Why Investors Care so Much About a Few Dots

The Federal Reserve Open Market Committee (FOMC) is set to meet this week and is widely expected to announce a 0.25% increase in the Federal Funds Rate (FFR). This would mark the third increase of 2018 and bring the targeted range for the FFR to 2.0-2.25%. With this action fully priced into the market, all eyes will be on the Fed’s forward guidance, particularly the committee’s expectation for the FFR in 2019. The most recent expectation from the Fed is for one more increase this year, and another three next year, which would bring the FFR above 3%. Individual committee member rate expectations are represented as dots on the below chart, which makes these dots the main attraction for many investors.

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So why does this matter so much? With the economy humming along nicely this year and inflation well contained around the Fed’s target level of 2%, the FOMC appears to be using this opportunity to bring the Fed Funds Rate to a normal level, after being at the zero bond for years post the financial crisis. This action does not come without consequences, however. In recent weeks we have seen a spike in volatility in emerging markets, which many market participants are ascribing to the tightening of monetary policy by the Fed. The economic boost that fiscal stimulus has brought will also begin to wind down in 2019. And don’t forget the yield curve, which has flattened to very low levels. Another four hikes in the next 15 months would likely cause the curve to invert, which has historically preceded a recession.

So don’t worry about the headlines detailing the 25bps hike in the Fed Funds Rate. Watch the dots, as that forward guidance will be what investors care most about.

Source: Federal Reserve

CPI Suggests Moderate Inflation

Headline CPI for the month of August printed last week at 2.7% year-over-year, and core CPI (excluding food and energy prices) came in at 2.2%. This was below consensus estimates of 2.8% headline and 2.4% core. Inflation has moved up steadily throughout the year in 2018, rising from 2.1% year-over-year headline and 1.8% core at the end of last year. The incrementally softer print for August was driven by declines in apparel and medical care prices. Meanwhile, owner’s equivalent rent (OER), which has been the steadiest contributor to inflation for several years, continued its strength. Looking at the 6-month annualized increase in core CPI reveals a somewhat tamer picture of inflation of just 1.9% growth, and highlights that some of the strength in the year-over-year data has been driven by base effects, or gains that are measured against relatively weak inflation numbers from last year.

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Looking forward, we will be watching the housing market closely as certain data points have been showing signs of a slowing market in recent months, which could dampen the strength of the OER component and further moderate inflation growth.

Nominal wage growth has moved up this year, and is being watched as a potential indicator for accelerating inflation. However, after adjusting wages for inflation, real wage growth remains low at 0.2% year-over-year, and has fallen throughout the year as inflation has risen more than nominal wages.

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None of this will alter the market pricing-in another Fed hike at the September meeting next week, as the rate increase has been well telegraphed and is a near certainty. Subsequent inflation prints will be watched very closely as a further decline in the year-over-year figures could cause the Fed to delay the forecasted hike at the December meeting, which the market is currently pricing at about a 72% likelihood.

Sources: Bloomberg, BMO

Contagion and U.S. High Grade Credit Markets

Emerging market weakness and financial market contagion risks are again in the news. 
In our view, this bout of emerging market weakness stems from a number of causes: a stronger U.S. dollar reflecting Federal Reserve rate hikes, an elevated exposure to dollar denominated debt in many emerging market countries (notably Turkey, South Africa and Argentina), and a continuing economic slowdown in China.

A slowdown in China is a bigger factor in this episode of emerging market risk than in the past. China now contributes about 15% to the global economy compared with about 3% two decades ago. And, importantly, China contributes more than 30% to all global growth. Today, when China sneezes, many of their emerging market trading partners catch a cold. 
We can see this weakness and contagion risk in emerging market currencies, which are down 8.6% since March. Additionally, emerging market equities are approaching bear market status; the MSCI index is down close to 20% since recent highs. Finally, we have all seen the charts on copper, which is down about 20% in just the last few months. Copper didn’t catch a cold, it got the flu!

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The concern is that weaker emerging markets will lead to a broader based sell off in developed markets, and could eventually lead to material weakness in high grade credit markets. This would be classic contagion.

To date, this has not occurred. With very low unemployment, cyclically high GDP, record breaking corporate profits and contained inflation, the U.S. economy continues to perform well. We are doing better than most of the world. Responding to these good fundamentals, the stock market is setting new highs, with two new trillion-dollar market capitalization companies, one located just across the street from our offices in Seattle!

