Consumer Price Index Ticks Up

Inflation, as measured by the Consumer Price Index, continued to tick up last month. The July CPI registered a gain of 0.2% versus June. Year over year, the measure was up 2.9%, the largest annual increase since 2011. Excluding the volatile food and energy categories, CPI rose 2.4% year over year. 

CPI ex Food & Energy Y/Y

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Driving the gains were increases in “owners’ equivalent rent,” which essentially measures shelter costs. A 0.3% rise in this category accounted for 60% of the increase in the overall level of CPI. The strong economy is also contributing to an increase in prices, with certain service items, such as hotel rates and airline fares, posting solid gains and reversing declines in June.

For us, there are two key takeaways from the report. 

First, a steadily increasing level of inflation will likely keep the Fed on track for a rate hike at their September meeting. The Fed has recently expressed confidence that inflation is coming back to levels more consistent with their 2% target. And although the CPI is not the Fed’s preferred measure of inflation (that is reserved for the personal consumer expenditure index), it does indicate that inflation is running at levels consistent with the Fed’s objectives.

Second, and something that we will be watching moving forward, is whether consumers can stomach higher levels of inflation given that wage growth remains tepid. In addition to CPI, average hourly earnings were released last week and showed that wage gains are not keeping up. For the first time since 2012, wage gains after accounting for inflation turned negative.

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Given that strong consumer spending has been a boost to the U.S. economy, any reversal could have negative impacts for GDP growth in the future. And with inflation registering at these levels, we shouldn’t expect the Fed to scale back on their monetary policy normalization process anytime soon. Tighter policy with weaker growth typically makes for volatile markets, so it will be important to see how consumers react to lower real wages and if they dip into savings to keep the spending going. 

Sources: Bloomberg, Labor Department, WSJ
 

Central Banks: Signal Versus Noise

Major central banks around the world made some important announcements over the last two weeks. We believe these announcements give us some clear signals as to the course of the economy and markets—yet most were drowned out by the noise of technology earnings, trade wars and the all-consuming political news cycle. We have to admit, listening to Elon Musk can be far more amusing than listening in on the Bank of Japan.

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The important signal is that central banks are generally moving from easing to tightening as economies recover and inflation moves closer to targets. As we know, less central bank accommodation usually leads to slower growth and can make the markets for risky assets go wonky. 

Last week the Federal Reserve justified its tightening stance by using the word strong four times in regards to economic conditions: “Economic activity has been rising at a strong rate…job gains have been strong…household spending and business fixed investment have grown strongly…supporting strong labor market conditions.” It is no surprise we, and the rest of the developed world, expect the Fed to raise rates at its September meeting and to keep on raising rates thereafter. 

Two weeks ago the European Central Bank (ECB) reiterated the message it intends to scale down its quantitative easing in September and then halt by year end. We even expect the ECB to think about raising rates. Maybe not at the moment, but the long-term direction is clear.

In other central bank news, the Bank of England (BOE) raised rates last Thursday to their highest levels in nearly a decade. The BOE is attempting to both hold down inflation and prepare for a potential economic downturn as Britain exits the European Union. It is easier to cut rates and support a weakening economy if rates are already well above zero. 

The one standout in all this easing is the Bank of Japan, which still has made no indication it will increase rates. The interest rate on its 10-year bond is now less than 15 bps.  

Although the signals for economic tightening are clear, the timing remains buried in noise

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

Earnings Season – Food Fight!

Corporate earnings season is that time of year when we get an update from management on revenues, earnings and the state of the business. The season occurs shortly after the end of every fiscal quarter and runs for a few weeks. Company sponsored earnings calls, press releases and power point presentations are closely followed by securities analysts who look for updates and new ideas. For those in the business it’s a big deal, and a bit of a food fight as analysts all compete to ask the best questions and to lob the cleverest insights. These food fights are important as we need to closely follow portfolio investments. When an investment thesis changes we will respond with a trade.

This quarter the food fight was a healthy one. With 240 companies in the S&P 500 reporting as of writing, this was an exceptional quarter with overall revenue growth of 9.5% and earnings per share (EPS) growth of 25.1%. Banks (the main course for many portfolios) are posting revenue growth of 6.0% and EPS growth of 22.7%. These are really outstanding numbers and everyone seems to be doing well! The numbers have been brought to us by: the Federal Reserve’s recent ultra-loose monetary policy, an exceptionally long U.S. economic expansion, generationally low unemployment, strong global economic growth and earnings which have been supersized by the recent massive tax cut. Add a large side order of buybacks (further boosting EPS) and dessert in the form of low labor costs, which are still quite modest compared to historical averages.

