The past quarter has had its fair share of market moving events, including another Federal Reserve (Fed) hike, a flattening yield curve, geo-political events and potential tariff wars. As we wrote last quarter, separating the signal from the noise remains challenging, but we feel it is the key to keeping perspective. To paraphrase the fabled French inspector Jacques Clouseau: Nothing matters but the facts! Without them investing is nothing more than a guessing game!
The Fed, as expected, raised the target federal funds rate to 1.75-2.00% in June and the markets yawned. The Fed was quite transparent about the hike, so this is a normal market response. Surprisingly, the markets actually reacted more negatively to the Italian elections but have since reversed course. In fact, rolling one-year volatility for the bond market reached an all-time low this quarter.
The key question is: When do rising rates and a flatter yield curve matter both for the bond market and the economy? As we discussed last quarter, we feel short-term rates are still well below the level at which economic growth would be stunted. Looking at the fed funds rate alone is not very helpful; one should also look at the neutral rate as well as the shape and level of the yield curve. As the curve has flattened, investors have become worried that it may signal an impending recession given that a flat yield curve preceded the past two recessions. But according to a recent piece by UBS economists, there are two reasons this may not be the case today. First, when we’ve had flat curves in the past, they were typically accompanied by restrictive monetary policy (i.e., the fed funds rate was above the neutral rate – the theoretical interest rate that neither accelerates nor slows Gross Domestic Product (GDP) growth – thereby sucking credit from the system.) Second, flat to declining long-term rates have historically occurred when the Fed is attempting to reverse the effects of a recession, not during the midst of a tightening cycle.
Additionally, as highlighted by Evercore ISI research, past recessions have usually followed a peak in rates when the fed funds rate approached the nominal GDP growth rate, but we are meaningfully below that today. The twelve-month average fed funds rate is 1.4% compared to nominal GDP growth rate of 3.9%. The last time we had such a gap during a rate normalization by the Fed was 2005, which was still three years before the next recession. This dovetails nicely with the Fed’s view that the risk of an imminent slowdown is low and that rates will likely peak in 2020, when the median expectation is for a fed funds rate of 3.5% versus nominal GDP of 3.9-4.2%. These levels are more in-line with restrictive monetary conditions, despite being lower than past peaks. Of course, given the accuracy of past Fed projections, we continue to view these as guesstimates.
Evercore ISI adds that recessions have usually started after average hourly earnings growth has accelerated to ~4%. It is currently under 3% today and given the slow pace of acceleration, they estimate it will take ten years to reach 4%! If we had to draw one conclusion from this, it would be that we are still 100-150 basis points (1.0%-1.5%) below where we should start to worry that short-term interest rates are a concern for economic growth.
On the geo-political front, there were two notable events: the North Korea/U.S. summit and the Italian elections. Tensions with North Korea seem to have subsided following the much-anticipated meeting between President Trump and Kim Jong Un. There was not much to report regarding concrete agreements, but at least the two leaders are talking. Now we need to wait for further developments there.
The Italian elections are a bit more nuanced. The populist, anti-Euro party won top seats but still needed to cobble together a coalition government. Fears about Italy leaving the Euro and willfully defaulting on its debt (both sub-texts of the campaign) were short-lived and the markets have since recovered from the knee-jerk selloff immediately following the election. Our observation is that when the economy is generally benign and improving, markets find other reasons to worry, and now we think we can move the possibility of nuclear war with North Korea and Italian secession/default to the back burner.
This brings us to tariffs. Much has been written about the negative impact of a trade war, especially between America and China, but also with Mexico, Canada and Europe. For the past few decades, the norm has been for the U.S. to buy more from our trading partners than we sell. While this has created large recurring trade deficits, especially with China and Mexico, it has also lowered the price on many goods and improved the purchasing power of the American consumer at a time when wage growth has been anemic. These countries in turn use their trading surpluses to invest in U.S. Treasuries – especially China and Japan – which helps us fund our balance of payments deficit. It has been a stable, symbiotic relationship for many years. The U.S. is still the world’s largest economy, and it would be difficult to imagine running surpluses with all of our trading partners who would then need us to buy their government bonds to fund their trade deficits.