When central banks raise rates and reduce liquidity, it leads to increased volatility. We have seen this movie before. Watching the latest sequel, we will become worried if we see the U.S. economy move towards recession, corporate profits take a steep downturn, or if China tilts toward a hard landing. Yet this worrisome scenario is not our base case. 

Our base case is for modestly slower growth as the Fed starts to take away liquidity. We have been modestly reducing risk, as valuations are rich and fundamentals are past peak, and will continue to reduce if risks continue to rise.

Emerging market contagion may be news, but is anything but new.

Sources: The Wall Street Journal, Bloomberg, the Financial Times, BCA Research

Jackson Hole – Summer Home to Our Central Bankers

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The Jackson Hole Federal Reserve Economic Symposium, held last weekend in Wyoming, is the only time of year when U.S. Central Bankers get to loosen their ties, breathe a little fresh air and wax philosophically about monetary policy. But let’s not get too excited—it’s no Burning Man!
We care about Jackson Hole as we hunt for short-term clues as to the speed of rate hikes and the destination for fed funds rate over the next few years. We all wonder if the Fed will pause raising rates for emerging market mayhem, if higher inflation or lower unemployment will push higher the fed funds target rate, or whether the committee is more likely to just gradually, modestly and carefully raise rates and shrink its balance sheet as the economy continues to improve?
Jay Powell, chair of the committee, clearly indicated there is no clarity. The world is uncertain, and the Fed’s crystal ball remains cloudy as it constantly tries to navigate between “moving too fast and needlessly shortening the expansion, versus moving too slowly and risking a destabilizing overheating.”  Mr. Powell reiterated the Fed’s talking points, that “if the strong growth in income and jobs continues, further gradual increases in the target range for the fed funds rate will likely be appropriate.”  Though he was quick to note that this is the consensus view, there are differing opinions on the committee. The markets interpreted his comments as mildly dovish, and stocks rose as the dollar fell.
Despite the good short-term news, Mr. Powell also commented on a number of longer-term structural challenges facing the U.S. economy that generally can’t be fixed by raising or lowering the fed funds rate. Real wages (particularly for medium- and low-income workers) have grown quite slowly in recent decades, economic mobility in the United States has declined and is now lower than in most other advanced economies, the U.S. federal budget deficit is unsustainable and there is continuing low productivity. More interesting side bar conversations included challenges to the economy stemming from monopoly power and corporate consolidation, the potential for technology to reshape how retailers set prices and the trade-offs between stability and competition in the banking sector. We shall see if these trial balloons get any traction!
Ultimately, it was no Burning Man in Jackson Hole, with no disruptive technologies announced or new visions for the future proposed. But when it comes to central banking, maybe cautious, conservative and calm is the best course.
Enjoy the last days of your summer.

Sources: The Federal Reserve, the Wall Street Journal, Bloomberg, the Financial Times

Property Tax Revenues Drive Stability for Local General Obligation Bonds

The SNW Investment Team maintains a stable outlook on the Local General Obligation Bond (Local GO) Sector and recommends a marketweight allocation to it. We expect Local GO credits to provide stability relative to other tax-backed sectors, as well as to more economically sensitive revenue bond sectors. We also expect that credit spreads in the sector will be less volatile than in other sectors. The outlook assumes that the level of issuance of Local GO bonds will remain in line with recent trends.

Property taxes are the primary source of revenue to repay Local GO bonds, and we continue to expect that they will provide stable revenue. Property valuations underlying tax revenues have had robust growth, and even in the event of an economic downturn, property tax provisions typically create a banking of gains that can offset decreased valuation. Given the lags between economic activity and property tax collections, we expect that any impacts from a downturn in real estate conditions would not be realized until the 2020 or 2021 fiscal years.

Despite recent financial market performance, pension liabilities remain a long-term credit issue due to changing demographics, growing expenditures and continually increasing contribution levels. The type of GO pledge can mitigate the impact of pensions or other factors. Local GO bonds backed by unlimited tax pledges provide stronger bondholder protections than Limited Tax GOs, and the risk profile of the Unlimited Tax GO is significantly lower than local appropriation debt despite recent rating agency upgrades.

The SNW Investment team has seen tactical opportunities for value in the Local GO Sector, particularly with some mid-grade quality bonds in the A rating category. We will continue to look for opportunities to invest in Local GO credits that provide credit stability and value.

Source: SNWAM Research