Monthly Commentary - Halyard Asset Management

April 2019 – Monthly Commentary

May 20, 2019/in Monthly Commentary/by halyard

April 2019

As we’ve written for the last few years, interest rates across the yield curve are too low given the strong economic backdrop. Testament to its sustainability, the U.S. economy has continued to grow despite the behavior of politicians on both sides of the aisle and the Atlantic Ocean. The sharp drop in interest rates from the fourth quarter of last year through January was due in part to the U.S. government shutdown. That was followed by an even lower yield in March as Great Britain approached their BREXIT deadline. After the U.K. and the E.U. kicked the BREXIT can down the road, U.S. investors returned to complacency and volatility fell out of the stock and bond markets. However, that abatement was not to last as Donald Trump’s attempt to reach a trade and intellectual property agreement with the Chinese fizzled. The market impact has been the same as the previous two episodes; stock prices and interest rates both falling precipitously. Economists and political pundits are forecasting that an outright trade war is unlikely but warn that should such an event come to pass it would be detrimental to the economy.

Earlier this month the Trump administration levied a 25% tariff on an additional $200 Billion of Chinese imports. In response, China will impose a similar tariff on $60 billion U.S. goods shipped to China. The overwhelming majority of those Chinese imports are food and energy. Because the trade balance between the U.S. and China is so lopsided in favor of Chinese exporters, which is the reason for the trade war, a prolonged war is not likely to tip the U.S. economy into recession. But with virtually all Chinese imports being subject to tariff, there’s likely to be an uptick in inflation and some business disruption. A large percentage of goods sold at companies like Walmart and Amazon are imported from China. With their narrow profit margins, neither company will be able to absorb the increased cost of goods sold and will need to pass the cost increase onto consumers. The typical Walmart shopper is a budget-constrained consumer and is in no position pay 25% more for any of their purchases. They will be forced to either buy less of their typical basket of goods or substitute a U.S. made product for the Chinese made good. The latter is, after all, the object of the war. But given the dependence of the American buyers on Chinese made goods, a near term substitution is likely to be problematic. With that, we envision a situation where GDP expands initially due to the heightened cost of goods sold, but GDP ultimately takes a hit because economic activity slows as goods become unaffordable and retailers need to cut costs by firing workers. Trump has been upbeat about the situation and has promised to have a meeting with Premier Xi at the G20 meetings later this month. But that doesn’t ensure that the tariffs don’t start to bite this summer. It’s no wonder the capital markets are in a bit of a panic.

With the risk of failed negotiations rising, speculators have raised the likelihood of a Fed Funds rate cut and now expect a 25 basis point cut by the end of this year and another 25 basis point cut in 2020. In fact, Trump is already calling for the Federal Reserve to cut rates to support the trade war. We are at a loss as to what a rate cut would do for the trade war, but Trump has made it a habit of badgering the Fed to cut rates.

Continuing with the Federal Reserve, the central bank issued a rare warning about the riskiness of the leveraged loan market, warning investors that the credit quality of the broad market has deteriorated and that prices are likely to come under severe pressure in the next downturn. We would take that a step further and spread that warning to the BBB-rated component of the investment grade market. We’ve analyzed more than a few companies that have questionable balance sheets and deem their BBB-rating to be one or two quarters from being downgraded into junk territory. The worry with such a situation is the junk bond buying universe is much smaller than the investment grade universe which is likely to exacerbate an otherwise challenging situation.

