Our Insights

June 30, 2019 — Market Insights
Market Review
 

Stronger than expected growth in 1Q…

  • U.S. GDP growth rebounded in the first quarter to 3.1% q/q annualized, picking up the pace after a lackluster end to 2018; personal consumption growth continued to trend lower, however, falling to 0.9% q/q annualized. 
  • Slower consumption growth was more than offset by other factors, including positive contributions from net exports and inventories, but incoming data suggest a reversal of these measures in 2Q with stronger consumption and a negative drag from trade and inventories.

…but slowdown expected in 2Q

  • Retail sales since February support the stronger trend in spending in 2Q, while on the business side the ISM Manufacturing Index fell to 51.7 in June, the lowest level since 2016.
  • Business activity, while still expansionary, continues to slow; uncertainty regarding trade policy, increased geopolitical risks, the waning effects of tax-related stimulus, and the lagged effects of tighter monetary policy have all weighed heavily on investment. 
  • Market consensus is currently calling for growth to slow in the second quarter, in the range of 1.5% to 2.0%.
  • In response to subdued economic data, the Treasury market rallied considerably during the quarter. The 3-month T-Bill versus 10-year Treasury curve has been inverted since late May – while not necessarily signaling that a recession is imminent, the message is perhaps that an economic slowdown is becoming more certain.
  • On the other hand, it was “bad news is good news” again for the equity market with the S&P 500 at all time highs at the end of June.

FED pivots to more dovish policy approach…

  • The Fed left interest rates unchanged during the second quarter as expected, and has yet to change its policy rate in 2019; however, the shift in policy stance over the past six months has been dramatic. 
  • When 2018 ended, the Fed was firmly on a path to tighter monetary policy in the year ahead; since December the Fed’s message has gone from tightening to patience to dovish policy easing.
  • At the June FOMC meeting, the Fed signaled that it stands ready to ease monetary policy in order to prolong the current economic expansion – current market expectations are for 2 to 3 rate cuts between now and year-end. However, any disconnect between the Fed’s actions and market expectations could be a source of volatility going forward.

…As low unemployment and tepid inflation persist

  • Inflation continued along a muted path in the second quarter, and sustained 2% inflation consistent with the Fed’s target remained elusive.
  • Core CPI moderated to 2% y/y in May while the Fed’s preferred measure of inflation, core PCE, slipped back to 1.6%.
  • The unemployment rate continued to hover at the lowest level in 50 years while job creation was choppy during the quarter: after 216,000 jobs were added in April, May disappointed with an increase of only 72,000 but was followed by a June reading that was much stronger than expected with 224,000 new jobs added.

Interest rates fall further while most non-treasury sectors outperform during the quarter

  • The Fed turned even more dovish at its June policy meeting, signaling that it stands ready to ease monetary policy in order to prolong the current economic expansion. However, the size and timing of rate cuts may be at odds with current market expectations and this disconnect has the potential to create some volatility should the Fed’s actions underwhelm the market.
  • Interest rates declined meaningfully across maturities during the quarter with 10-year rates ending at around 2%, 40 bps lower than at the end of March. While the 2s/10s curve remains positive, the 3-month T-Bill versus 10-year Treasury curve has been inverted since late May.
  • The expectation of rate cuts reignited the rally in risk assets that started at the beginning of the year. Spread sectors generally outperformed Treasuries, with the exception of Agency MBS. Outperformance was led by Investment Grade Corporate Bonds. Long bonds performed better than intermediate maturities, generating 191 bps excess return versus 62 bps. BBBs and crossovers outperformed AA/A rated bonds.
  • Corporate spreads retraced some year-to-date tightening in May before moving back to fair levels in June; supply remains down year-over-year (~12%) while demand was strong to end the quarter.
  • ABS also performed well, aided by a continued rally in swap spreads; supply for the first half of the year is flat versus 1H2018 and demand remains solid.
  • Agency MBS was the only major spread sector to post negative excess returns for the quarter and year-to-date. With the 10-year Treasury hovering near 2% and 30-year mortgage rates at 3.75%, negative convexity was the primary driver of underperformance. Elevated volatility and supply concerns also played a role.
  • The information contained herein reflects the views of Galliard Capital Management, Inc. & sources believed to be reliable by Galliard as of the date of publication. The views expressed here may change at any time subsequent to the date of publication. This publication is for informational purposes only. For institutional investor use only.