The Fed Is a Two-Handed Economist

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“Give me a one-handed economist. All my economists say, 'On the one hand...' then, 'But on the other...” – Harry Truman

On the one hand, the Federal Reserve announced last week that further rate hikes are on pause and shrinking the Fed balance sheet may end sooner than anticipated. The U.S. economy is solid and inflation is well controlled, said the Fed, but since the rest of the world was a bit wobblier, it would be prudent to wait for more data. Patience is the world of the day. There is nothing like a dovish announcement from the Fed to plump the price of financial assets. The financial markets now believe more strongly that economic growth should continue for a while longer as monetary and fiscal policy stay accommodating. The Fed has our back.

On the other hand, what was so wobbly about the rest of the world to make the Fed rethink both its path of interest rate normalization and the size of its still bloated balance sheet? Chairman Powell laid out the case quite eloquently in the first of the Fed’s expanded news conferences. “Growth has slowed in some major foreign economies,” he said, “Particularly China and Europe. There is elevated uncertainty around several unresolved government policy issues, including Brexit, ongoing trade negotiations, and the effects from the partial government shutdown in the United States. Financial conditions tightened considerably late in 2018, and remain less supportive of growth than they were earlier in 2018.” We applaud the Fed’s new policy of increased transparency, including more frequent press conferences.

Furthermore, we are glad economists only have two hands—more would be too confusing! We see the Fed’s actions as consistent with promoting economic growth and full employment, all within the bounds of its 2.0% inflation target. But we also see economic growth slowing around the world as we approach the later stages of the current economic and credit cycles.

Sources: Bloomberg, the Financial Times, The Federal Reserve

All Eyes on the FOMC

The Federal Open Market Committee is set to meet this week to discuss the current state of affairs in the economy and to set monetary policy. In the past, this meeting would have been relatively uneventful as Fed Chair Powell only gave post-meeting press conferences after every other meeting. Market participants took this to mean that any significant changes were unlikely at a non-press conference meeting. This is no longer the case as there will be a press conference after every meeting moving forward. The Fed made this change to promote transparency, which has been a long-standing goal of the past few Fed Chairs. While transparency will certainly increase with the move, so will the focus by the market.

This week the focus will be on the word “patient,” which has been used extensively by FOMC members in recent public communication regarding their approach to any future rate increases. It wasn’t long ago that their decision to raise the Fed Funds Rate in December, and pencil-in another two rate hikes this year, caused quite a stir across financial markets. Since then, FOMC members have been doing their best to calm markets by indicating their willingness to wait some time before another rate hike. This “patience” campaign has been well received as financial markets have performed quite well thus far in 2019.

We expect the tone of this week’s meeting to continue with the “patience” theme and expect to hear an update on the wind-down of the Fed’s balance sheet, which has become a hot topic in financial circles of late. Ultimately, Fed decisions will be a focus across financial markets this year, for both bond and stock investors alike, particularly as we are approaching the later stages of the current economic and credit cycles.

How Doing Good Can Sometimes Be Bad

A quick note: The SNW Impact Strategy is entering its third year this month. To highlight the Strategy, over the course of 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.

The Law of Unintended Consequences

Every action results in both intended and unintended consequences. No action—good, bad, neutral or mixed—is exempt. As human beings, we lose sight of this when we feel we are doing what is right, but even a good action can result in negative consequences. And these consequences can outweigh the benefits of that good action. This is true for nonprofits, governments, individuals and private corporations.

Negative consequences, especially those that outweigh the positive benefits of an action, are something we certainly want to avoid as ESG product managers and investors.

TOMS Shoes: A One-for-One Giving Model

TOMS Shoes offers perhaps one of the most familiar examples of a good action creating unwanted and unintended consequences. At one point, for every pair of TOMS shoes bought, the company donated a pair of shoes to a child in a developing or undeveloped country. Many agreed that this was not just good for humanity, but also good for business. Using this system, TOMS gave away more than 35 million pairs of shoes between 2006 and 2015.

Unfortunately, TOMS’ one-for-one giving model was harmful in ways the company had not anticipated. In recipient communities, local producers were put out of business or struggled to make a living, thus disrupting the local economy.

TOMS and its founder came under fire for what was widely seen as a short-sighted and overly simplistic approach to corporate social responsibility (CSR). Although this is an older example, we use it to illustrate how a company can take a more nuanced approach to corporate social responsibility. After receiving intense criticism, TOMS retooled its CSR strategy. TOMS still operates on a one-for-one model, but now the one-for-one system is leveraged to build thoughtful partnerships and improve access to safe drinking water, reduce birth-related fatalities through training, provide medical care for vision-related issues, and address bullying through training and prevention programs.