March 2019 – Monthly Commentary

April 22, 2019/in Monthly Commentary/by halyard

March 2019

Investor perception has turned with regard to fundamental economic activity and the pricing of interest rates. The Federal Reserve has targeted the Fed Funds rate at approximately 2.42% while the yield on the 5-year Treasury note is 2.30%. That the 5-year note yields less than the overnight rate is known as an inversion and typically a sign of an unhealthy market. When the yield curve inverts, it indicates that investors expect the average overnight rate for that term will be below that of the current overnight rate. In essence, investors are locking in the rate for 5 years before the Fed cuts rates. We believe that given current economic fundamentals, the thought that the Fed will lower rates is ridiculous. And yet one well-respected professional investor wondered if the Fed would be forced to cut interest rates to meet the expectations of investors. Given the degree of confusion the Fed has created, the question, which would normally be considered absurd, is a valid concern. In addressing that concern, the ultra-dovish Minneapolis Fed President, Neel Kashkari, said that he didn’t believe that an immediate rate cut is justified. Of course it isn’t justified! Rates have fallen because the Fed is buying bonds and plans to cease balance sheet runoff in May, meaning they will be buying even more bonds. It’s foolish to look to the bond market as an economic indicator because the Fed is manipulating the indicator. They could look at the unemployment rate which stand at 3.8%, only 0.1% higher than the low touched this century, or the 7 million jobs that are available but remain unfilled. Similarly, for the week ending March 30, initial claims for unemployment insurance totaled 202,000, the lowest level since 1969. To put that into perspective, the workforce in 1969 according to the Federal Reserve of St. Louis was approximately 81 million workers. As of February the workforce totaled more than 163 million.

But employment has historically been a lagging indicator and perhaps those unfilled jobs will go away with a recession. Counter to that argument is the S&P 500 which has recovered from the hedge fund dump that happened in December and now stands just below its all-time high.

Since the dovish about face in December, the clear beneficiaries are the rate sensitive industries. After nearly a year of disappointing sales, auto sales in March registered an annualized 17.5 million units, well above consensus expectations. Similarly, since the beginning of the year mortgage applications have skyrocketed with purchases climbing nearly 10% and refinancing jumping an eye popping 58% year-over-year, respectively.

Much has been written about how much of a role Donald Trump played in the Fed’s policy reversal with most concluding that Chairman Powell caved to Presidential pressure. The Fed board members have sought to downplay the President’s role, but that has done little to change consensus thinking. What seems obvious is that Trump believes that his cajoling was effective and that the rally in stock prices this year is to his credit. What also seems clear is that he believes cutting interest rates would be even better. The “more is better” mentality seems to now extend beyond browbeating Powell, to stocking the board with Governors sympathetic to Trump’s wishes. For the most part, the Federal Reserve Board has been above politics and the Fed Chairmen have avoided having politics play a role in their decision making. To change that policy risks damaging the economy for years or even decades to come. The reason why the Fed tightens monetary policy when activity is robust and eases policy when activity slows is to attempt to balance employment and inflation with steady growth. At this stage of the economic cycle a 3.00% Fed Funds rate is arguably a sensible neutral rate. Instead, Trump is advocating cutting interest rates and reintroducing bond buying in an attempt to reaccelerate growth. As a mature economy, the U.S. is going to have a natural growth rate of between 2% to 3%. To push growth above that pace is certain to come with consequences.

February 2019 – Monthly Commentary

March 19, 2019/in Monthly Commentary/by halyard

February 2019

It would appear that economic pundits believe that the U.S. economy is either sustainably robust or faltering and on the verge of recession. Certainly, Central Bankers around the globe are suspiciously reassuring that economic growth is just right and in case things go awry, they stand ready and able to act. Much as Fed Chairman Powell did in his speech last month, European Central Bank President Mario Draghi gave a sobering assessment of the European economy, recognizing that business activity in the region has slowed materially. In response, he vowed to not raise interest rates in 2019 and to reimplement the Targeted Long-Term Refinancing Operation for the third time (TLTRO III). TLTRO is the program in which the ECB issues low cost loans to European Banks with the idea that the banks will turn around and relend the cash to borrowers, thereby stimulating growth. At least that is the stated goal of the program. In reality, the reimplementation is being put in place because the previous TLTRO is rolling off and the ECB needs to head off a funding crisis of their own creation. Despite the dovish turn in policy, we doubt that it will result in anything more than tepid growth in the region. As we’ve discussed on several occasions, we think that the problem with economic growth in Europe is structural. Monetary policy can provide a short term burst to activity but the socialist tendencies and high consumption tax will keep the economy from growing rapidly.

