Inflation Peek-a-Boo

Inflation continued its game of peek-a-boo with the markets last week. The consumer price index (CPI) print came out above expectations for the first time in five months, giving the markets a little surprise. CPI rose 1.9% year-over-year and beat 1.8% market expectations. Excluding food and energy, the so-called core CPI rose 1.7%. Shelter costs rose the most since 2005, driven by a 4.4% rise in lodging away from home; most of that came from a 5.1% rise in hotel costs, the largest gain since 1991. We expect the data to offer even more surprises over the next few months due to the recent major hurricanes, which can distort the numbers.

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While this little game is fun, it does have serious implications. The Fed is looking at inflation data as one measure to determine the speed of rate increases. Lower CPI prints over the last few months have the markets believing the Fed will be dovish, that rate increases will be slow and that it is still safe to bid up the price of risky assets. Stock markets have recently reached new highs and treasury yields are lower this year. After last week’s CPI data the odds for a December rate increase rose to slightly over 40%, and treasury yields ticked up a few basis points. 

Last week reminds us that while inflation is currently tame it is often a lagging indicator, usually showing up very late in the economic cycle. The recovery from the last recession has been very slow, so we should not be too surprised by stubbornly low inflation data. Yet low unemployment with a tightening labor market, a continuing and synchronized worldwide economic recovery and ten years of massively stimulative central bank accommodation should lead to higher inflation and continued Fed rate increases in the future. 

Like everyone, we are closely watching this game of peek-a-boo to get some sense of how fast central bank accommodation will be withdrawn. We currently believe the process of rate normalization will be as slow and as steady as the now long-lived economic recovery. So the game continues.

Source: Bureau of Labor Statistics, Bloomberg, The Financial Times   

SNW Asset Management Recertified as a B Corp

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SNW Asset Management has been recertified as a B Corporation, an achievement that was only possible through collaboration with our colleagues within OFI Global and with our partners at B Lab, the certifying body. As a Certified B Corp, SNW is part of a community of more than 2100 other B Corps in over 130 industries from at least 50 countries that share a common goal: to redefine success in business. Not to be confused with the Benefit Corporation designation, a legal status defined by individual state law, a B Corp is a for-profit company that meets rigorous standards of social and environmental performance, accountability and transparency as defined, administered and reviewed by the non-profit B Lab.

SNW has been a certified B Corp since June, 2014. This designation was and is a reflection of our commitment to our team members, our customers and our community to behave as a responsible corporate actor, working to improve our social and environmental impact. This is reflected not only in our SNW Impact Strategy, but in our approach to day-to-day operations and to the decisions made by the team's leadership. B Lab evaluates this commitment and approach across five axes: Environment, Workers, Customers, Community and Governance. As part of our recertification process, SNW was re-evaluated in each of these areas and met or exceeded the standards in all.

The recertification of SNW as a B Corp would not have been possible without close collaboration with and support from our parent company, OFI Global. This support is part of OFI's commitment to the SNW team and to ensuring that the company is a great place to work and strong corporate citizen—the same qualities that are embedded in the standards for qualifying as a Certified B Corp.
 

Delay by Dollar?

After nearly three years of asset purchases and negative interest rates, the European Central Bank has nursed the region back to health and raised inflation from anemic levels. With the economy on the upswing, all signs point to reduced stimulus in 2018, but there’s one obstacle standing in the way: the U.S. dollar. Driven by geopolitical risks and gridlock in Washington, the greenback has declined more than 13 percent against the Euro this year. This can be problematic for the ECB for a couple of reasons. For one, when the Euro rises against the dollar, European exports become more expensive. Typically, this means that European companies will sell fewer goods overseas, which can hurt growth and exacerbate the need for accommodative policy. A rising Euro can also undercut the ECB’s inflation target. A strong currency makes imported goods cheaper for Eurozone residents, which hampers the central bank’s ability to hit its 2% inflation target. Indeed, the ECB marginally reduced its expectations for inflation in 2018 and 2019 to 1.2 percent and 1.5 percent respectively. The central bank’s GDP forecast for 2017 was revised higher to 2.2 percent from 1.9 percent in June, while the projections for 2018 (1.8 percent) and 2019 (1.7 percent) remained unchanged. In his news conference last Thursday, Mario Draghi, the President of the ECB, noted that the bulk of the decisions regarding the asset purchase program would likely take place in October. The ECB has said it will continue its quantitative easing program by spending 60 billion Euros ($71 billion) a month in Eurozone bond markets at least through December, but has not commented on its plans for 2018. Draghi also reiterated that interest rates will be kept low for an extended period of time. Despite its caution, the ECB is incrementally moving towards a less accommodative policy stance, with guidance on the timing and pace of withdrawal expected in the coming months. The tone of this guidance will be important as too strong a statement could cause markets to roil and interest rates to move higher. We expect Draghi and the ECB to take a very measured approach, especially in the face of a strengthening currency.