USDA and Crop Dumping

The United States Department of Agriculture (USDA) often sells surplus crops abroad below market prices, or gives them away for free as a form of foreign aid, ostensibly to countries and communities in need of these crops. It seems like the perfect solution: surplus crops do not go to waste, and poverty- or disaster-stricken communities receive much-needed food.

But there is another side to this coin. Critics of the system often refer to it as “crop dumping.” In 2016, the USDA sent 500 metric tons of peanuts to Haiti despite a coalition of approximately 60 aid groups in the country arguing against it. This sudden infusion of peanut crops into the Haitian economy undermined the country’s peanut industry and the local economy, thus perpetuating and deepening existing economic issues. This type of foreign aid also has the potential to increase dependence on the aid, making it more difficult for communities and countries to prosper independently.

Affordable Housing in Low-Income Neighborhoods & Transit-Induced Gentrification

It makes sense to build more affordable housing units in low-income neighborhoods, but is there a point of diminishing returns? While low-income communities certainly need affordable housing, an increased number of available affordable housing units can actually lead to gentrification. In low-income and working-class neighborhoods, the addition of affordable housing can invite low-income creative and entrepreneurial populations who are looking not only for affordable places to live, but places where they can make a mark.

Both populations tend to engage in placemaking and spur revitalization efforts, which makes low-income neighborhoods attractive to middle- and high-income populations. And this, of course, can lead to displacement of the original low-income residents. Transit-oriented development can also lead to gentrification and displacement by appealing to young professionals and upwardly mobile populations who are increasingly wary of car ownership and attracted to areas with good public transportation.

Gentrification is a sticky subject, a complex phenomenon that engenders strong opinions. But any public planning, private development or community investment project targeting low-income neighborhoods or populations must consider both the short-term and long-term implications of that project, including whether it will lead to gentrification and displacement.

Why CSR and Public Programs Such as These Don’t Work Every Time

There are a few reasons why many corporate responsibility programs, public projects and nonprofit initiatives sometimes get it wrong when trying to do right:

  1. Many problems are multi-faceted and complicated. Giving a pair of shoes to a child, though commendable, does not fix the systemic issues causing that child to be shoeless in the first place. Just as governments cannot print money to fix an economy, giving donations, whether clothing items or food items, does not address the cause of the problems they are meant to fix.

  2. Citizens and governments of developed countries do not necessarily know what is good for a developing or undeveloped country. And companies such as TOMS, though well-meaning, come from a position of western privilege and rarely have a true understanding of the social, political and geopolitical issues causing or affecting critical situations in these countries and communities.

  3. Communities ravaged by environmental disasters or poverty know what they need, but their input is rarely part of the equation when it must be. A lack of input from community members and stakeholders is a blind spot that even the best-intentioned are susceptible to.

Doing Good in an Informed and Deliberate Way

We all want to feel like we are doing good in the world, whether that means serving food at a soup kitchen or investing in a company with a strong corporate social responsibility program. These are by all accounts good things. But doing good is about more than making a gesture; it is about taking the time to understand the true costs and benefits of an action, and either doing what is in the best interest of the community you are trying to help or best serving long-term environmental goals.

We must be especially careful about not investing in bandages when we should be investing in cures. For us, this means evaluating investments with an understanding that surface good may not be good enough, and that to make positive social and environmental impacts we as a society must cultivate a deeper understanding of cause-and-effect. We must be informed and deliberate in our actions.

With this in mind, our approach to evaluating investment opportunities for the SNW Impact Strategy is a holistic approach based on realistic and pragmatic inputs. We go beyond just the use of proceeds in the immediate term to evaluate what the medium- and long-term positive social or environmental impact may be. With many of the credits we invest in, the projects have been completed and we are able to look at the outcomes with real certainty. With projects and issuers that are new to the market, our evaluation is predicated on known data and conservative projections. Our aim is to identify those investments with the clearest net positive social or environmental impact, to ensure that we avoid good intentions leading to bad outcomes.

Earnings Season – The Sugar Rush Fades

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Corporate earnings were on a sugar rush over the last year thanks to a large slice of corporate tax cuts with thick icing from synchronized global growth. In the 1st quarter of 2018, S&P revenues were up 8.2% and earnings up a staggering 22.5%! That’s a big piece of cake! If we look ahead to the 1st quarter of 2019 the sugar rush fades, as analysts are expecting revenue to rise 5.5% and earnings only 3.1%.

This week kicks off the 4th quarter 2018 earnings season. Analysts are expecting a good quarter, with revenue up 9.2% and earnings up 16.0%, but the real story will be management’s comments and forecasts for the remainder for 2019. Coming down from the sugar rush may not be pretty.

