Asset Class: U.S. Fixed Income

November 2018 Fixed Income Market Update

Economic and market perspective

Oil prices declined over 10% in October closing at $65 a barrel. Earlier in the month, oil prices had increased above $76 based on strong economic data and tensions in the Middle East regarding the killing of Saudi journalist Jamal Khashoggi. However, a general decline in market sentiment and concerns global demand could wane as a result of trade tensions between the U.S and China contributed to the decline during October. Also weighing on prices were increased supply of oil from Saudi Arabia, Russia and Libya, which offset decreased supply from Venezuela and Iran.

European Union (E.U.) stresses with Italy continued in the month as the E.U. rejected a member state’s budget for the first time. Based on the proposed budget, Italy’s 2019 budget deficit was higher than levels considered acceptable by the E.U. The Italian government indicated to date that it will not change its plans for the budget for 2019.

For the third quarter European GDP rose only 0.2%. The European growth figures were below expectations and the lowest levels of growth in over four years. At the same time, Eurostat’s preliminary inflation report showed Euro region countries experiencing 2.1% inflation. This marked the fifth consecutive month of Euro inflation above the European Central Bank’s (ECB) target of just below 2%. Core inflation rose 1.3%, a modest increase from the prior reading of 1.1%. Europe’s unemployment rate was 8.1% as of September. The disappointing growth figures could weigh on the ECB’s decisions regarding asset purchases and future rate hikes.

In Brazil, Jair Bolsonaro won election as the country’s next president. In terms of economic policy, he ran on a platform of privatization of government entities and deregulation of the economy, particularly as it pertains to the country’s natural resources. His election is viewed as a change of direction for South America’s largest economy. He was considered the more market friendly of the candidates and markets have welcomed his election.

Minutes from the Federal Open Market Committee’s September 25-26th meeting were released in mid-October. The Fed had raised the Fed Funds rate by 25 basis points to 2.0% – 2.25% at that meeting. The minutes noted the Committee’s view that “further gradual increases in the target range for the federal Funds Rate would most likely be consistent with a sustained economic expansion, strong labor market conditions.” President Trump has criticized the Fed’s decision to raise rates, but to date this does not appear to have impacted the Fed’s path going forward. Fed Funds futures are projecting over a 70% likelihood of a fourth rate hike this year at the December meeting.

The employment cost index (ECI), another measure of wages, rose 0.8% in the third quarter above market expectations. For the trailing 12 months, ECI rose 2.8%, the same as last quarter matching the highest level in 10 years. Private sector wages rose 3.1% for the trailing year, the first time above 3% since 2008.

US midterm elections will be held on November 6th. Consensus expectations are for Republicans to maintain control of the Senate and for Democrats to gain control of the House of Representatives. Potential policy implications include a second round of tax reform and funding for an infrastructure package depending on the outcome of congressional elections.

Outlook and conclusions

In our view, markets in October exhibited the same interplay between rates and risk assets they have for much of the year. The pattern which has developed is one where strong economic data in the U.S. prompts interest rates to test new upper bounds, before the combination of pressure from higher rates and geopolitical uncertainties pulls rates down from their peaks. Nonetheless, rates settled at their highest month-end level of the year and with them, yields on broad fixed income benchmarks closed above 3.5% for the first time since 2009. This interplay has led to volatility and wider spreads despite the continued solid fundamentals. The combination of those solid fundamentals and higher yields reinforces our view of the attractiveness of fixed income, but with a watchful eye to continued volatility.

 

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