Big Week, Smaller Numbers

Last week offered a limitless buffet of economic updates for those who cannot resist offers of all-you-can-eat! The Fed released minutes, the ECB held a meeting, the IMF came out with new projections, and for dessert large U.S. banks were grilled by Congress. The options were overwhelming!

But what to eat? Our pick of the news were IMF projections cooked up with a wide array of ingredients. The major points of their outlook are: after strong growth in 2017 and early 2018, economic growth slowed in the second half of 2018. After a few quarters of weakness, growth is set to stabilize by 2H19. However, despite the better news, most risks are still tilted to the downside.

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Global economic activity decelerated notably in the second half of last year due to well-known events. China slowed after enacting regulatory tightening to rein in their shadow banking system in conjunction with an increase in trade tensions with the United States, the euro area lost speed as consumer and business confidence weakened, car production in Germany turned down and Italian sovereign spreads widened. Overall financial conditions tightening as markets sold off at the end of 2018. Because of these events, the IMF reduced 2019 global growth forecasts to 3.3%, with advanced economies down to a smaller 1.8%.

The just released IMF global economic forecasts now indicate the possibility for a small increase in global growth in 2020. This improvement is correlated with the Fed’s pause on rate hikes, China offering some stimulus, improvements in global financial markets sentiment, and the anticipated stabilization in Europe as China (a major export market for Europe) turns the corner. Still, growth will not be uniform with advanced economies still weakening into 2020 and global economic improvements coming from emerging markets and developing economies.

Despite the expectation for global economic stability and some modest growth, the warning of risks to the downside and still slower growth in advanced economies does not make you want to save room for dessert. The litany of risks prompting caution include a further escalation of trade tensions, a sharp deterioration in market sentiment like in the 4th quarter, a reassessment of the Fed’s pause due to the reemergence of inflation, a no-deal Brexit and continued political discord due to rising inequality and the rise of populism.

Maybe it’s best to just skip dessert.

Sources: IMF, Bloomberg

1Q19: Pivot to Stability or End of Cycle Noise?

What a difference a quarter makes!

Markets pivoted dramatically 1Q19, veering from the expectation rising rates would hurt the stock market and slow the economy to the belief that growth could be extended with a more accommodating Fed and Chinese stimulus. The yield curve flattened as rates declined in the 4th quarter, and then fell further and inverted in the first quarter with the hope of Fed rate cuts. By the end of the first quarter, the one-month Treasury yielded more than the ten-year Treasury. During the same period, corporate credit spreads ballooned 52 bps on economic fears, and then abruptly pivoted and tightened 38 bps with the hope Fed patience could extend economic growth. This is not normal middle of the cycle behavior.

1Q19 Total Return*

1-5yr Index 1-10yr Index Total Market Index

Treasury/Agency 1.21 1.56 2.17

Municipal 1.35 2.09 2.95

Corporate 2.63 3.80 5.01

*ICE/BAML Index Return Data

Munis: Municipals had a great quarter and easily beat treasuries. This outperformance was due to very strong technicals resulting from large flows into mutual funds in conjunction with light supply from issuers. As usual when there are more buyers and fewer sellers, prices go up.

As the price of municipal bonds increase, yields fall. We saw that, for some muni investors in lower tax brackets, lower muni yields made it possible to sell municipals and buy taxable bonds to earn a superior all in after-tax return. This was an important trade in some of our Blend Strategy accounts during the quarter.

Corporates: This was an exceptional first quarter for corporate bonds, with spreads tightening 38 bps. In conjunction with lower interest rates, corporates produced market leading returns.

It appears the markets awoke in 2019 and decided that corporate bonds had become too cheap and that the world was not as scary as it seemed. As the quarter evolved, the Fed moved from patient to dovish, and Chinese stimulus was formally announced on January 14th. However, as soon as all this good news was digested in early February, the rally in spreads started to lose some steam.

It is difficult to see corporates continuing to produce Q1 type excess returns as we move through the rest of the year.

Overall: So, was the first quarter a durable pivot to economic stability or just some noise at the end of a long economic cycle?

We see the potential for some short-term stability as the Fed and other central bankers have grown more accommodating and willing to stay accommodating for as long as it takes. We see unemployment low and wages rising, and we see banks still willing to lend. The cycle could go on for a while longer.

But we also see recent market noise as yet another telltale sign of a weakening U.S. economy. The trend of slowing GDP growth is evident in the U.S. and more pronounced in China. Furthermore, one can argue some parts of Europe are now bordering on recession. Slower growth is not surprising, as the Fed has raised rates over the last two years, fiscal stimulus is waning, world trade has been noticeably weakened by protectionism and corporate profit margins are past peak.

With all this noise in a slowing economy, we will continue to position portfolios conservatively and stay prepared for the next pivot and next opportunity.

Sources: Federal Reserve, Bloomberg

SNW Impact Insight: Climate Change at the Fed

A quick note: To highlight the SNW Impact Strategy through 2019, we will be periodically sharing thoughts and observations from the team responsible for the research and ratings. These pieces are intended to share the context of how the ratings are derived, the philosophy behind ESG and impact ratings, and how the industry is currently positioned. They may feature entities that we do not currently invest in.

Glenn D. Rudebusch, senior policy adviser and executive vice president in the Federal Reserve Bank of San Francisco’s economic research department, outlined the economic impacts of climate change in an Economic Letter released on March 25th. The letter highlighted the likely direct and indirect impacts that will result from rising sea levels, increasing temperatures and changing weather patterns, as well as from resource reallocation to deal with these impacts and to increase climate resiliency in affected communities. This includes both near- and long-term impacts that may yield negative economic outcomes.

