Inflation and Oil – Not Always a Slippery Slope

Last week West Texas Intermediate (WTI) oil prices rose to $63 per barrel, up from $27 in early 2016. Rising oil prices can be inflationary and in extreme cases, like the 1973 and 1979 oil shocks, rapidly rising oil prices can lead to recessions and inflation. Those who remember shortages and gas lines know it’s no fun pushing a large Chevy Impala after the gas tank runs dry!

But this time rising oil prices are not a slippery slope to inflation.  

Oil prices are rising now from very low levels as record inventories are finally coming back into balance (see chart below). As you remember, back in 2013 and 2014 inventories were low, prices were above $100 barrel and OPEC decided to flood the oil market to put the U.S. shale oil industry out of business. When that didn’t work, OPEC and other oil producing nations reduced production, and inventories slowly came back into balance. Better to earn more dollars on less production than to go bankrupt pumping lots of oil! To be fair, today’s rising prices are not just a function of lower inventories, but also a function of strong energy demand and higher global tensions.

So why won’t inventories continue to fall and prices rise?

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As we get to the sweet spot of $60-70 a barrel for WTI, U.S. shale oil becomes more competitive and production rises. Shale production is a game changer in the oil industry. It used to take a decade or more to find and develop large conventional oil fields, like Prudhoe Bay in Alaska, where a long and lumpy supply response contributed to boom and bust price cycles. But shale production can come on line in a matter of months, not years or decades. This rapid supply function should help moderate the boom and bust cycle. The EIA (U.S. Energy Information Administration) notes U.S. crude oil production averaged 9.3 million barrels per day (b/d) in 2017 and production is forecast to average 10.3 million b/d in 2018, which would mark the highest annual average production in U.S. history, surpassing the previous record set in 1970. The EIA forecasts production to increase to an average of 10.8 million b/d in 2019. On top of increased U.S. production, Saudi Arabia and Russia are running large budget deficits and will want to raise their production as soon as they can do so without ballooning inventories and crushing prices.

The risk of a sharp rise in oil prices contributing to inflation is reduced due to U.S. shale becoming the oil industry swing producer. But despite this reduced risk, we still need to worry (sometimes a lot) about military conflicts cutting off supplies and pushing up prices – oil will always be a little slippery!

Source: U.S. Energy Information Administration, The Financial Times, Bloomberg

Muni Supply Hits a January Freeze

As the east coast digs out of the recent winter blast, the muni new issuance market is likely to be frozen for a while longer. Not because there are fundamental issues in the market, but because so much was issued in December, that there simply isn’t much left to do as we start 2018. We wrote about the tax-reform induced supply wave a few weeks ago here:
Thus far, the numbers are playing out as expected. December was a record month for muni issuance, with over $64 billion sold, surpassing the prior record in 1985 of ~$55 billion. Looking ahead, there was a meager $1 billion sold last week, and 30-day visible supply, which gives a rough indication of deals in the pipeline, stands at approximately $7.5B. We think this means municipals are poised for a nice run relative to other investment grade sectors as there simply aren’t enough bonds to go around. Returns last week highlighted this as the ICE/BAML Municipal index was flat, while the ICE/BAML Government/Corporate Index fell slightly. And while 1-week does not make a year, it could be a precursor of things to come. This trend is most impactful to our Blend Strategy, where we have the option of owning both taxable and tax-free bonds. As the muni market underperformed in December because of the heavy supply, we added exposure to the sector, and now look to benefit from the deep freeze. For more information on the Blend Strategy, see our recent blog post here:

Stay warm out there. 

Source: ICE BAML, Janney Montgomery Scott, SIFMA

2017 Review and Outlook

2017 Review and Outlook

At this time last year investors worried about the end of the bond rally that has been a force in fixed income investing for about as long as many of us can remember – where were you in 1981 when the bond bull market began with interest rates over 15%?  

Interest Rates Have Been Falling Since 1981

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But as we all know, changes in interest rates are only one part of the bond return equation, with yield (i.e. income generation) being the other component. This is especially true in the intermediate and short end of the curve, where income determines the majority of a bond’s return. When one holds high quality intermediate bonds to maturity, as we often do, then income really determines returns. In looking at 2017, we see this illustrated quite well. Returns were positive in the year considering the 2-year treasury rose 72 bps, the 5-year 30 bps and the 10-year was flat.