No party lasts forever, and concerns are coming from both the top down and bottom up. From the top down it is no surprise economic growth is slowing around the world. We see noticeably slower GDP growth in China and Europe, and just recently we are seeing indications of slower growth in the U.S. In response to this data, we see the U.S. Federal Reserve tilting toward a patient approach regarding future rate increases, and it would not be surprising to see China offer some stimulus.

From the bottom up we are seeing negative earnings revisions and more cautionary comments from many companies including FedEx, Apple, Macy’s, American Airlines, BlackRock and Jaguar Land Rover. We are even seeing some layoff announcements: Sears’ bankruptcy, with the potential layoff of 50,000 retail workers, is not encouraging. But not all the news is negative, as this week General Motors took up guidance for 2019.

The let down from a sugar rush should surprise no one, and our portfolios are conservatively positioned in corporate risk to ride out this slowdown. But since the news is full of surprises these days, we will remain ready to take advantage if another serving of cake is offered, although we all know too much sugar is not good for you!

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

A Look Back, A Look Ahead

As we entered 2018, fixed income investors were primarily focused on the Federal Reserve and what a normalizing monetary policy environment would mean for fixed income returns. As we exit 2018 and look ahead to 2019, all eyes continue to be on the Fed, but for very different reasons.

For much of 2018, financial markets enjoyed a strong domestic and global economic backdrop, robust corporate revenue and earnings growth, and solid market performance from investment sectors ranging from stocks to high yield corporate bonds. This environment allowed the Federal Reserve to continue the monetary policy normalization process it began in late 2016 by raising the Fed Funds Rate a total of four times.

The environment has now changed.

Late in 2018 investors suddenly began to price-in a more downbeat outlook. Estimates for economic growth, earnings growth and inflation have all declined, yet the Fed expects to continue raising the Fed Funds rate another two times during 2019. The market is pricing-in no additional rate hikes. As such, all eyes remain on the Fed, but unlike 2018, when investors were fixated on how the near certain rate hikes would play out, this time they are waiting to see if the Fed will raise rates at all.

Rates: A regular topic of conversation in 2018 was the flattening of the yield curve. Short-term rates tend to be tied to Fed action, while long-term rates are typically correlated to economic growth and inflation. With estimates for inflation and future economic growth subdued, long-term rates, such as 10-year and 30-year yields, remained stable throughout 2018 after a sharp rise in Q1. Short-term rates moved higher with the Fed, but because short-term bonds have less sensitivity to rate increases than long-term bonds, the price impact on returns was limited. This dynamic, coupled with interest income generation, allowed bond returns to be positive, despite the Fed’s rate increases.

2018 Total Return

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

Treasury/Agency 1.53 1.44 0.83

Municipal 1.79 1.69 1.04

Corporate 1.00 -0.17 -2.25

*ICE/BAML Index Return Data

Munis: Tax-free municipals led all investment grade sectors in 2018 and are positioned to perform well again in 2019. A strong technical backdrop was the main driver for muni returns, as supply fell by more than 20% year/year due the elimination of advanced refunding transactions. This year, the expectation is for technicals to remain supportive. Broadly, fundamental credit quality has strengthened over the last several years as the improving economy and strong financial market environment has improved the financial position of many municipalities. The issues around underfunded pension and healthcare liabilities remain acute, however, and must be analyzed thoroughly when making municipal investments.

Corporates: Volatility in risk markets spilled over into the investment grade corporate market during the year, causing corporates to underperform most investment grade sectors. The additional yield on corporate bonds compared to risk-free assets like U.S. Treasuries, a metric known as credit spread, increased as investors began to price-in a riskier environment. Elevated debt levels across much of corporate America, as well as rising borrowing costs as outstanding debt comes due, are two areas of investor concern. While yields in the corporate space have increased, they do not yet offer enough value to create a compelling risk/reward tradeoff in our minds. As such, we are maintaining what has been a very conservative allocation to the sector.

Overall: Moving forward, 2019 brings a new level of uncertainty for investors. Monetary policy has tightened and the U.S. economy is set to continue growing. But this growth is expected to proceed at a slower rate, and both trade and geopolitical tensions to remain high. We believe that financial market volatility is likely to continue into next year, and have positioned our portfolios for it, with a high percentage of AA and AAA rated bonds held across our strategies. At some point in 2019 it is possible that more attractive entry points to take risk in investment grade bonds will present themselves, but we are not there yet. In the meantime, we will continue to let our portfolios perform as investment grade bond portfolios are meant to, especially in markets such as these: with stability.

Source: ICE/BAML