Also during the month, Bank of England Governor Mark Carney reversed his opinion of the consequences to the economy should the United Kingdom leave the European Union without an agreement on trade. In November, Carney opined that should a no-deal BREXIT come to pass, the economy could contract as much as 7% and the exchange rate for the Pound Sterling could fall as much as 25% against the Euro and the U.S. dollar. On Thursday he tempered that forecast saying that the economic impact would only be about half of what he originally forecast. Nonetheless, a contraction of economic activity on the order of 3% in the U.K. is likely to have repercussions for U.K. as well as continental Europe. At the time of this writing, with two weeks until the so called divorce date, no solution for an amicable split from the European Union exists. Ironically, the FTSE 100 is 5% higher, with interest rates and the value of the Pound Sterling marginally unchanged over the first two months of the year. One can only guess at the value of those markets one month from now.

Turning to the U.S., despite the “full court press” of dovish comments by the various members of the FOMC, economic growth continues to impress. On the last day of February, Q4 2018 GDP was released, showing 2.6% quarter-over-quarter growth, annualized. That outcome was surprising given that consensus was expecting at 2.2%. Even more impressive, when compared to the Q4 2017, growth for the period registered 3.1%. Moreover, that growth was achieved despite an abysmal month for stock prices and concern the economy was on the verge of recession. Despite that gloomy end to year, stocks have demonstrated impressive resilience, rallying 11% in the first two months of this year. That comes on the back of solid growth in fourth quarter earnings. Equity investors are again “climbing the wall of worry” investing in stocks despite the government closure that started the year and the on-again off-again trade negotiations between the U.S. and China. The big question is how investors will react when the U.K. and the Europe Union finally split.

January 2019 – Monthly Commentary

March 19, 2019/in Monthly Commentary/by halyard

January 2019

The January Federal Open Market Committee (FOMC) meeting yielded no rate hike and a dovish outlook for interest rates, as expected. Chairman Powell concluded this meeting with a press conference as will be the convention following every FOMC meeting going forward. The standard to date had been to have a press conference every other meeting. Our guess is that he would have preferred to skip this one given his marked about-face on interest rates. Typically, the Chairman is lobbed “softball” questions in a tacit understanding that the media doesn’t want to embarrass him. Such was especially the case with the thin-skinned previous Chairs Bernanke and Yellen. However, in a break from that understanding, Chairman Powell was bluntly asked pointed questions such as, “is the Fed at the end of rate hike cycle, what would it take for interest rates to rise, has the risk of recession increased, and is trade policy influencing the FOMC decision making.” Those are all questions the Chairman would prefer not to answer since they directly affect the capital markets and pose the risk of him being wrong again. He is now clearly perceived as having been wrong back in September when he said the Fed Funds rate was nowhere near the neutral rate. What’s worse, one questioner asked if there was now a Powell equity put in place. The insinuation, of course, is that’s now the conventional wisdom. The idea of a FOMC put originally came into play when Alan Greenspan cut rates sharply in the wake of the 1987 stock market crash. With each subsequent large market correction, the Fed would ease monetary policy conditions. The more severe the correction, the more severe the easing of monetary policy. Until it reached the absurdity that we’ve witnessed in the wake of the 2008 financial panic with 0% interest rates and the Fed buying more than $4 Trillion in government debt.

Chairman Powell’s hawkish tone and December rate hike panicked investors and resulted in the sharp fall in stock prices. He reacted by reversing his hawkish rhetoric and assessment of interest rates. We think there’s a very good chance that reversal will come back to haunt him later this year. The economy continues to demonstrate robust strength. The January employment report showed that 304,000 new jobs were created in the month; a shocking amount of job creation given this stage of the cycle. In addition, average hourly earnings rose 3.2% over last year’s reading, down 0.1% from last month but the highest rate of change since 2009. It wasn’t that long ago that economists were bemoaning that wage grow couldn’t break above 2%. To be fair, consumer confidence and softer measures of economic activity such as manufacturer surveys are portraying a slowing in economic activity, but we argue that it’s self-inflicted damage from the White House and Congress. Despite the stories about government workers who were unable to pay the mortgage, put food on the table and purchase necessities for the family, the shutdown effected a very small subset of the population. However, it had the collateral effect of depressing the general confidence of the country as a whole. Whether in agreement with the strategy or against, it’s hard to argue that it didn’t have a negative impact on consumer sentiment.