Referencing the latest National Climate Assessment released in November 2018, the FRBSF letter provides insight into how markets and central banks may react to climate change. Risks from climate change are of concern to central banks, including the Federal Reserve, as they may require a change in monetary policy. As Rudebusch points out, "Climate-related financial risks could affect the economy through elevated credit spreads, greater precautionary saving, and, in the extreme, a financial crisis. There could also be direct effects in the form of larger and more frequent macroeconomic shocks associated with the infrastructure damage, agricultural losses, and commodity price spikes caused by the droughts, floods, and hurricanes amplified by climate change." These factors, while initially local, may have global carry-on effects. Alongside these direct impacts, adaptation and resilient responses will require the diversion of resources from productive capital accumulation. In combination, as the letter points out, "Climate change is becoming relevant for a range of macroeconomic issues, including potential output growth, capital formation, productivity, and the long-run level of the real interest rate."

With that said, however, Rudebusch points out that the Federal Reserve's statutory mandate of price stability and full employment will restrict the actions the organization can take. The use of policy to support climate change mitigation through the transition to a low-carbon economy, through support for an appropriate pricing of carbon or through other direct actions focused on environmental sustainability are all beyond the remit of the Fed. However, the analysis and policy decisions undertaken by the Federal Reserve can and should take climate change and its effects into consideration as "the volatility induced by climate change and the efforts to adapt to new conditions and to limit or mitigate climate change" are increasingly relevant.

In January, twenty senators sent a letter to the Chairman of the Federal Reserve and to the Comptroller of the Currency urging them to bear in mind that their agencies are responsible for protecting the stability of the U.S. financial system and urging them to ensure that the nation's financial system is ready for climate change. In February, Chairman Powell of the Federal Reserve told legislators that the inquiry about climate change was a "fair question" to ask, and he promised to look into it. These financial risks are increasingly apparent, as what was once considered a long-term issue begins to express itself in more near-term impacts.

Our approach to credit analysis, even outside the holdings in our SNW Impact Strategy, includes an integrated approach to evaluating material and relevant climate and environmental factors in all sectors in which we invest. Our view continues to be that prudently managing risk and being aware of the full spectrum of origins of such risk is a critical responsibility. This includes near-, mid-, and long-term idiosyncratic risks that may affect the ability of issuers to repay their outstanding obligations. We will continue this approach and adjust strategy and positioning as needed.

The Fed Managed to Surprise Us Again

The Fed is on a roll. Just when we thought the Federal Open Market Committee (FOMC) couldn’t surprise markets with any more dovish (easy monetary policy) announcements, it did just that.

Following its two-day policy meeting last week, the FOMC announced on Wednesday the expectation for no additional rate hikes in 2019 (after expecting two hikes as recently as December) and only one 25 basis point increase next year. In addition, the FOMC announced an earlier than expected end to its balance sheet reduction process.

Both stock and bond markets reacted positively to the news on Wednesday and Thursday. Stocks because the Fed put is back, meaning that the Fed will do everything in its power to keep the current expansion in both the economy and financial markets going strong. Bonds because less monetary policy tightening is generally good for valuations, especially when inflation is under control.

Friday was a different story, however. On the back of weak economic data out of Europe, we saw a classic “risk-off” day. Stocks fell, corporate credit spreads widened and TIPS breakevens (a measure of inflation expectations) declined. Long-term U.S. Treasuries rallied and took certain yield curves into inversion territory, which historically has been a signal of a pending recession.

It now appears to us that financial markets have discounted much of the Fed’s dovishness. And with the Fed on-hold for further monetary policy announcements, moves in risk assets are likely to be driven mainly by how the economy evolves. Will the recent weakness in overseas economies, namely Europe and China, be transitory or more long-lasting, and will it bleed over into the U.S. economy, are the key questions moving forward. Any substantial change in inflation or inflation expectations will also be important to monitor.

High quality bonds such as tax-exempt municipals, U.S. Treasuries and highly rated corporate bonds have performed well, and will continue to encounter favorable conditions moving forward. The jury is still out for riskier assets such as lower rated corporates, however. Given the current environment, we think it’s prudent to position our strategies with a conservative bent, and remain patient to see how the situation evolves.

Source: Federal Reserve

Spring Is in the Air – We’ll see if the Fed Agrees

Spring is an optimistic time of year, with the smell of grass and fresh flowers, longer days and bright sunshine. And it is so predictable – it happens every year!

If only the economic cycle were as predictable! Recessions happen infrequently and the last one ended in June of 2009.

One of the classic tools for predicting recessions is the NY Fed’s “Probability of U.S. Recession Predicted by Treasury Spread – Twelve Months Ahead.” This model uses the difference between 10-year and 3-month Treasury rates to calculate the probability of a recession in the United States twelve months ahead. As you can imagine, the Fed has been tracking and analyzing this data for decades and it does a pretty good job.

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As the data indicates, it is hard to see a recession in 2019 with the U.S. economy still so strong. But as the chart also shows, the risk of a recession can rise or fall suddenly for any number of reasons. What we take way from this data is treasury spreads indicate the economic cycle is at least in late fall: leaves are turning red and gold and there is chill in the evening air.

We will get an update from the Fed this week when the Federal Open Market Committee meets to set monetary policy. The post-meeting statement and press conference will provide insights into the FOMC’s thinking on both the economy and interest rates. We don’t expect any changes to the Fed Funds Rate, but like so many previous meetings, all eyes will be on the dot plot, which highlights committee members expectations for future rate moves.

Markets also do a good job of anticipating the changing of the season and will move ahead of an actual recession. We note investment grade credit spreads appear to have reached their cyclical tights in February 2018, and the last S&P 500 top was in September 2018.

In the coming weeks we will start getting outside more often to enjoy the sunshine, and we will also ensure portfolios are getting ready for cooler weather.

Source: NY Federal Reserve