Corporate Earnings Recession

Earnings season starts this week and the news is expected to be disappointing. Bloomberg is projecting S&P 500 earnings in the second quarter 13.8% lower than the same time last year, and earnings could be negative again in the third quarter. Two negative quarters in a row is the classic definition of a recession.

While this may sound alarming, and while the trend is clearly weak, once you unpack the numbers it does not look so bad.

Let’s start with the good numbers. First, margins are near cyclical highs. Much lower corporate taxes, lower interest rates, lower energy costs, contained wage growth since the great recession and above trend U.S. GDP growth have plumped up earnings over the last few years. A pause in growth should be expected at some point.

Quarterly S&P Sales and Earnings Trends

Moving on to the bad numbers, GDP growth is fading around the globe, tariffs are a drag on earnings (remember tariffs are just another tax), a stronger dollar is hurting exports, emerging wage inflation is starting to impact earnings (as unemployment rates reach a 50-year low) and capacity constraints have led to higher transportation and logistics costs.

So, are investors correct in being so blasé about weaker corporate earnings? At the end the day it is hard to get worked up about a pull-back in corporate earnings when the Fed and the ECB (and just about every other central bank) are loose and expected to loosen further. China is ready and able to support its economy if needed, fiscal policy around the world remains loose and the U.S. consumer is doing well.

As we mentioned last week, we will all be looking for the proverbial green shoots in earnings and GDP to confirm central bank loosening will sustain this long running economic recovery. But until we see some evidence, as well as perhaps some happy guidance this earnings season, we prefer staying conservative and liquid with the conviction there will be better opportunities ahead.

Sources: Bloomberg, Goldman Sachs, the Financial Times

University of Alaska: A Case Study for the Higher Education Sector

The University of Alaska is making headlines due to the governor’s veto of a significant portion of its revenue stream. Though the higher education sector continues to face negative pressure, SNW believes the potential financial crisis affecting this university is an isolated event. Such drastic funding cuts and possible financial and rating deterioration does not represent the broader higher education universe.

On July 2nd, Moody’s placed the A1 rating of the University of Alaska on review for downgrade. Moody’s review is driven by the governor’s line item veto, which reduces the University’s state funding by 41%. A special legislative session will begin in early July in which the legislature will have the opportunity to override the governor’s actions. Several factors go into rating reviews, including the ability and willingness to adjust expenses to maintain fiscal health. After considering all credit factors, including legislative actions, the Moody’s rating action on the University of Alaska could be multi-notched.

Given the decade long deterioration on the University of Alaska’s rating, the review for downgrade isn’t surprising. That said, SNW believes state funding cuts that lead to possible multiple notch rating downgrades is certainly a unique situation. The University of Alaska is more susceptible to changes in state appropriations for revenues than other universities, given nearly 50% of its operating budget is supported by the state. To put this in perspective, Moody’s median appropriation for all public higher education universities is 24%. Furthermore, there is a decline in Alaska’s high school graduate rate, affecting demand and the associated revenue stream. This pressures the operations of the University of Alaska and makes it more susceptible to the fiscal and economic condition of the state (and its volatile energy sector dependence).

Despite this negative higher education headline and the challenges facing the sector, SNW believes both private and public university bonds offer value after careful analysis. Higher education institutions with the greatest rating defensibility are typically sizeable state universities with diverse revenue streams and large student populations. SNW will continue to monitor the higher education sector to find bonds that offer the most stability and value.

Source: Bloomberg, Moody’s, Newsweek

2Q19: Central Banks to the Rescue?

The Federal Reserve and global central banks were in the spotlight this quarter. As global and U.S. growth and inflation prospects weakened, central banks promised to become more accommodative. This tug of war between two titanic forces, bankers and the economy, can result in more than a little volatility, which is what we witnessed the past three months.

The treasury market rallied hard in the second quarter, with the 10-year note yield falling 41 bps and the 2-year falling 51 bps. Clearly the markets began to discount slower growth and inflation. With this rally the yield curve inverted, and now the 10-year is approximately 40 bps below the Fed funds rate. This is a deep inversion and usually a sign a recession is on the horizon.

With the rally in rates and central bank support, all major investment grade fixed income sectors and maturities generated positive returns during Q2.

2Q19 Total Return*

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

Treasury 1.83 2.32 3.06

Municipal 1.10 1.59 2.34

Corporate 2.14 3.13 4.35

*ICE/BAML Index Return Data

Munis

There were several factors impacting muni returns in the second quarter. Most importantly there continued to be more buyers than sellers, a trend that continued from Q1. Recent tax law changes have not only reduced the supply of municipal bond offerings, but have also increased the demand for tax-free income, particularly from individuals in high-tax states.

Municipals lagged other sectors somewhat in Q2, as this asset class often reacts slowly to sharp changes in rates. Moving forward, we expect the supply and demand imbalance to take hold and improve relative performance throughout the remainder of the year.

Corporates

After a very strong first quarter, corporates experienced some choppiness in April and May before turning around in June.

