Asset Management: Fixed Income Insights

February 2018 Fixed Income Market Update

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Economic and market perspective

The International Monetary Fund (IMF) raised its global growth forecast to 3.9% for 2018 and 2019, a 0.2% increase for each year. The global increase was largely driven by U.S. tax policy reform, which also led to a 0.4% increase in the IMF forecast for U.S. growth in 2018 to 2.7%. Every major economy is now expanding and the forecast projects the U.S. as having the best growth among developed nations.

The U.S. tax reform passed in December is having a more rapid impact than anticipated with many companies publically announcing bonuses and raises for employees. Several major companies have announced investments into the U.S. based on impacts of the changes in tax legislation, examples include Apple and Exxon-Mobil with investments of $350 billion and $50 billion, respectively. These announcements have contributed to increasingly positive economic sentiment. This sentiment has also been seen in metrics such as the National Association of Business Economics’ survey which showed 48% of its member companies have increased wages in the past three months. With no companies in the survey reporting cuts, the 48% net positive reading is the highest since January 2000.

Changes in withholding for personal income taxes are scheduled to begin in February, which should generally increase disposable income. Prior to tax reform taking effect, for 2017 the Bloomberg Consumer Comfort Index hit its highest level since 2001. The measure averaged 50 for the year, above the average of 43 in 2016, and was driven by low unemployment and inflation and the strong stock market.

The Institute for Supply Management’s measure of factory activity showed 2017 to be the best year for manufacturing in 13 years. Other metrics in the report also showed the strength of the sector with production at its highest since 2010 and new orders at their highest level in 14 years.

The U.S. government shut down briefly in January, but reopened quickly with little impact to markets. The agreed continuing resolution funds government spending until mid-February at which point there is potential for another shutdown barring a longer resolution or another stop gap funding measure.

As expected, the Federal Open Market Committee did not change the Fed Funds rate when it met on January 30-31. The statement released after the meeting noted the committee’s expectations that inflation would increase towards the Fed target later in the year. This was the final meeting chaired by Janet Yellen. As expected, President Trump’s nominee for the next Chair of the Fed, Federal Reserve Governor Jerome Powell, was easily confirmed by the Senate in January. His term begins February 3 and he will chair the March 20-21 meeting, where markets are projecting a 99% likelihood of a hike in the Fed Funds rate.

In January, a report stated that senior Chinese government officials implied future purchases of U.S. Treasuries could be curtailed or ended. While the report may have an element of political posturing, it is significant as China is the largest holder of U.S. Treasuries, owning more than $1.2 trillion worth of the securities. With expected increasing government deficits from tax cuts and without spending cuts (and possibly additional spending on infrastructure), Treasury issuance is expected to increase in 2018. The January primary dealer survey suggests higher levels of issuance for the year even versus last quarter’s expectations.

 

Outlook and conclusions

In our view, after years of rates failing to move higher and underwhelming consensus expectations, ten year Treasury yields moved up meaningfully in January. The broader optimism for growth that has been factored into other asset classes appears to be finally permeating Treasuries, a rational response to the fact that lofty earnings and growth expectations are being realized far more in the current period than usual. Along with modestly increased expectations of inflation, this reaction is reasonable based solely on fundamentals, but also factors in shifts in supply/demand dynamics. The expected increase in Treasury issuance is real, and whether China steps back as an investor or not, the increased possibility is enough to shift perception. While we have suggested we expected rates to move higher and believe there is continued room for Treasury yields to move up, for a variety of reasons including inflation, we do not currently envision a near term break-out for rates. Nonetheless, in managing for the current environment, we see the value of non-governmental sectors, in particular credit, to reduce pure rate exposure. Despite tight spreads in the sector, the current economic momentum and potential for higher rates suggest a reasonable excess return outlook.

 

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