Expectations High for Q2 GDP Growth
- The pace of GDP growth for U.S. economy softened in the first quarter to 2.0% annualized. Personal consumption fell from a 4% growth rate in 4Q17 to just 0.9% annualized in the first quarter.
- Consumer spending appears to have rebounded during the second quarter. Control Group Retail Sales rose at a 5% pace over the last three months through May, up from just 2.1% growth in March.
- The Institute for Supply Management’s (ISM) survey of manufacturing activity bounced back from an April low of 57.3 to end the quarter at 60.2. Similarly, the ISM services index rebounded from its 2018 low of 56.8 in April to reach 59.1 in June.
- The Atlanta Fed’s GDPNow forecast for GDP growth in the second quarter stands at 3.8% (as of 7/6/18).
'U.S. vs. the World' Trade Skirmish Heats Up
- With the implementation of unilateral tariffs on up to $50 billion worth of Chinese goods set for July 6th – and the threat of tariffs on a further $400 billion of imports – the Trump administration has continued to raise the stakes in the trade dispute with China.
- In addition, with the already imposed tariffs on steel and aluminum, and talk of $275bn in tariffs on auto imports, the administration has broadened the boundaries of the trade dispute beyond China to include other major trading partners like the EU, Canada and Mexico.
- The dollar rallied 5% on a trade-weighted basis during the quarter, Chinese stocks fell over 13% in U.S. dollar terms and emerging markets currencies fell sharply as investors assessed the potential impacts of a trade war on global growth.
Fed Raises in June and Adds 4th Hike to its 2018 Forecast
- The Fed raised its policy rate during the quarter via a single 25bp hike at its June meeting. The policy rate now stands at a range of 1.75% to 2.0%.
- FOMC participants raised their expectations for the pace of hikes in 2018 to include a 4th rate hike, while maintaining their expectation of a high-water mark for Fed Funds of 3.4% by the end of 2020.
- The Fed’s official statements and meeting minutes released during the quarter offered a positive assessment of the economy and little evidence of reconsidering the pace of rate hikes in response to the escalation of trade tensions.
Inflation Edges Higher, Job Market Remains Hot
- Despite month-to-month noise, the trend of gradually rising inflation is clearly visible in both the headline and core measures of both CPI and PCE. Notably, the Fed’s preferred inflation measure, core PCE, reached the Fed’s target level of 2.0% in May.
- The sharp rise in headline CPI inflation to a six-year high in May partly reflected “base effects” of weak readings from early 2017 rolling out of the annual figures.
- Employers added an average of 210,000 jobs a month during the quarter, sending the unemployment rate to a 48-year low of 3.8% in May before rising back to 4.0% in June.
- Wage growth, as measured by average hourly earnings, rose 2.7% year-over-year in June. While positive, the pace of wage gains remains muted given the continued robust pace of hiring.
Interest Rates Continue Upward Trend on Fed Hike, Growth Expectations - Spread Sectors Suffer with Trade War Talk
- The Fed raised its policy rate via a single 25 basis point hike at its June meeting. Policymakers also raised their forecast of the total number of hikes in 2018 to four hikes, up from three at the March meeting.
- Interest rates rose modestly across the yield curve, with shorter maturities rising in near lock-step with the Fed hike. The yield on the 10-year T-Note and the 30-year T-Bond rose just 12 bps and 2 bps, respectively, resulting in a flattening of the yield curve.
- The 3-month LIBOR-OIS spread fell from a high of near 60 bps at the start of the quarter to 39.5 at the end of June.
- Investment grade corporate bonds were the worst performing sector over the quarter. A combination of relatively tight spreads and waning demand from overseas investors and corporate treasury managers weighed on the sector, while an increase in M&A-related issuance boosted supply. Intermediate corporate bonds slipped only -11 bps vs. similar-duration Treasuries, while long corporates underperformed Treasuries by -288 bps. AA/A-rated bonds outperformed BBBs and crossovers.