Similarly, the trade battle with China has gone back and forth from being close to resolution to seeming likely to drag on for a very long time. The effect on the U.S. economy so far has been muted, at best, but a number of companies that operate on a global scale have reported that tariffs are impacting their business. If the two countries are able to arrive on a solution in the near-term, either real or perceived, that would bode very well for market sentiment and consumer confidence. If unable to reach a compromise, the earnings of global companies will come under pressure. The worry is that the contraction in those companies could have a contagion effect to domestic business and the consumer as a whole. In that instance, economic growth would be at risk.

December 2018 – Monthly Commentary

January 25, 2019/in Monthly Commentary/by halyard

December 2018

As we expected, the Federal Reserve lifted the overnight lending rate by 25 basis points in December and indicated that they would lift rates two more times in 2019, backing away from their forecast of more frequent rate hikes. Also, as we expected, Fed Chair Powell gave a dovish assessment of the Fed’s view of the economy and markets. However, that did little to calm investors, with December being another “bloodbath” for equity holders. As measured by the S&P 500, stocks fell 9.20% for the month. The period was challenging for fixed income as well, driven primarily by a widening in credit spreads. The panic was so widespread that it seemed there was no place to hide from the selling. However, despite the credit widening and loss of faith in the Fed, our Reserve Cash Management (RCM) strategy survived the market weakness and profited for the period. Given that positive outcome, we would like to use this monthly update to give an overview of the RCM strategy.

As of year-end, we estimate that the reserve cash management (RCM) composite portfolio has a yield to maturity of approximately 3.24% and an average effective duration of 71 days. We find the characteristics of the RCM particularly attractive given that the Barclay’s Aggregate Bond Index has a yield to maturity of 3.28% and an average duration of maturity of 6.2 years. The Federal Reserve’s base case is for two additional rate hikes in 2019. Thus, we think that short maturity portfolios continue to offer a better risk reward over the next 6 to 12 months.

As we start the new year the 3-month LIBOR interest rate stands at 2.80%. Overwhelmingly, 3-month LIBOR is the reference rate for floating rate notes. The increased volatility in the capital markets, and the reversal of Fed Chairman Powell’s hawkish tone from early October precipitated a shift out of floating rate notes and into fixed rate bonds. An investor should be indifferent between holding a fixed rate note versus a floating rate note, if the expected return of each note is the same given the investor’s outlook for interest rates.

Based upon trades that Halyard has observed in the market, there appears to have been indiscriminant selling in this space with floating rate paper trading at less than fair value relative to its fixed rate counterpart. Halyard believes this may be the effect of asset allocators shifting from floating to fixed rate coupon bonds using ETFs. The allocators sell the ETF and then the ETF sells bonds to meet the redemption – often at levels below fair value. While the ETF investor is expressing his interest rate view, the ETF’s are selling floating rate assets at price levels that seem to imply a sharp decline in LIBOR during the note’s average life – which seems inconsistent with the view of possible interest rate hikes in 2019.

We favor floating rate paper maturing in 2019 and 2020. Following the equity drawdown and Chairman Powell’s recent less hawkish tone, the Fed Fund’s futures market is no longer implying any interest rate hike in 2019 and a possible interest rate cut in 2020. While we acknowledge the possibility of fewer interest rate hikes, we still see front end interest rates moving higher. If the Fed’s base case for two additional interest rate hikes in 2019 comes to pass, 3 month LIBOR should move higher and possibly approach 3.25% by late 2019. A further increase in LIBOR will increase the coupon income of floating rate notes. In that scenario, we expect the yield on the RCM strategy to rise commensurately.

November 2018 – Monthly Commentary

December 26, 2018/in Monthly Commentary/by halyard

November 2018

As the fourth quarter began, the S&P 500 index sat just below an all-time high, with expectations that earnings would continue to surprise to the upside and Q4 GDP would again post 3% or greater growth. But those expectations were almost immediately dashed by a trifecta of confusing news in the form of Chairman Powell backtracking on his hawkish comments from a month earlier, plunging oil prices, and the trade war with China.

