Is Inflation Ready to Take Off?

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Unfortunately, the markets are no closer to answering this question after last week’s inconclusive data. As we have been saying, inflation appears to be the key to financial market performance moving forward, and we are scouring all the data trying to find some clues about its direction.

At his press conference on Wednesday following the most recent FOMC meeting, Fed Chairman Jerome Powell left the markets confused. Last year we were all excited about the prospect of more press conferences, more data points and more insights—but sometimes less is more.

In the March press conference, Mr. Powell voiced his concern that low inflation is one of the great challenges facing central bankers. Just one month later he downplayed concerns about lower inflation, saying that the current low numbers are merely “transitory.”  The markets were certainly looking for some guidance as to whether a rate cut would be offered later this year, and with his latest remarks some air was let out of that balloon.

Friday’s much anticipated non-farm payroll and related numbers were equally inconclusive.  They were inflationary, as payrolls climbed by a strong 263,000 in April, and the unemployment rate fell to 3.6%. Yet this was a mixed report, as the lower unemployment reading was due in part to the participation rate decreasing to 62.8% from 63.0%. And wages rose only 3.2%, which was below expectations. So yes, the economy is still doing fine, with the unemployment rate near a 50-year low and wage inflation disproportionately helping low income workers, but the data is perhaps not strong enough to convince the markets that inflation is ready to take off.

Waiting for inflation is not a game for the impatient. Inflation has been called by some clever strategists the “mother of all lagging indicators,” and it appears to be living up to this nickname. So pull up your comfy chair—this could take a while.

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

The Economic Data Point that Really Matters Continues to Disappoint, which may be a Good Thing

The quarterly release of U.S. GDP (Gross Domestic Product) growth is typically a headline datapoint for economists and investors as the reading gives the broadest picture as to how the U.S. economy is performing. These days however, financial markets are largely looking past it, and instead focusing on inflation, which is the key to financial market performance moving forward.

Friday’s first quarter GDP report showed an economy that largely picked up where it left off in 2018. GDP grew at a 3.2% seasonally adjusted annual rate, which follows full year 2018 GDP growth of 3%. Details within the report showed a buildup in inventories and a boost from net exports as the main catalysts for the advance, while tepid consumer and business spending were offsets. Economists expect many of these items to reverse in Q2, which will leave growth closer to the 2%, still a healthy level.

Core inflation, as measured by the price index for personal consumption expenditures, rose at a 1.6% rate in March, well below the Fed’s target for 2% growth. This matters because the Fed, which holds a meeting this Tuesday and Wednesday, has noted that weak inflation is one of the key factors behind the current “pause” in raising rates, after predicting two rate hikes coming into 2019. Tepid inflation should allow the Fed to maintain this stance; this has been a key driver of the rally in both stock and bond markets this year. Should inflation accelerate, which most market participants are not expecting, we could see a return to the Fed induced volatility that defined the fourth quarter of last year. Until then, let the good times roll.

Source: Bloomberg, WSJ

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.