U.S. Growth Finishes 2017 on a Solid Footing
- The U.S. economy grew at solid pace in the fourth quarter, advancing +2.9% over the prior quarter on an annualized basis. For the full year, GDP growth measured +2.3%.
- GDP growth in Q4 was driven by solid personal consumption (+4.0 %q/q annualized) and business investment (+6.8%). On the negative side, inventories and net imports were drags on growth.
- The Institute for Supply Management’s (ISM) survey of manufacturing activity finished the quarter at 59.3, in-line with December’s reading. The ISM services index meanwhile rose to 58.8 in March from 56.0 in December. Both figures are consistent with annualized GDP growth above 3.0%.
Job Market Gains Seen Pushing Wages Higher
- Despite weaker than expected payroll gains in March, employers still added an average of 202,000 jobs per month over the quarter. The unemployment rate stands at +4.1%, while the broader “U-6” underemployment rate fell to 8.0% in March.
- As a measure of just how much the job market has strengthened since the beginning of the expansion, the number of unemployed job seekers per job opening fell to just 1.1 workers per opening in January, from a cycle-high of nearly 6.6 workers per opening in July 2009.
- Average hourly earnings rose 2.7% y/y in March, and the Atlanta Fed’s Wage Growth Tracker showed median wage growth advanced at a 2.9% pace (q/q annualized) in February.
Fed Raises Policy Rate in March, Tweaks Dot Plot Higher
- The Fed raised its policy rate by 25 bps at its March meeting, to a range of 1.50% to 1.75%. Consistent with prior forecasts, policymakers signaled they expected a total of three hikes in 2018.
- Meanwhile, policymakers raised their expectations for the pace of hikes in 2019 and 2020, raising the median projection for end-2019 Fed Funds to 2.9%, from December’s forecast of 2.7% and bumping their end-2020 forecast to 3.4% from 3.1%.
- FOMC participants also raised their median forecasts for GDP growth, core inflation, and labor market gains (lower unemployment rate) for the next several years.
Core Inflation Measures Rebounding So Far in 2018
- While year-over-year measures of core price inflation have risen only modestly since late-2017, quarter-over-quarter figures show a marked advance in both core CPI and core PCE. For the three months ended February core CPI advanced at a 3.1% annualized pace, while core PCE rose at a 2.8% pace over the same period.
- With weak inflation prints from March-May 2017 set to roll out of the annual numbers, we could see a pop in year-on-year inflation figures over the next several months.
- The breakeven inflation level priced into 10-year TIPS rose modestly during the quarter, reaching 2.06% at the end of March.
Rates Rise in Near-Parallel Shift, Credit Sectors Weaken on Rates, Growth Fears
- The Fed hiked its policy rate by 25 bps in March, to a range of 1.50% to 1.75%. FOMC participant forecasts showed policymakers still expect a total of three hikes in 2018.
- Interest rates rose in broadly parallel fashion during the quarter. The 2-year US Treasury rose 38 bps to end the quarter at 2.27%, the highest level since 2008. Meanwhile, the yield on the 30-year US T-Bond rose 23 bps to 2.97%.
- The spread between 3-month Libor and 3-month overnight indexed swaps (OIS) spiked to a post-crisis high of +59 bps during the quarter. Most investors attributed the move to technical factors like increased T-bill supply and weaker overseas demand for shorter maturity Libor-based assets.
- Interest rate volatility rose as stocks fell sharply in February and remained highly volatile for the remainder of the quarter.
- Investment grade corporate bonds underperformed similar duration U.S. Treasuries by -79 bps over the quarter. The selloff in equities and sluggish investor demand led to a widening in spreads across the corporate maturity curve. Higher quality outperformed lower quality BBB-rated and crossover credits. From a sector perspective, financials and certain industrial sectors affected by M&A risk (food companies, diversified manufacturing) were the worst performers.
- Agency MBS underperformed Treasuries during the quarter (-39 bps excess returns) as interest rate volatility picked up and mortgage rates rose sharply. As an offset to higher rates, MBS net supply has generally been lower than expected and home price appreciation has remained solid.
- ABS excess returns (-19 bps) suffered primarily from the widening of front-end swap spreads; 2-yr swap spreads gapped 12 bps wider on the quarter. CMBS posted slight underperformance versus Treasuries on the quarter (-6 bps excess returns). Relative to other spread sectors, particularly investment grade corporates, CMBS had a strong month.
Corporate Credit Shows Cracks
- The Bloomberg Barclays U.S. Corporate Investment Grade index returned -2.32% over the first quarter of 2018, underperforming similar-duration U.S. Treasuries by 79 bps.
- The selloff in equities and the resulting spike in volatility weighed on investor confidence in the corporate market this quarter. The spread widening, which was initially isolated to front-end maturities, extended across the curve by the end of the quarter. Trade war talk between the U.S. and China, including industry-specific tariff proposals, also served to rattle credit markets.
- During the quarter, wireline telecom, packaging and independent energy companies outperformed the broader market. On the negative side, financials, diversified manufacturers and food names lagged. Overall, higher quality outperformed BBB’s and crossover names, and shorter maturities outperformed longer bonds.
- The option-adjusted spread (OAS) of the IG Corporate index widened +16 bps over the quarter to finish at +109 bps to Treasuries.
Corporate Issuance Underwhelms
- Investment grade new issuance totaled $319 billion in the first quarter, according to SIFMA, representing a 20% decline from 1Q17’s new issue volume. Similar to last year, corporate issuance continues to be skewed to lower quality (BBB and A) rated issuers.
- To the extent markets remain stable overall, we would not be surprised to see new issue volumes pickup somewhat in the second quarter. In addition, M&A activity could lead to higher-than-expected issuance volumes.
Agency MBS Modestly Weaker, Wider Swap Spreads Weigh on ABS
- The Bloomberg Barclays MBS index returned -1.19% for the first quarter, underperforming similar duration Treasuries by 39 bps. Over the last 12 months, Agency MBS posted excess returns of +28 bps.
- The Freddie Mac Weekly Survey Rate of "no points" 30-year mortgage rates rose 45 bps over the quarter to end at 4.44%. While historically still very low, mortgage rates are now the highest since January 2014. Nevertheless, the housing market continues to steam ahead. The National Association of Realtors Existing Homes Sales Months Supply Index is at an all-time low of ~3 months and the S&P Case-Shiller 20-City Home Price Index registered another 6.40% year-over-year increase for the month of January. Notably, the Case-Shiller Index is now only 0.69% below the peak set back in 2006
- ABS generated -19 bps of excess return for the quarter. Swaps spreads on the short end of the curve widened by 10-12 bps during the quarter, weighing on ABS returns. CMBS meanwhile managed to underperform Treasuries by just 6 bps over the quarter, despite headwinds from widening swap spreads and weakness in corporate credit.
ABS Supply Matches 2017 Pace, CMBS Supply Rises on Jump In SASB
- At ~$51 billion, ABS new issue supply was flat YTD with 2017. Notably, Auto ABS supply was 13% higher than 2017’s pace while Credit Card ABS supply was 38% lower than this time last year.
- CMBS primary supply has been robust, finishing first quarter 56% higher than the same time period last year. Notably, however, the split between CMBS Conduit and Single Asset/Single Borrower (SASB) is dramatic. Conduit supply was practically flat versus 2017 while SASB supply was 250% higher than 1Q17 ($10bn vs. $3bn).
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.