In the first paragraph of last month’s market update we describe Chairman Powell’s October 3rd speech as the most hawkish in a decade. So hawkish that we wrote “one wonders if the Fed is prepared to raise the Fed Funds above the 3.0 to 3.5% neutral range.” On the back of that comment and the stock market plunge that followed, President Trump took to criticizing the Fed Chairman for jeopardizing the sustainability of the economy. Apparently, Powell took the criticism to heart because just a month later, at his presentation to the Economic Club of New York, he softened his tone materially. In the speech he described the current Funds rate as being just below the lower end of the range of estimates for the neutral rate. With the overnight rate currently targeted at 2.0% to 2.25%, Powell’s comment suggest that investor perception of the neutral rate is too high and the “risk-off trade” (stock prices lower) reversed. That was the initial reaction to the comment and the stock price rally continued into the next week as investors were cheered by comments that the U.S. China trade spat was showing signs of easing.

However, that wasn’t the only issue concerning the markets. The second “spur in the side” of investors was falling oil prices. Historically a fall in the price of oil was deemed a net benefit to economy as it was the equivalent of a tax cut for consumers. However, the U.S. has become a large producer of the commodity; so much so that last month the country exported more oil than it imported for the first time ever. With the price of the oil falling, the profitability of domestic producers falls as does the credit quality of those companies. Over the two-month period ending December, West Texas Intermediate prices have fallen about 30%, prompting worries that banks exposed to the sector could experience a wave of defaults. With that worry came broad based weakness in stock prices.

The third source of investor anxiety has been the ongoing trade war with China. The sabre rattling which had intensified for the first two months of the quarter seemed to subside somewhat following the G-20 meeting in early December. A meeting between Trump and China President Xi yielded a delay in further sanctions for 90 days with the hope that the entire matter could be resolved in that time. However, the arrest of Huawei CFO Meng Wanzhou, the daughter of the founder of Huawei Telecom, has complicated matters. The charge is that she circumvented trade sanctions with Iran and is being held without bail, being deemed a flight risk. The Chinese government has been vocal in their displeasure with the arrest and the company has denied wrongdoing. At the time of this writing, she remains in custody and the impact that will have on trade negotiations is not clear.

What is clear is that investors don’t like the degree of uncertainty that’s arisen in the capital markets. The economy continues to generate jobs at a robust pace as the number of unfilled jobs remains at an elevated level. Moreover, with inflation continuing to tick higher, we believe that Chairman Powell’s comments in October were a true description of monetary policy. But given the heightened market volatility and his walking back of those comments at the economic club luncheon, we expect that the Fed will raise the overnight rate by 25 basis points in December, as expected, but will sound a dovish tone at the post-meeting press conference. Moreover, we now think that rate hikes in 2019 will be limited to two.

October 2018 – Market Commentary

November 28, 2018/in Monthly Commentary/by halyard

October 2018

In recognition of the strength of the economy Fed Chairman Powell delivered the most hawkish speech of any Central Banker in the last ten years on October 2nd. Speaking before the National Association of Business Economists he described the economy as operating with “limited slack” and that “the Fed would act with authority if inflation expectations shift.” There are many observers who would describe the Fed’s current pace of rate hikes as already acting with authority. One wonders if that is a warning that the Fed is prepared to raise the Fed Funds above the 3.0% to 3.5% neutral range that is the current expectation.

It would appear that equity investors fear that to be the case. October was a dreadful month for stock prices and has been dubbed “Red October” for the viciousness of the selloff. At its nadir, the S&P 500 index touched 2603, more than 11% lower than the 2940 peak reached just a month earlier. That drop masks some of the even larger price corrections in individual stock prices, with Biotech and Financial shares taking more than their share of the punishment. Investors have latched on to a narrative that rising interest rates are going to cause financial services firms to suffer a decline in net income, despite actual results showing otherwise. As we pointed out several months ago, the relative flatness of the U.S. Treasury yield curve is not what drives bank results. It’s their net interest margins and we’ve seen them mostly expand through this earnings season.

