills as investors speculated on future rate hikes. The TED spread, as the spread between LIBOR and Treasury Bills is known traded at an average spread of 30 basis point for much of the last five years. However, following Jerome Powell’s elevation to Federal Reserve Chairman, the spread widened more than 60 basis points as investors began to discount a more aggressive rate hiking cycle. That widening has reversed and has since narrowed to 21 basis points. We believe the collapse in spread reflects a return of complacency by fixed income investors, and a belief that the Federal Reserve is close to the end of the rate hiking cycle. We do not entirely agree with that logic. Our forecast is that the Fed will raise rates later this month and again in December, followed by two more hikes in 2019. Beyond that, forecasting becomes more challenging.
Year-over-year economic growth for 2018 is likely to be the fastest in some time but the bigger question is will it be sustainable into next year and beyond? The short answer is that it’s not likely. Tax cuts juiced the economy this year and we may feel the benefit into next year but the U.S. is a developed economy and with population growth of only about 1.0% and a de facto moratorium on immigration, current economic growth is going to be nearly impossible to sustain. Perhaps, if taxes are lowered again, economic growth would accelerate, but that’s not likely to happen given the deteriorating fiscal state of the U.S. What’s for sure is that at some point sequential growth, which is how the economist’s measure GDP growth, is going to be negative. We have argued on numerous occasions that year-over-year growth is a better measure of activity as it compares “apples to apples,” but the convention in the United States is sequential comparison. The policy reaction to that decline in activity is dependent on the cause of the downtick. For example, we could have a robust Q4 2018 followed by a decline in activity in Q1 2019, especially if the country experiences a harsh winter. In that instance, investors might not like it, but it would be no reason to call for a recession. Growth would likely return in the next quarter. On the other hand, if the decline is precipitated by a crisis of investor confidence, the stock market and its heady valuation could be at risk for a meaningful pullback. As always, we remain vigilant to those risks.