2017 Returns                                                  BofAML Intermediate Returns (1-10 Yr)
Treasuries                                                               1.08%
Municipals                                                              2.83%
Corporates                                                             3.31%

In addition to demonstrating the power of income, this data highlights the impact (or lack thereof) that rate hikes by the Federal Reserve can have on bond returns. The three rate hikes in 2017 caused short-term rates to rise. However, bonds with short-term maturities exhibit limited price sensitivity to changes in rates, and when longer-term rates don’t move much, like we saw last year, bond returns are positive. Alas, these trends combined to produce an environment for bond investors that we have described as “the sweet spot.”

So, will we stay in the sweet spot this year? Let’s look at a few of the factors we expect will have an impact on fixed income markets in 2018.

Fundamentals: The economy is growing nicely in the United States and around the world. The recovery from the great recession has been frustratingly slow and sub-par compared with other recoveries, a real tortoise vs. hare recovery, yet this recovery has the potential to continue for a while longer in the absence of a major central bank policy mistake or a black swan.  

Consistent economic growth is a tailwind for corporate bonds and for municipal tax receipts. More people are working, companies’ earnings are very strong, the stock market is hitting new highs and property prices are rising. Adding to strong fundamentals are benefits we may receive from changes in the tax code. We do see much of the benefit going to corporations, which will likely result in higher dividends, stock buy-backs and capital expenditures. Yet there are some consumption benefits to lower personal tax rates. The combination of corporate and personal tax cuts could help extend this economic cycle by pulling demand forward. 

Technicals: Supply and demand should favor municipals in 2018. The supply of municipal bonds will likely be lower in 2018 as new legislation takes away the tax shield from some forms of municipal issuance. At the same time, the demand for municipals could grow in 2018 in high tax states where personal exemptions are newly limited. More buyers and fewer bonds could push up prices.

Corporates should continue to be supported, as domestic buyers are still looking for any return in a yield starved environment, and foreign buyers are still investing in U.S. markets as European and Japanese interest rates remain close to zero or even negative.

Valuations: We are not going to say valuations are attractive. After close to ten years of historically low interest rates we should not be surprised that just about all asset classes are rich: treasuries, corporates, municipals, stocks and even Seattle real estate, our hometown. 

But these asset valuations got rich due to a combination of low interest rates and a growing economy, and until these factors change the path of least resistance is for the rich to stay rich. 

Outlook 2018: The big question in our mind is when will inflation pick up enough for central banks to raise rates at a faster pace and tip this recovery into a recession. As economists often note, economic expansions don’t die of old age – they are murdered by the Fed!  At some point the Fed will get behind the inflation curve and be forced to more aggressively raise rates.

Still, we are not worried about inflation and aggressive Fed interest rate hikes at this time. Inflation remains stubbornly low in the U.S., with wages held in check by the powerful twin forces of globalization and automation. In addition to these factors, high government, corporate and personal debt levels tend to moderate growth and, therefore, inflation. We have a ways to go before the Fed acts decisively. As for Europe and Japan, we do not see pressure to raise rates in 2018 or even in 2019. Europe is still in recovery mode and Japan’s battle with disinflation is at best fighting to a draw. 

The final part of this forecast is the possibility of black swans, or the unknown-unknowns, as Secretary of Defense Donald Rumsfeld so famously quipped in 2002. Black swans are even more difficult to forecast than interest rates, but we do know they regularly occur, especially when the world is rapidly changing. In anticipating these unknowns, we feel we are structurally insulated from their worst impacts by duration neutrality; by holding high quality assets; by diversifying asset classes, industries and issuers; and through the benefits of separate account management.

We trust 2018 will be another decent year, whatever comes our way. Happy New Year! 

Source: Bloomberg, BofAML

MuniLand: Pension Obligation Bonds or Pension Obligation Bombs?

Last week the City of Houston came to market with a $1.0 billion voter-approved pension obligation bond or POB. As a refresher, POBs are issued in the taxable market by local and state governments for the purpose of paying unfunded pension liabilities. Key to the success of POBs is the ability to arbitrage the cost of debt versus the returns for the pension assets and reasonably managing future pension costs. If the issuer cannot earn enough relative to the cost of the debt, as well as manage the pension plans in a manner that reduces the pension liability, then the outcome will likely be credit underperformance and potential rating downgrades.