Of course none of that matters with the results of the mid-term election and the retaking of the House of Representative by Democrats. With a Democratic House and a Republican Senate, the President is going to face an uphill battle to get anything done. There had been grumblings that if the Republicans had been successful, Trump would continue with Keynesian policies by cutting taxes further and quite possibly revive his desire for an infrastructure plan. Now the Democrats have the votes to block any future plans and gridlock is likely for at least the next two years.

The impact to the market has been mildly favorable, with the Dow Jones Index rallying more than 500 points on the day after the election. Equity investors, it would appear, believe that gridlock is the most favorable outcome. Bond investors seem to have come to the same conclusion, as well. Namely, that the expected rate of growth will not accelerate and, therefore, the Federal Reserve will not be forced to push the lending rate above its equilibrium rate.

Indeed, we agree with the immediate reaction as we view the economy as being on a self-sustaining course and that the expected gridlock will actual be beneficial to that sustainability. It’s important to remember that the U.S. Government is already running a $1 Trillion deficit and there is an enormous amount of stimulus still in the system from years of bond buying. Moreover, with the economy at full employment and the number of unfilled jobs continuing to total more than seven million, we are still at risk of overheating. Especially going in the holiday season. Again, one wonders if the Fed will need to raise their targeted neutral interest rate.

September 2018 – Monthly Commentary

October 19, 2018/in Monthly Commentary/by halyard

September 2018

The Federal Reserve releases the value and composition of their Open Market holdings every Wednesday afternoon. These are the securities the Fed bought when, in their judgement, the economy demanded artificially low interest rates. On Wednesday September 5, the value of the Open Market holdings fell below $4 trillion dollars for the first time since peaking at $4.24 Trillion in April 2017. That represents a reduction of approximately 5% and a milestone in monetary policy, though the Fed is unlikely to champion it as such. Namely, because there are plenty of critics that argue the size of their emergency monetary policy should have never reached that size. The program to reduce the reinvestment of maturing securities has now been in effect for a year and, as of October, the amount of maturing debt not reinvested has reached the Fed’s stated goal $50 Billion a month. That’s up from $10 billion a month when the program began last October. At the commencement of the program investors feared the absence of Fed buying would pressure interest rates higher, especially when the amount reached full effect. To date, it could be argued that the impact has been muted as rates have only risen marginally. However, with the ten year note above 3% and the economy continuing to run hot, one wonders if the reduced demand will finally push interest rates materially higher. An important consideration is the growth in the budget deficit. Over the last twelve months the United States has run a budget deficit of $1.2 trillion dollars. That’s roughly an additional $100 billion a month, when combined with the Fed’s $50 billion roll-off, adds to the supply of treasuries that needs to be absorbed by the market. Also of consideration, the Fed has never defined exactly what they would deem a normalized balance sheet. At the start of the crisis, the assumption was that it would fall back to the pre-crisis level, but it’s now assumed that the steady state amount will be more like $2.5 to $3 Trillion.

Two months ago, we wrote about the global emerging market bond rout and the illogic of the lopsided risk/reward tradeoff of the sector, especially when global interest rates are at very low levels. Since then we’ve heard conflicting arguments of “it was only a matter of time before the emerging markets corrected” (the Halyard opinion) versus the opinion that the recent correction is a “buying opportunity.” What’s certain is emerging market bonds share a similar risk/reward profile to high yield debt and investors have largely ignored that similarity. To the contrary, the high yield bond market has rallied with the Bloomberg Barclays U.S. Corporate High Yield Index generating a total return though September of 2.56%, despite rising interest rates. That has driven the yield spread to 310 basis points, the lowest level since prior to the crisis. The price action has been achieved despite a deterioration of aggregate credit quality.