Corporate earnings expectations ticked down, leverage continued to leak higher and, consequently, spreads started to widen. At one point in the quarter spreads were 21bps wider from the tights. But then the Federal Reserve and other central banks indicated they would move to ease, and this was the signal for corporates to tighten.

Corporate spreads have been gradually widening since early 2018, as markets anticipate slower growth and higher leverage in conjunction with stretched valuations. It is hard to see a reversal of this slow widening trend, as we are skeptical the Fed has the power to suspend the business and credit cycles. However, even with modest widening, corporates can still produce positive returns vs. treasuries due to their yield advantage.

Overall

The markets are placing faith in the power of central banks to keep this recovery alive and growing while simultaneously keeping inflation within the target range.

For now, the markets seem to have suspended judgement, and there is a rare simultaneous rally in most all asset classes: stocks, bonds, oil and gold. Even bitcoin is getting into the act. However, we are not going to count on this rally continuing.

We think rates are likely closer to a bottom. The way to bet is for a range bound market as central banks try put a floor on growth and plump up inflation. Yet we believe they will continue to find these efforts challenging.

Risk assets like corporates will operate in choppier markets in the near term, as the Fed and other central banks roll out rate cuts or other stimulative measures in the 3rd quarter. We will all be looking for the proverbial green shoots to verify central bank success. But until we see some evidence, we prefer staying conservative and liquid with the conviction there will be better opportunities ahead.

Sources: Federal Reserve, Bloomberg

Well, They Did it Again

For the third week in a row, we are publishing our thoughts on central bank activity. We try our best to diversify topics in these notes, but as we’ve continued to highlight (and with last week proving our thesis correct), it is central banks that have become the main driver of financial market behavior in the current environment.

All three major central banks around the world (Bank of Japan, European Central Bank and Federal Reserve) met or spoke publicly last week. And even though no explicit policy action was taken, their words were more than enough to move markets. In all three cases, the leaders of the institutions articulated that they stand ready to take additional easing action should it be necessary to support their economies. These words provided a boost to stocks, a boost to bonds…a boost to pretty much everything.

For the Fed specifically, the committee expects to cut interest rates by 0.50% in the coming quarters. This expectation affirmed what the bond market has been pricing-in for the last several weeks. It also gave a boost to equities and other risk assets, as the action shows the FOMC is committed to keeping this economy growing in whatever way it can.

For bonds, short-term interest rates (think 2-year bonds) fell significantly while longer-term rates (10+ years) rose slightly. This “steepening” of the yield curve tells us that the rally we’ve seen in long-term bond yields in 2019 is closer to its end than its beginning, and that we are likely to settle in to a range bound trading environment from here.

For risk assets (think equities and credit products), the story is not so simple. Fundamentals are weakening, and the question becomes whether assurances for future monetary policy easing will be enough to halt the slowdown. That is, will fed easing later this year be too little, too late to arrest weakening in US and global economies? The next round of economic data hits in early July and is expected to be relatively tepid. We will hear from corporate America during Q2 earnings season. And let’s not forget the U.S./China meeting at the G20 next week.

So, while the picture for bonds is seemingly straightforward, the situation for risk assets is fluid. Several of our risk bets have paid off (short-BBB corps, natural gas pre-pays, housing and our taxable muni overweight), and we have dry powder. We are staying conservative, liquid and ready to act on any opportunity that comes about as politicians and policymakers attempt to thread the needle.

Central Banks Take the Spotlight This Week

If you’ve been a regular reader of our weekly market notes this year, you’ll know that we are hyper-focused on central bank policy as the main driver of financial markets in 2019. As such, this week will be a busy one as we’ll hear from most of the world’s major central banks as they meet to discuss and set monetary policy. And while many global central banks have limited options to announce further monetary stimulus in the wake of what is becoming a fragile global economic environment, the Federal Reserve can take more decisive action.

The famous January pivot by the Fed took the FOMC’s (Federal Open Market Committee) expectation for 2019 Fed Funds Rate increases from two to zero. Financial markets responded favorably. How they proceed moving forward will be equally as important. Futures markets are currently pricing in about 2.5 interest rate cuts by the end of the year. As of the last meeting, the Fed articulated the expectation for no rate cuts this year.

A rate cut this week appears unlikely as the fortunes of the economic outlook could change later this month with the G20 meeting and any breakthroughs on trade. In addition, while data coming in from the business sector is softening, the consumer appears healthy. Both retail sales and consumer confidence beat expectations in May.

However, even without a rate cut this week, the Fed has powerful communication tools it can use to signal easiness ahead. Chairman Powell will give a post-meeting press conference, where he can assure markets that the FOMC stands ready to act. In addition, economic projection materials, which include the committee’s views on future growth, inflation, and more importantly, the level of the Fed Funds Rate, will also be released. We, and the markets, expect these items to signal rate cuts in the months ahead.

In times like these, asset pricing is dependent on the Fed and the markets agreeing on the future course of policy action. This week provides the Fed the opportunity to move closer to the markets. Anything less will likely create an environment similar to the fourth quarter of last year, where volatility spiked and risk assets declined.

Source: SNW Research Team