Asset Class: U.S. Fixed Income

December 2018 Fixed Income Market Update

Economic and market perspective

After months of increasing rounds of tariffs between the U.S. and China, the meeting at the G-20 between President Trump and President Xi was highly anticipated. The meeting, which occurred over the final weekend of the month (and after markets closed for the month) appears to have resulted in a temporary break in the escalation of tariffs. As part of the 90 day deal the U.S. agreed to, the U.S. will pause the introduction of further tariffs and increases in rates on existing tariffs in exchange for China agreeing to make significant purchases of U.S. goods.

In addition to concerns around trade tensions, weakening economic data globally contributed to the risk off sentiment in November. Chinese third quarter GDP growth slowed to its lowest level since 2009 at 6.5% and official PMI measures showed manufacturing slowing to no growth with a PMI reading of 50.0 (50 being the divider between growth and contraction on the PMI scale.) Similarly, in addition to last month’s weak GDP growth figures in Europe (+0.2%), this month’s European PMI figures fell short of expectations at 52.4, the lowest levels in four years.

Brexit remained in the news as Prime Minister Theresa May’s proposal to exit the European Union, which appeared to be supported by international parties, elicited strong pushback within the U.K. This pushback included the resignations of multiple ministers; it is currently expected that her proposal will not pass parliament.

European Union (E.U.) tensions with Italy over budget deficits continued in the month after it had appeared more progress had been made. A second E.U. committee agreed that the proposed Italian budget would not comply with E.U. budgetary rules, allowing the E.U. to formally begin a process of disciplinary procedures against Italy. Those procedures are not expected to begin until January and any agreements in the interim could avoid that process. The process could result in financial sanctions.

The Federal Open Market Committee met on November 7-8th and announced no change in policy, in line with expectations. Minutes of the meeting were subsequently released later in the month. The minutes included a reference to raising rates again “fairly soon”, which is widely understood to be the December meeting. Fed Funds futures are projecting over a 75% likelihood of a fourth rate hike this year at the December meeting.

In the last week of the month, both Fed Chair Jerome Powell and Fed Vice Chair Richard Clarida suggested the current Fed Funds rate was “just below” neutral. This language walks back Chair Powell’s comment last month that the Fed Funds rate was a “long way” from neutral.

Consensus was largely met in the U.S. midterm elections held on November 6th. Republicans maintained control of the Senate (picking up 2 seats) and Democrats gained control of the House of Representatives (picking up approximately 40 seats.) The results would seem to limit the potential for a second round of tax reform and shifts focus to areas where bipartisan agreement could be reached. Near term, election induced jitters have faded as no extreme results materialized, but longer term, Democrats assuming control of House committees could increase oversight and investigations into the Trump administration, which could increase volatility from political headlines.

Outlook and conclusions

In our view, fading risk sentiment, while not without basis, has been disproportionate to economic fundamentals. In the U.S. in particular, though there are concerns that the Fed will push too far or economic data will materially deteriorate, neither fear has yet materialized. Overseas, the story is different where growth does appear to be slowing. The global sentiment shift has been most acutely seen in oil, but has also pushed credit spreads to two year wides and MBS spreads to four year wides, while pulling the 10 year Treasury back to around the 3% level. Interestingly, on balance, these changes have left yields on broad benchmarks relatively unchanged since last month and near 10 year highs. These levels of yield remain attractive with an increased opportunity set in the non-governmental sectors, but the prospects of further volatility remain as markets sort through numerous geopolitical, monetary policy and fundamental economic developments.

 

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