Let’s look at the facts. U.S. trade in goods with the world in 2017 totaled about $3.9 trillion, made up of $1.6 trillion of exports and $2.3 trillion of imports, or a roughly $700 billion deficit. Our largest trading partners are the European Union ($717B total/$151B deficit), China ($635B total/$375B deficit), Canada ($582B total/$17B deficit) and Mexico ($458B total/$71B deficit). As you can see, these partners make up about 61% of our trade and 77% of our trade deficits.
With the exception of China and Canada, the most important goods we trade with our large partners are cars, car parts and trucks. In fact, Deutsche Bank estimates that over two thirds of our imports from Mexico are intra-company trade (e.g., Ford imports its Mexican made cars back to the U.S.). Our largest trade with Canada is in energy, followed by, you guessed it, cars. We think that trade differences related to transportation products are more easily overcome through negotiation (since the partners in many cases are separate divisions of the same firms) and will eventually be settled to the market’s satisfaction.
China is a bit more complicated as they export many everyday goods, such as cell phones, apparel and personal electronics. They are also the second largest single economy behind the U.S. and restrict access to foreign companies doing business there. As it was with Japan when they were the ascending global export powerhouse in the 1980s, it is not a level playing field when doing business in and exporting to China. We believe that restriction is at the heart of what we will euphemistically call trade negotiations with China. We expect that more bluster and tweet storms are forthcoming from both sides but, in the end, both will choose what is in each country’s best interests. Does China really want to raise the price of imported food goods from the U.S., and does the U.S. really want the inflationary side effects of rising prices from Chinese imports, especially going into a mid-term election? We don’t think so.
The difference in the reaction by each country’s equity markets to the trade war rhetoric suggests that the balance will shift a bit in favor of the U.S. From their respective peaks in late January, the Shanghai stock Index (Shanghai Shenzhen CSI 300 Index) is down 19.2% while the S&P 500 Index is only down 4.6%. We would expect an improvement of terms, a reasonable reduction in trade inequality and some increased access to China’s markets. We hope this will get resolved sooner rather than later and allow both sides to call it a win and move on.
So, where does recent market activity leave investors? We are still in a low growth recovery, and asset prices are not existentially cheap but are not as rich as they were last year, especially in fixed income securities. We are cautiously optimistic that the recovery still has a few years left to run, and we are taking advantage of higher short-term rates to buy higher quality bonds, such as investment grade floating rate notes and commercial paper. We still find higher quality companies in the non-investment grade sector attractive, but we have our eyes on the lower tiers of the investment grade universe for future opportunities.
This brings us to a second question: Do we see any bubbles forming? Over the past few years the BBB part of the U.S. investment grade market has grown substantially relative to other sectors in the fixed income universe. The ICE BofAML BBB U.S. Corporate Index is now ~$3 trillion in size, comprising about 48% of the investment grade corporate universe. This compares to about $1.3 trillion in the U.S. High Yield market. In other words, the lowest rung of the investment grade universe has increased 50% over the past five years, compared to just 6.5% for the high yield market. If the economy weakens in a few years, fallen angels will likely become more prevalent, potentially pushing an unprecedented volume of debt from investment grade to high yield. In the past, down economic cycles have typically been reliable opportunities to pick up higher quality companies’ bonds cheaply as spreads tend to widen when supply increases. The difference today is the possible magnitude of the opportunity.
In the meantime, we continue to be vigilant in looking for attractively priced bonds in companies we feel are either overlooked or misunderstood, and we are trying to increase the quality of the portfolio by buying shorter investment-grade bonds where it makes sense. While we are still carrying a fair amount of dry powder, the cost of doing so is diminishing as yields on the shortest paper have risen, thereby causing less of a yield drag. Thank you for your continued support.
Carl Kaufman Bradley Kane Craig Manchuck
Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
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No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management.
The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance.
Shanghai Shenzhen CSI 300 Index is a free-float weighted index that consists of 300 A-share stocks listed on the Shanghai or Shenzhen Stock Exchanges.
The ICE BofAML BBB U.S. Corporate Index is a subset of the ICE BofAML U.S. Corporate Index including all securities rated BBB1 through BBB3, inclusive. The ICE BofAML U.S. Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt policy issued in the U.S. domestic market.
Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period.
A basis point is a unit that is equal to 1/100th of 1%.
A spread is the difference between the bid and the ask price of a security or asset. It can also refer to an options position established by purchasing one option and selling another option of the same class but of a different series.
© Osterweis Capital Management
© Osterweis Capital Management
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