- Agency MBS posted +15 bps of excess return vs. U.S. Treasuries during the quarter, with most of that gain coming in April. Net supply of MBS from home purchase and refinancing activity has remained muted, giving a technical boost to the sector.
- ABS outperformed similar-duration Treasuries by 17 bps over Q2, boosted by a 2-5 bps tightening in swap spreads and a continued strong macro economic backdrop for prime consumer credit (low unemployment, solid wage gains, rising home prices). Auto ABS returns modestly outpaced credit card receivables during the quarter.
- Commercial Mortgage-Backed Securities (CMBS) posted flat excess returns vs. Treasuries during the quarter. Measured vs. corporate REITS (-25 bps excess return) or banking (-63 bps), CMBS outperformed other credit-sensitive assets over the quarter. CMBS performance was supported by lower net new issuance, particularly in traditional conduit deals, as well as continued strength in commercial property valuations.
Corporate Bonds Languish, Credit Curves Steepen
- The Bloomberg Barclays U.S. Corporate Investment Grade index returned -0.98% over the second quarter of 2018, underperforming similar-duration U.S. Treasuries by 100 bps.
- Shorter corporates (1-3 year and 3-5 year maturities) actually posted positive excess returns while 10-30 year maturities bore the brunt of the spread widening. The long-end of the corporate index underperformed similar-duration Treasuries by 288 bps over the quarter.
- During the quarter, Rails, Cable/Satellite, Wirelines and Metals/Mining names were among the worst performers, while REITS, Integrated Oil and Homebuilders outperformed the broader index. BBBs and crossovers underperformed AA/A rated issuers for the quarter.
- The option-adjusted spread (OAS) of the IG Corporate index widened +14 bps during the quarter, to +123 bps over Treasuries, the widest level of the last 16 months.
Despite Boost from M&A Deals, Corporate Issuance Remains Down vs. 2017
- Several large M&A transactions contributed to a flurry of new issue activity in May and June. Three so-called “mega deals” accounted for nearly $43 billion of new issue supply over the last two months of the quarter: Bayer-Monsanto ($15bn), Walmart-Flipkart ($16bn) and Vodafone-Liberty Global ($11.5bn).
- Investment grade new issuance totaled $338 billion in the second quarter, according to SIFMA. Over 1H18, total new issue volume of $662 billion represents a 10% decline from 1H17’s new issue volume.
Agency MBS Holds Ground, Buoyed by Low Net Supply
- The Bloomberg Barclays MBS index returned -0.23% for the second quarter, outperforming similar duration Treasuries by 15 bps. Over the last 12 months, Agency MBS posted excess returns of 47 bps. Agency MBS continues to benefit from lighter-than-expected net new mortgage supply. Through May, net new issue MBS supply was just $90 billion vs. $132 billion for the same timeframe in 2017.
- The Freddie Mac Weekly Survey Rate ended June at 4.55%, just 10bps higher on the quarter. Still, with mortgage rates the highest since 2014, mortgage applications and refinancings are hovering at multi-decade lows.
- The housing market continues to exhibit tight technicals with the National Association of Realtors Existing Homes Sales Months Supply Index near all-time lows (~4 months) and an unrelenting pace of 5%-6% year-over-year increases in home prices over the last four years. The Case-Shiller Index of nationwide home prices is now 1.8% higher than the pre-crisis peak set in 2006.
ABS Benefits from Tighter Swap Spreads; CMBS New Issue Still Dominated by SASB Deals
- The Bloomberg Barclays ABS index outperformed Treasuries by 17 bps over the quarter, aided by a 2-5 bps decline in swap spreads. Year-to-date ABS new issue supply of ~$110 billion was roughly flat with 2017’s first-half tally.
- CMBS excess returns were flat over the second quarter. This compares favorably to other credit-sensitive sectors, including corporate REITS (-25 bps excess return) or banking (- 63 bps). Overall, CMBS supply for 1H18 was flat with 2017; however, conduit deal supply is 20% lower than 2017, while Single-Asset/Single-Borrower (SASB) deal volume is up 58% YTD over 2017.
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.