Asset Class: U.S. Fixed Income

September 2018 Fixed Income Market Update

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Economic and market perspective

In addition to emerging market currency stress during August, Italy contributed to a decline in global risk sentiment as it was rumored to seek additional support from the European Central Bank (ECB) in the form of additional purchase of government debt. Italy denied this rumor, but concerns remained given budgetary problems and a review of its sovereign debt rating. The spread of Italian bonds versus German bonds hit its widest level in over five years.

Trade remained in headlines, as the United States and Mexico reached a bilateral agreement on key aspects of the ongoing trade negotiations to modernize or replace NAFTA. To date, few details are available, but changes to the trade arrangement appear to focus on heavy manufacturing, particularly automobiles. The announcement notably did not initially include Canada, though Canada has been invited to participate in the final agreement. President Trump has suggested additional tariffs could be implemented on Canada if it does not join the new agreement.

Unlike the progress with Mexico, trade relations with China remain tense. After the U.S. implemented tariffs on another $16 billion in Chinese goods in August, China reciprocated as well as raised the issue to the World Trade Organization (WTO). The WTO process creates a 60-day period for the U.S. and China to hold further trade talks. Talks are already in progress regarding steel tariffs and U.S. allegations of Chinese intellectual property theft. In total, the U.S. is considering tariffs on up to $200 billion in Chinese goods, with China threatening tariffs on up to $60 billion in U.S. goods. President Trump suggested that the full amount could be implemented as early as the first week of September. At the end of the month, President Trump stated in an interview “If they don’t shape up, I would withdraw from the WTO.” Partially in response to trade tensions, the People’s Bank of China reintroduced a “counter-cyclical factor” to support its currency.

For the second quarter, U.S. corporate profits for S&P 500 companies rose 24.8% over the past year. This was the second largest yearly increase since 2010 and was benefitted by a 33% decrease in taxes paid due to tax reform. Sales also rose almost 10%, the fastest increase since 2011.

Minutes from the July 31-August 1 meeting of the Federal Open Market Committee were released in August. In the minutes, the Committee expressed that “it would likely soon be appropriate to take another step in removing policy accommodation” if economic data remained in line with their outlook. With expectations of additional hikes, many Committee members believed that “fairly soon” policy would no longer be described as “accommodative.” The market is projecting a near certainty of an additional hike at the September 25-26 meeting and approximately a 60% chance for a second additional hike before the year is over. On August 24, Jerome Powell spoke for the first time as Fed Chairman at the Jackson Hole Economic Policy Symposium. His speech focused on policy decision making amidst the uncertainty of economic data and generally called for a gradual approach in monetary policy, but did not indicate any meaningful change in policy.

Despite expectations of a decline, consumer confidence rose in August according to the Conference Board. The August level of 133.4 was the highest level since 2000, improving from 127.9 in July. The present conditions index rose to 172.2 from 166.1 and the expectations index rose to 107.6 from 102.4. Also released in August, the Conference Board’s Leading Economic Index rose 0.6% for July to a level of 110.7.

Outlook and conclusions

In our view, the contrast of the generally positive U.S. landscape to the performance of fixed income assets in August is noteworthy and reflects the impact of global events on the U.S. market. Interest rates moved down slightly during the period driven by global risk aversion despite continued robust economic data in the U.S. and the easing of trade policy tensions. While tariffs and protectionism remain a potential source of volatility, on the margin they are less so given the progress on the trade agreement with Mexico and its implications for the ability of the U.S. to reach other deals. Non-governmental assets modestly underperformed despite data that would generally be supportive of those sectors. Global synchronized growth has faded and there is now a divergence of U.S. versus international economic conditions. Along these lines, we expect U.S. monetary policy to continue to tighten gradually, and to a greater degree than global policy. In this environment, heightened volatility is likely to persist, while U.S. fundamentals remain supportive.

 

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