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December 31, 2019 — Market Insights
Market Review

Growth Held Steady in 3Q with a Healthy Consumers…

  • U.S. GDP growth came in stronger than expected at 2.1% annualized in the third quarter. Buoyant consumer spending continued to offset flagging business activity; however, the margin of this offset was somewhat less than at mid-year.
  • Personal consumption growth of 3.2% moderated slightly while retail sales have slowed considerably since peaking in mid-summer.
  • The unemployment rate remained at a 50-year low of 3.5% in November, and job creation accelerated during the fourth quarter, easing concerns that slowness in business activity would eventually lead to weakness in the labor market.
  • Lower mortgage rates have driven a flurry of robust housing activity since the middle of the third quarter. While some of this is base effect related, the economic impact of renewed housing activity is a positive.

…While Businesses Continued to Struggle

  • On the business side, data releases continued to highlight a flagging sector, particularly in manufacturing.
  • The December ISM Manufacturing Index reading slipped further into contractionary territory to 47.2, another post-financial crisis low point. The ISM Non-Manufacturing and Composite Indices have remained expansionary, further highlighting the weakness in manufacturing.
  • Although growth is expected to slow further in 4Q – forecasts are now calling for GDP in the 1.5% - 2.0% range – the lagged effects of supportive monetary policy and the potential for a trade war cease-fire have set the stage for increasing business output in the quarters ahead.

Supportive Monetary Policy and Trade War Deal…

  • As expected, the Fed delivered a third consecutive 25 bps interest rate cut in October. However, the post-meeting message strongly suggested that a pause in further policy accommodation was in order given resilience in broader economic data.
  • At the December meeting, the Fed unanimously voted to keep policy rates unchanged, cementing the idea that the series of “mid-cycle adjustments” had come to an end.
  • On the trade policy front, the U.S. and China have agreed to a Phase I trade deal, expected to be signed in mid-January. The deal reportedly includes a roll-back of some existing tariffs, a hold on new tariffs scheduled for December, and a promise of increased Chinese purchases of U.S. agricultural products.

…Reduced Downside Risks to the Economy

  • With the economy on firmer footing than in August and September, the Fed has some breathing room to be patient. Benign inflation measures and subdued inflation expectations also give the Fed room to keep rates low: core PCE, the Fed’s preferred inflation measure, fell to 1.6% annualized in November from a high of 1.8% in August.
  • The market perceives a very low probability of monetary policy action in the year ahead; however, an asymmetric easing bias exists with the hurdle for raising rates being considerably higher than for cutting rates.
  • The economic significance of the recent trade deal is minimal; however, it signals a less volatile negotiation between the U.S. and China, at least for the time being, which could have a positive impact on business sentiment.

Yield Curve Steepens During the Quarter, Most Non-Treasury Sectors Outperform

  • Supportive monetary policy since last summer and recent progress on the trade war with China have reduced downside risks to the broader economy. As a result, interest rates have come off their lows and both the 2s-10s and 3mo-10yr inversions reversed early in the quarter.
  • Overall, interest rates increased across intermediate and longer maturities during the quarter, with 10-year rates ending at roughly 1.90% and 30-year rates finishing close to 2.40%. Shorter rates moved lower with the Fed’s October rate cut.
  • 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.
  • Most spread sectors outperformed like-duration Treasuries during the fourth quarter, led by Corporate bonds. Long Corporates meaningfully outperformed intermediate and shorter maturities, while BBB and crossover/high yield names continued to outperform higher quality bonds.
  • Corporate valuations reached 2019 tights in December as new issue supply underwhelmed expectations for the month ($18.9 billion vs. $25 billion). For the year, IG issuance was down modestly versus 2018.
  • Agency MBS had a nice turnaround from an excess return standpoint, outperforming like-duration Treasuries every month since August. Accommodative monetary policy and the Phase I trade deal with China have lowered interest rate volatility expectations – as a result, Agency MBS valuations looked relatively attractive by the end of November.
  • 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.
  • ABS generated slightly negative excess returns for the quarter as the rally in swap spreads witnessed since summer 2018 reversed. Notably, 2-3 year swap spreads are 10 bps wider since the end of the third quarter. ABS new issue supply was $237 billion in 2019, basically flat versus 2018.
  • Swap spread widening also impacted CMBS, but the sector modestly outperformed like-duration Treasuries for the quarter; CMBS was the best performing securitized sector for the year. Total private label CMBS supply hit $97 billion in 2019, a 23% increase from the prior year; more than half came in the single-asset/single-borrower space (SASB).