Economic Momentum Slows in 4Q…
- The U.S. economy grew at a q/q annualized pace of 2.2% in the fourth quarter, losing momentum after strong second and third quarter growth.
- Notably, personal consumption growth slowed to 2.5% in the last quarter of the year, from 3.5% and 3.8% in the third and second quarter respectively.
- On the other hand, business activity continues to expand, albeit at a slightly slower pace: the ISM Manufacturing Index has bounced around 54-56 in the first quarter, still in expansionary territory but lower than the 58-60 readings throughout most of 2018.
- Market consensus is currently calling for continued slowing growth in the first quarter, in the range of 1.3% to 1.7%.
…Trend Expected to Continue in 1Q
- In addition to the slowing trends in consumer spending and business output, the economy also dealt with a number of disruptive events in the first quarter: the longest Government shutdown in U.S. history, continued trade wars, and extreme cold weather are all expected to weigh on growth.
- While estimates of the economic impact of these factors is relatively muted at present, the more important impact may have been psychological – the University of Michigan Consumer Sentiment Index fell sharply in January, to the lowest level in several years, although it has since rebounded.
- Market reaction has been mixed, with the S&P 500 once again near all-time highs by the end of March and corporate credit spreads retracing the widening seen at the end of the year; meanwhile, the Treasury market has rallied considerably with the 3-month to 10-year part of the yield curve inverting for a short time, the first time this has happened since 2007.
Fed Claims Markets with Patient Approach...
- The Fed left interest rates unchanged during the first quarter as expected. In stark contrast to the policy signal sent in December, the message from the Fed at the January meeting stressed patience going forward.
- This pivot instilled the markets with renewed confidence, triggering a rally in risk assets throughout the quarter. Nevertheless, concerns about slowing global growth continue to weigh heavily on market expectations.
- At the March FOMC meeting, the Fed maintained its dovish stance as it adjusted its expectation for future rate hikes from two to zero in 2019, and announced the end of its balance sheet run-off in the fall; markets are now pricing in the possibility of a rate cut later this year.
…Amid Continued Muted Inflation and Slowing Job Growth
- Inflation readings remain muted with the Consumer Price Index falling to 1.5% in February. Core CPI continues to hover at 2.2%, but more importantly Core PCE, the Fed’s preferred measure of inflation, remains at around 1.8%.
- Job creation stumbled in February, with only 33k jobs added, but this could be an anomaly with more solid jobs numbers of 227k, 312k, and 196k in December, January, and March respectively. Leading indicators such as Initial Jobless Claims and Continuing Jobless Claims have recently improved, suggesting job creation remains intact.
- Average Hourly Earnings increased by 3.2% to 3.4% in each month of the quarter, continuing a trend that started in late 2017. The unemployment rate ended the quarter at 3.8% after rising to 4% in January due to the Government shutdown.
Interest Rates Fall While Non-Treasury Sectors Outperform as Spreads Recover
- The Fed remained on hold during the first quarter as expected. The Fed’s tone has shifted considerably since the end of last year; whereas the policy pivot that happened a few months ago provided the market with confidence, the recent policy message has been perceived as extremely dovish.
- Interest rates declined meaningfully across maturities after the Fed meeting in March, with the exception of the very short end of the curve which is anchored by the Fed Funds rate. Intermediate maturities (5-10 years) fell the most.
- Spread sectors generally outperformed Treasuries over the quarter, led by High Yield and Investment Grade Corporate Bonds. Long bonds performed better than intermediate maturities, generating 412 bps excess return versus 210 bps. BBBs and crossovers outperformed AA/A rated bonds.
- Agency MBS posted 28 bps of excess return vs. Treasuries during the quarter and 9 bps of excess return for the year ending March 31, 2019. Continued run-off of the Fed’s Agency MBS portfolio effectively creates supply that needs to be absorbed by the market.
- ABS generated 40 bps of excess return for the quarter and 74 bps for the last twelve months. Over the last year, ABS excess returns have benefitted from a sizable rally in swap spreads: 2-year swap spreads have narrowed from 31 bps in March 2018 to 12 bps in March 2019.
- CMBS excess return was 118 bps for the first quarter, which more than offset the sector’s underperformance in the fourth quarter, and 87 bps for the last 1-year period. Once again, non-Agency CMBS sector performance was highly correlated with intermediate Investment Grade Corporates; however, similar to ABS, sector performance has also benefitted from swap spread tightening.
Corporate Bonds Outperform, Spreads Retrace Fourth Quarter Widening
- Investment Grade Corporate Bonds outperformed like-duration Treasuries over the first quarter, generating 273 bps excess return. High Yield Corporate Bonds also outperformed, posting 573 bps of excess return.
- While IG Corporates performed well overall, long Corporates posted the strongest IG excess return for the quarter, outperforming like-duration Treasuries by 412 bps. Short Corporates (1-3 year and 3-5 year maturities) generated excess returns of 83 bps and 202 bps respectively.
- Higher quality bonds (AA/A-rated) generally underperformed lower quality, higher beta issues (BBB/crossover) over the quarter. Industrials and Financials outperformed Utilities, with Energy and Communications among the strongest performers while REITS and Electric Utilities lagged.
- Corporate spreads performed well during the quarter along with other risk assets. However, with supply constraints, slowing growth, and a dovish Fed, the risk/reward in Corporates has shifted. Spreads were approaching fair value at the end of March.
- New issue volumes picked up in the first quarter after a very low $9 billion IG issuance and $0.6 billion HY issuance in December 2018. IG new issue was approximately $107 billion, $99 billion, and $110 billion in January, February, and March respectively. High yield new issue was approximately $20 billion, $22 billion, and $25 billion over the same three months. In total, Corporate new issue is down only about 3% in 1Q19 relative to 1Q18, approximately $382 billion versus $392 billion (SIFMA data).
Fed Pivot and First Quarter Spread Rally and Securitized Returns
- Although concerns about slowing global growth continue, the Fed’s policy pivot in January sparked a rally across securitized spread products. After a difficult fourth quarter, Agency MBS posted 28 bps excess return versus like-duration Treasuries and Agency CMBS generated an excess return of 73 bps.
- Non-Agency CMBS, arguably the most credit sensitive securitized sector, posted an excess return of 148 bps for the quarter. On the supply side, CMBS new issue is down 26% in 1Q19 relative to 1Q18; looking at conduit supply alone, the trend is even more pronounced. Conduit lenders have lost market share to balance sheet lenders over the last several years. Additionally, with the wave of 2006/2007 maturities in the rear-view mirror, the natural source of refi supply in previously securitized mortgages is lower going forward.
- ABS generated 40 bps of excess return for the quarter. ABS returns have benefitted from both a rally in swap spreads and strong demand as the short, high quality nature of the sector provides safety when uncertainty is on the rise. ABS primary supply is basically flat with supply in 1Q18.
- At the end of its policy meeting in March, the Fed announced the end of its balance sheet reduction. In the fall, Agency MBS will continue to run-off at a maximum of $20 billion per month with proceeds reinvested in Treasury securities, which has implications for valuations. Meanwhile, away from monetary policy, the market continues to prepare for UMBS trading which begins in just a few months.
- After peaking at 4.94% last November, 30-year mortgage rates have come down to 4.06% at the end of the quarter. The sizeable change in primary mortgage rates is positive for a housing market that has been slowing for the past year – lower rates could help boost the housing market as it heads into the peak summer season.
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.