But will the food fight be just as big next quarter? We believe earnings will be good for the remainder of 2018, but should fade thereafter. We may have already seen the high-water mark. A less accommodating Fed, higher interest rates, a stronger dollar, a slowing world economy, a growing list of tariffs, wage pressures and higher energy costs should all help to moderate earnings in the coming quarters.

Sources: Bloomberg, the Wall Street Journal, the Financial Times

Short Munis, Tall Performance

Thus far in 2018, municipal bonds with maturities five years and shorter have materially outperformed their taxable counterparts. As the Federal Reserve has raised the overnight policy rate, short maturity Treasury yields have marched higher. Meanwhile, in the municipal market yields have not moved much at all, and for the shortest bonds (less than 1-year to maturity) yields have even declined. This has led to a significant divergence in the yield offered by short maturity municipal bonds and short maturity taxable bonds such as corporates. 

See the below chart for the YTD change in the 2-year AAA municipal yield divided by the 2-year Treasury yield. This ratio is one way to assess the relative value of tax-free municipals compared to taxable bonds. At 61%, 2-year munis are trading at some of the richest levels on record.   

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The largest drivers of the trend have been very negative net supply (more bonds maturing than being issued) in the municipal market, coupled with a preference by municipal investors to stay short as they anticipate higher rates, and as the finally solid flows into the market we’ve seen so far this year continue to drive demand.

In our Blend Strategy, we entered the year with an overweight allocation to municipal bonds. As short maturity munis have outperformed over the last 7 months, we recently made a shift and sold exposure to short municipal bonds in favor of short corporate bonds. We have executed this trade over the last 2 weeks, reducing our overweight to tax-exempt municipal bonds from 8% to 3%. We received very strong execution on the sale side of the transaction as the dynamics that have led to municipal outperformance in this part of the curve remain intact. The flexibility of the Blend Strategy in moving between investment grade market segments as relative value shifts over time is highlighted by a trade like this. As always, we will continue to monitor these changes and will be prepared to take advantage of such opportunities as they arise.

Sources: JPM & Bloomberg

Less Liquidity + Higher Debt = No Day at the Beach!

It’s summer, and the only liquidity we should be thinking about is a cold beverage on a warm beach. Summers in Seattle are way too short, and since the rainy season is always just around the corner we need to enjoy the sun while we can.

Despite the distractions offered by warmer weather, we are noticing some market developments that are far from bright and sunny. The first is liquidity and the second is debt, both of which were highlighted in a recent report produced by the Bank for International Settlements.  

We often talk about how the Federal Reserve is raising the fed funds rates and reducing its balance sheet. This is draining liquidity from the capital markets and will likely eventually lead to lower economic growth and the next recession. As the old saying goes, “Economic expansions do not die of old age, they are murdered by the Fed.” We know we are well along in this cycle of interest rate hikes, and it is important to note the Fed is not alone in taking away liquidity. Many of the world’s central banks are also planning on raising rates, which will impact the U.S. 

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Higher debt levels are a second important issue.  The financial crisis in 2007/2008 did not lead to lower debt levels as one would expect. As the crisis unfolded, central banks stepped in with aggressive liquidity measures to keep the world financial plumbing intact. Governments borrowed and spent with abandon to soften the recession, and corporations capitalized on ultra-cheap money to increase dividends, fund buybacks and make acquisitions. Only households modestly reduced debt directly after the recession. But some research suggests much of this debt reduction can be attributed to forgiveness of mortgage loans during foreclosures, not to debt repayment.  

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Note : AE = Advanced Economies, EME = Emerging Market Economies

So here we are trying to enjoy that cold beverage with the knowledge liquidity is draining, debt is piling up and the consequence will be more volatility and likely lower prices for risky assets. The good news is that as Seattle residents our rain jacket is always close at hand. We are currently positioning portfolios for more volatility by scaling back on credit risk, keeping liquidity high, and maintaining duration exposure close to home.

Enjoy the sun!

Sources: The Financial Times, Bloomberg, The Bank for International Settlements