Asset Management: Fixed Income Insights

September 2017 Fixed Income Market Update

Flooding

 
Economic and market perspective

Hurricane Harvey resulted in devastating flooding in Houston, the fourth largest city in the United States, and throughout southeast Texas and Louisiana. Half a million people are believed to be impacted by the flooding, either needing temporary shelter or having experienced property damage. Estimates of the damage are as high as $100 billion and a prolonged rebuild will be required. The current expected impact to third quarter GDP is a decrease of 0.2%, though the impact of rebuilding is expected to add an equivalent amount of growth to fourth quarter GDP.

In addition to the direct damage to the region, the Texas gulf coast contains significant oil refining capabilities. With approximately 25% of oil refining capacity forced offline, including the nation’s largest refinery, only 8 million barrels of gasoline are being refined a day versus average daily consumption of 9.7 million barrels. Gasoline futures rose 25% for the month, despite the price of oil falling 6% during August.

The federal debt-ceiling was expected to be reached at the end of September. In anticipation, lawmakers had begun debating the conditions under which they would approve an increase to the maximum amount the country can borrow, including threats of a government shut-down. Hurricane Harvey has shifted that debate as billions of dollars in emergency funding are expected to be needed. This expense would pull forward the date of hitting the debt limit and politicians are likely to find it unpalatable to oppose raising the debt ceiling to aid the disaster stricken areas.

In response to continued missile tests by North Korea, the United Nations Security Council imposed additional economic sanctions on the country. China, viewed as North Korea’s closest ally, agreed to implement the U.N. sanctions. In response to continued threats from Kim Jong Un, President Trump warned the dictator of “fire and fury like the world has never seen” if North Korea were to attack. In response, the North Korean leader threatened to strike the U.S. territory of Guam with a nuclear warhead, before backing down. While tensions seemed to abate during the month, North Korea launched a missile over Japan at the end of August, reigniting regional concerns.

 
Outlook and conclusions

Minutes from the Federal Open Market Committee’s July 25-26th meeting were released in August. Of note, there appeared to be a difference of opinion regarding whether the recent decline in inflation should push back the timing of the next rate hike or whether unemployment had declined sufficiently that risks to inaction were increasing. The Fed’s next meeting is September 19-20. There is almost no expectation of an additional rate hike at that meeting, though many expect the Fed will announce the beginning of the gradual wind-down of the $4.2 trillion balance sheet. Fed Fund Futures imply about a one-third chance of an additional hike in December.

At the annual Jackson Hole Economic Policy Symposium, Fed Chair Janet Yellen spoke out in favor of financial regulation put in place since the crisis. Her view contrasts with President Trump’s push for deregulation, which has increased speculation that President Trump will nominate a different candidate when Chair Yellen’s term expires next year. Mario Draghi, President of the European Central Bank (ECB), delivered a more optimistic speech about European and global growth giving credit to global central banks for their significant level of accommodation. At the same time, he acknowledged that inflation has failed to meet ECB targets.

In our view, improving economic growth data and corporate profits are encouraging, however, data is not uniformly positive with weaker inflation data and still middling wage growth data. Treasuries appear to have priced in more of the negative data and have been impacted by August’s exogenous events (North Korean tensions, debt-ceiling debate and Hurricane Harvey.) In this environment, non-governmental sectors underperformed Treasuries, yet the fundamentals for those non-governmental sectors remain robust. The Fed is expected to provide further clarity on their balance sheet wind-down timing in September, but the accommodative nature of the plan has alleviated some market concerns and the Fed minutes show meaningful deliberation around the costs and benefits of future hikes. In aggregate, these positions suggest reasonably supportive central bank policy, even in normalization, and a benign landscape for U.S. fixed income.

 

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