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September 30, 2019 — Market Insights
Market Review

Growth Slowed in 2Q…

  • U.S. GDP growth slowed to 2.00% in second quarter. Personal consumption growth of 4.6%, the strongest in over a year, propped up the economy as broad measures of manufacturing and business output slipped into contractionary territory.
  • Broadly speaking, data releases continue to highlight an economy that is a tale of two cities; business activity continues to slow while unemployment and consumer spending remain robust.

…as Business Sentiment Continues to Decline

  • The Institute for Supply Management (ISM) manufacturing index moved into contractionary territory, with the most recent reading of 47.8 marking a post-crisis low point. Similar trends have been emerging in measurements of business orders, construction spending, durable goods orders and business sentiment since mid-2018.
  • Continued strength in retail sales confirms a healthy consumer, at least for the time being. Worryingly, consumer confidence measures have also started to slip, evidenced by the sharp drop in the University of Michigan Consumer Sentiment Index in August to the lowest level since 2016.
  • Despite continued low unemployment, consistent wage gains and strong consumer spending, expectations for 3Q GDP growth are in the 1.8% to 2.1% range.
  • Over the next several months the market will focus on consumer related data including non-farm payrolls, initial unemployment claims, average hours worked and consumer confidence for any sign of cracks in consumer spending.

FED Path Looks Uncertain…

  • The Fed started the quarter with a dovish tone, delivering a 25 basis point policy rate cut at the July meeting along with an announcement that quantitative tightening (balance sheet runoff) would end in August rather than September, as previously communicated.
  • The Fed added a second 25 basis point rate curt at the September meeting, but the post-meeting message was slightly hawkish. Evidence from the meeting, including the non-unanimous vote and dot plot projections, indicated that the Fed is becoming more divided regarding the path of the economy and appropriate policy.
  • Additionally, the fits and starts of the US/China trade war continues to muddy the Fed’s signaling, making the process of detangling underlying economic forces from the effects of the trade war very difficult.

…As Unemployment Remains Low and Inflation Shows Life

  • Even as the unemployment rate fell to 3.5% in September, its lowest level in 50 years, job creation moved along at a slower pace in 3Q. The three-month rolling average in non-farm payroll growth was 157k at the end of September; not unhealthy, but notably lower than anytime in 2018.
  • While the Consumer Price Index (headline CPI) continues to underwhelm, core inflation is showing some signs of life as both Core CPI and Core PCE, the Fed’s preferred inflation measure, trended upward.
  • Hints of rising core inflation support the argument that multiple additional rate cuts by the Fed is not a foregone conclusion. However, it appears that the market believes inflation is tame and that easing monetary policy will likely continue in the near term. This disconnect has the potential to create volatility in the coming quarters.

Interest Rates Fall Further as Most Non-Treasury Sectors Outperform During the Quarter

  • The combination of deteriorating economic data, both at home and abroad, the dovish policy actions from the Federal Reserve, and the escalation of the trade war lead to a significant Treasury market rally in August. However, a series of positive economic data releases in September quickly calmed fears and resulted in a partial re-tracing of the August rally.
  • Overall, interest rates declined across maturities during the quarter, with 10-year rates ending at roughly 1.7% and 30-year rates finishing just north of 2%. While the 2s/10s curve inverted briefly in August before finishing the quarter positive, the 3-month T-Bill versus 10-year Treasury curve has been inverted since late May.
  • Spreads tightened modestly across most sectors, pushing excess returns positive for the quarter. Within credit, Long Corporates underperformed intermediate and shorter maturities, which was a drag on overall IG Corporate performance. BBB and crossover names continued to outperform AA/A rated bonds.
  • Corporate valuations finished the quarter in the fair-to-full range as supply, which surprised to the upside in September, continues to lag the same time period in 2018.
  • CMBS remains one of the best performing securitized sectors; while non-Agency CMBS sector performance continues to be highly correlated with intermediate IG Corporates, the defensive, secured nature of CMBS has resulted in lower excess return volatility throughout the year. New issuance continues to lag last year, down -14%, which has contributed to spread tightening year-to-date.
  • ABS also performed well, aided by a continued rally in swap spreads and flat supply versus the first three quarters of 2018.
  • Agency MBS, which saw excess returns oscillate between positive and negative over the quarter, posted slightly positive excess performance for the third quarter. Year-to-date excess returns remain negative on continued convexity concerns, as mortgage rates steadily march lower.
  • 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.