Source: BCA, Bloomberg, NYT

Municipal Impact from Hurricane Harvey

Hurricane Harvey, which hit the coast of Texas last week, has been one of the most devastating storms in U.S. history. It appears that it may have a similar impact as Superstorm Sandy (2012), Hurricane Katrina (2005) and Hurricane Andrew (1992). 

Wind and flooding from hurricanes have the potential to cause billions of dollars of damage, but most municipal credits are able to maintain strong credit quality after a storm has passed. We are more concerned about Harvey’s long-term impact to the tax or revenue base of municipalities than about the costs associated with providing emergency services during or immediately after the storm, as most of the cost of providing those services will be reimbursed by the federal or state government. Population shifts or the choice not to rebuild damaged or destroyed properties are of concern as they could impact the amount of revenue available to pay debt service for outstanding bonds. For the most part, the long-term credit quality of municipal debt has remained relatively stable after storms, and in some cases tax revenues have increased due to new construction or increased purchases of taxable items such as construction supplies or new motor vehicles.

While many municipalities have been able to weather devastating storms, not all credits are created equal, and a combination of storm location and intensity and a lack of financial cushion have revealed some weaker credits’ vulnerability to natural disasters, including hurricanes. The combination of an intense storm and weak credit characteristics can lead to prolonged recovery and rebuilding, which can also lead to downgrades or defaults. New York City and New Orleans provide a comparison of varying credit impacts from hurricanes. Both cities suffered severe damage, New York from Hurricane Sandy in 2012, and New Orleans from Hurricane Katrina in 2005, but the credit impact was less severe on NYC. New Orleans was already a relatively weak, BBB rated credit before Katrina hit, and it was downgraded to non-investment grade after the storm. Nearly twelve years later, which includes one of the longest periods of national economic growth, the population of the city is still below its pre-Katrina population.

In addition to reviewing the credit quality and assessing the ability of a municipality to face emergencies, we also work to mitigate disaster impacts on portfolios by evaluating the geographic diversification of holdings. We want to ensure, for example, that our holdings of Texas bonds are not concentrated in hurricane zones along the Gulf of Mexico. Our exposure to Harvey impacted credits is minimal, and the credits we do own are either AA or AAA rated, or insured by the Texas Permanent School Fund, which backs school district debt issued in Texas. 

Also, we hold no enterprise revenue debt of airports, hospitals or public power issuers in the region.

We will continue to monitor the impacts from Harvey, including its effects on credit and pricing of Texas bonds, while keeping an eye out for opportunities to add value by purchasing bonds that experience unwarranted credit spread widening. 

Source:  Moody’s, Standard & Poor’s

LIBOR and Smoke-Filled Rooms

LIBOR, the London Interbank Offered Rate, is used to price approximately $300-350 trillion in financial transactions. Most of these financial transactions are interest rates swaps, but syndicated loans and floating rate notes comprise an estimated $13+ trillion—almost equal to the debt held by the large central banks of the world! Since these are almost incomprehensibly large numbers, even a small change in LIBOR is globally significant. LIBOR rates are set daily by a small number of traders who, as we saw during the financial crisis, have had an interest in shading the truth to benefit their trading positions and bonuses, as well as the fortunes of their employers. This is the classic smoked-filled room, which came under scrutiny during the chaos of the financial crisis. Since then, regulators have intervened. Banks were fined about $9 billion, with potentially more to come, and better controls are now in place. But while fines have been paid and traders are now better monitored, so far little has been done to solve the underlying weaknesses in setting LIBOR rates.

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Convening in a smoke-filled room is not a fair way to set rates, but it appears that replacing LIBOR with a transparent and verifiable system is difficult for regulators in both London and Washington. LIBOR is a very subjective and complex measure, as it combines both an interest rate and a credit component, covers five different currencies and spans maturities that range from overnight to one year. In essence, it is an opinion, an informed view on the markets.

So how do you standardize this complex and often conflicted opinion?  Apparently, you try to compromise!  Just recently British regulators said they plan to phase out LIBOR by 2021 and replace it with a new benchmark less susceptible to manipulation. The UK’s proposed replacement, the Sterling Overnight Index Average, tracks overnight funding deals, but not longer-term rates. One problem is that any benchmark using real data lacks authority when there is no liquidity in the markets – at such times opinions are all you have to go on. In the U.S. the discussion is centered on a new rate linked to the cost of borrowing cash secured by U.S. government debt. This rate would include trades between banks and buy side firms, but would no longer be a reflection of interbank lending or bank credit strength. The compromise is still a work in progress among U.S. and UK regulators. 

Because there is much debt to be repriced and many terms to be renegotiated, this will take some time and effort. Luckily, the credit quality of LIBOR based bonds will not change: an “A” rated bond will remain “A” rated. Any pricing change at the issue level should be unnoticeable, and even a very small changes could be phased in over time. Good to know we have some time to allow the smoke to clear!

Source: The Financial Times, Bloomberg, Barron’s