Even more perplexing is the price rally in high yield bank debt. The sector proved disastrous to investors during the crisis. Prior to October 2008 bank debt was thought to be the safest form of high yield debt. The securities were marketed as being higher in the capital structure than high yield bonds, thereby insulating it from first losses, and touted as having never fallen below a price of 90 cents on the dollar. That is, until investors dumped the paper en masse and no buyers surfaced to take the other side of the liquidation. When the dust cleared, many individual loans traded as low as 60 cents on the dollar. Fast forward to 2018 and much of the same nonsense that was occurring prior to the crisis is happening again. New issue bank debt will set a record this year and the vast majority of that debt is structured as covenant lite loans, securities that don’t require the borrowers to maintain certain financial standards to avoid having the debt called. S&P estimates that 78% of loans currently outstanding are covenant-lite deals. Demand for the debt is being driven by Collateralized Loan Obligations (CLO’S). You’ll probably recall CLO’s from the financial crisis. They’re similar to an ETF in that many small loans are bought and packaged into a CLO wrapper and marketed as being less risky than individual holding’s. The pitch is the same as it was in the years before 2008. It may not be the same situation as that which faced emerging markets over the last two months, but it’s eerily similar. While there is no immediately recognizable catalyst that would cause a panic in the sector, the debt is priced for perfection.

August 2018 – Monthly Commentary

September 24, 2018/in Monthly Commentary/by halyard

August 2018

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 29^th. 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.

July 2018 – Monthly Commentary

September 4, 2018/in Monthly Commentary/by halyard

July 2018

The dog days of summer are upon us and the U.S. market has been relatively calm despite the daily barrage of news from around the globe. That’s not to say that global macro events are not on the mind of investors. Quite to the contrary. Donald Trump’s trade war is making the headlines daily, the health of the European banking system continues to be a worry, and the drama of The United Kingdom’s divorce from the European Union is entering its third year with no agreement in sight.

Also on the minds of investors is the continued collapse of emerging market economies and the value of the currencies that they represent. Quite often Investment advisors recommend emerging market debt as a way to diversify risk and add yield to a portfolio during times of calm. We’ve written on numerous occasions that the additional yield is not worth the added credit risk. The history of emerging market default is long and painful. At the time of this writing, the Turkish lira is in freefall due to the political missteps of their questionably elected leader and his attempt to manage monetary policy. Similarly, Russia again finds itself in the midst of a currency crisis based on the sanctions imposed by the United States. While that has pushed the value of the Ruble lower, the Russian economy is heavily dependent on oil revenue, and with the elevated level of oil prices the fallout is not nearly as bad as that of Turkey.

Also dragged down with the other emerging economies, the currencies of Korea, Thailand, and Singapore have all fallen versus the U.S. dollar. The driver behind the Asian currency selloff is decidedly China. The value of the Chinese Yuan versus the U.S. dollar is managed by the deep-pocketed Chinese government and has fallen nearly 8% in the last two months despite strict currency controls. The Chinese government claims they are taking steps to slow the decent of the Yuan but it continues to lose value. We believe that the devaluation is a thinly veiled attempt to retaliate against the tariffs put in place by the Trump administration. Just three years ago, the International Money Fund elevated the Yuan to World Reserve currency status and yet the Chinese government continues to manipulate its value. While not surprising, the IMF and its Chair, Christine Lagarde, have been mum on the subject.

As we wrote earlier, despite the perpetual diet of news, markets are enjoying a relatively quiet summer, with the S&P 500 index sitting just below an all-time high. That performance comes on the back of another terrific earning season in which sales grew 11%, and operating income rose an “eye-popping” 26% versus Q2 2017 results. What’s been conspicuously absent this season is the idea of “peak earnings” the media embraced to describe surprisingly strong Q1 earnings. Were pundits embarrassed to have gotten the call wrong or has investor sentiment changed and the opinion is now that the U.S. economy has shifted into high gear? We’re of the opinion that it’s a little bit of both. The tax cuts enacted late last year are absolutely contributing to bottom line growth as corporations are paying less in taxes. Moreover, they’re likely to support year-over-year growth for the rest of 2018 until comps become more challenging in April of 2019.

As the summer comes to a close and investors return to their trading desks, we expect that volatility will return. The question, as always, will it be upside volatility or downside?