Enter the City of Houston and its notable pension reforms and POB bonds. Houston pension reforms are notable because of the implementation of “cost corridors” on pension benefits for current and retired fire, police and municipal employees. In Houston’s case, market risk was transferred from the City of Houston to the retirees and employees. There was also a reduction of the assumed rate of return on pension assets to 7.0% from 8.0% or 8.5%, the implementation of a fixed 30 year amortization period and, finally, the City’s request of its voters (through a ballot referendum) for a $1.0 billion bond to stabilize the pension plans. The level of compromise between voter, employee, retiree and the city can only be described as impressive.

Two key provisions of Houston’s pension reforms are guided by the “cost corridor” concept, which means if pension assets grow slower than pension liabilities, current employees and retirees could receive benefit reductions because the city’s cost would be fixed. This represents a transfer of market risk to the pension plans from the city. These reforms could be used as a national model for pension reform because they ask all stakeholders to give and take.

Even with all of the compromises and the potential stabilization of the City of Houston’s finances, S&P Global Ratings warns in its December 6, 2017 report titled “Pension Obligation Bonds’ Credit Impact On U.S. Local Government Issuers,” POBs are a negative credit factor if issued in an environment of fiscal distress or as a mechanism of short-term budget relief. Generally, local governments do not need to issue POBs if their pension systems are well funded, return assumptions are conservative and if the city or county is fully funding its annual required contribution. Clearly, if a local government is issuing a POB something has gone wrong. Houston’s problems started with poor funding and the miscalculation of its pension liability. The result was a quick deterioration in funding ratios and significant fiscal stress.

S&P is correct that POBs alone do not fix pension issues. There are many cases where aggressive return assumptions or poor timing lead to unfortunate outcomes. S&P cites the New Orleans, LA 2000 POB and Stockton, CA 2008 POB as examples of POB risk. Nevertheless, we do not view Houston in the same light as New Orleans or Stockton because of the major and far-reaching pension reforms the city enacted, its diverse and thriving economy (anchored but not dependent oil and natural gas activity) and its significant taxing authority. These credit factors help defuse potential Houston pension obligation bombs.

Source: S&P Global Rating

Big Week for Central Banking

Spoiler alert: easy money will continue to prolong the economic expansion – no inflation in sight.

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The Federal Reserve kicked things off on Wednesday last week with a highly anticipated increase in the federal funds rate to 1.50%. The Fed also anticipates three further 25 bps increases in 2018. Additionally, the Fed’s balance sheet will shrink by $10 billion in December and $20 billion in January. Even with these changes monetary policy remains accommodating – rates are historically very low and money is easy. Looking to the future, Yellen and economists at the Fed anticipate stronger GDP growth of approximately 2.5% this year and next along with lower unemployment. Inflation is still below expectations, but there is faith wage pressures will mount as companies increasingly scramble to find workers. More interestingly, Yellen downplayed the impact of tax cuts. “While changes in tax policy will likely provide some lift to economic activity in coming years, the magnitude and timing of the macroeconomic effects of any tax package remain uncertain,” Yellen said, though she also suggested the tax package holds the potential to boost consumer spending and capital expenditures.

Across the pond, European monetary policy is even more accommodating. One day after the Fed’s announcement, the ECB announced its main refinancing rate will stay at 0% and the deposit rate will remain at minus 0.4 %. This is not just easy money, it’s free money!  Additionally, the ECB reiterated that it “stands ready” to increase the size of its bond-buying program in the unlikely event that the recovery sputters. The EU’s economy is doing quite well, by European standards, with the latest forecasts of 2.4% growth in 2017 and 2.3% in 2018. Inflation is still disappointing, however, with the latest forecasts suggesting headline inflation will finish 2017 at 1.5%, before dipping to 1.4% in 2018. Unemployment is still high in the EU, which means Europe will not benefit from wage pressure as we should in the U.S. Still, the ECB’s uber-easy policy is viewed as appropriate considering Europe’s economic recovery is a few years behind that of the United States.

Finally, the Bank of Japan meets this week, and despite some good recent GDP numbers, everyone expects its easy money policies to continue. So the message is really consistent across the globe: easy money policy supporting continued economic expansion with little change in sight. Happy Holidays!

Source: The Financial Times, Bloomberg, the NY Times, BCA Research, the Economist