Why Risk Assets are not Reacting Dramatically to the Inverted Yield Curve

As the yield curve fell deeper into inverted territory last week, a plethora of articles highlighting recessionary risk began to emerge. Wall street economists also took note by reducing their GDP estimates for the remainder of the year. The difference in yield between 3-month and 10-year U.S. Treasuries is a closely watched relationship. When negative, meaning short-term yields are higher than long-term yields, recessions have traditionally occurred.

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This notion has largely been shrugged-off by risk asset markets such as credit and equities, where we’ve seen some softness over the past few weeks, but not so much that would indicate a recession is in the immediate future.

Why the disconnect? Look no further than the Federal Reserve for the answer.

Bond markets are currently pricing-in nearly two rate cuts before the end of the year, which investors believe will have the effect of keeping this expansion running for a while longer. Key to the Fed engaging in monetary easing is inflation, which is running below the FOMC’s long-term targets. We are also watching the financial conditions index, which measures the health of the financial markets and includes metrics such as stock volatility, credit spreads and currency. This metric has declined in recent weeks, but not to levels of early 2019, when the Fed infamously pivoted their expectation from tighter policy to neutral policy.

In all, we are in a very precarious environment, largely because of trade tensions. Should trade deals be reached with our largest partners, China and Mexico, the yield curve could return to positive territory and recessionary fears would likely be minimized. But the longer trade related uncertainty remains in place, the chances for heightened market volatility increases. As such, we are remaining cautious with portfolio positioning as we wait for more clarity on the economic outlook.

Source: Bloomberg

Corporate Bonds Need the Economy to Remain Healthy in this Late Cycle Environment: Will it Happen?

The Office of the Comptroller of the Currency (OCC) charters, regulates, and supervises national banks and federal savings associations and licenses, regulates, and supervises the federal branches and agencies of foreign banking organizations.

Twice a year they publish a semiannual risk assessment for the banking sector which begins with a review of the economic landscape. Large banks are nothing more than a leveraged play on the economy, so the OCC has a desire to get the call right.

So, what is the OCC call? Slower growth with an increased risk of inflation and bubbles.

The OCC, channeling the Blue-Chip forecasts, predicts the economy will slow back to its long-term potential rate of growth over the next two years. The OCC reviews the usual suspects: fading stimulus from recent tax cuts, the drag from a higher fed funds rate, a shortage of workers with corresponding wage inflation, the overhang from rapid growth in corporate debt, global trade and policy uncertainty, and slower growth abroad. Their forecast expects annual GDP growth to slow to 2.6 percent in 2019 and 1.9 percent in 2020, the latter of which is in line with the Congressional Budget Office (CBO) estimate of the long-term trend for U.S. economic growth.

A forecast for slower growth is consensus, but the OCC goes a little wide of consensus by suggesting that even with slower growth a positive output gap could lead to an increased risk for inflation and financial bubbles.

U.S. Output Gap as Percent of Potential GDP

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Just to review, a positive output gap is when the economy is operating above its long-term potential (see chart above). This normally happens at the end of an economic cycle and this expansion is ten years old! When there is a positive output gap there is an excess of demand and factories and workers operate above their most efficient capacity. This can lead to wage pressure and other forms of inflation.

During each of the recent economic expansions inflation accelerated as the output gap expanded. During the past two expansions, once the economy operated with a positive output gap, imbalances presented in tech-telecom and housing. We are now in the late-expansionary phase of this cycle, a period when inflation or unsustainable asset values have developed in the past. We are cautious as this cycle is different in many ways from previous cycles and history rarely repeats itself, but it does often rhyme.

Whether the OCC is right or not and how quickly the growth slowdown shows up really matters for risk asset prices, particularly for corporate bonds. While we have written at length this year on inflation and how the evolving nature of inflation will dictate Fed action and its impact on corporates, we shouldn’t forget about fundamentals. The Wall Street Journal reminded investors of this in an article over the weekend.

Much has been written about the build-up in corporate leverage, particularly for borrowers rated BBB. This is largely sustainable in a growing economy. But should the OCC’s forecast for slowing growth come to fruition, or a downturn comes quicker because of geopolitical actions, all bets are off. These risks, coupled with mediocre yield compensation for taking corporate risk, is why we are treading lightly with our corporate exposure at this time.

Source: OCC, WSJ

Munis Keep Rolling Along

The tax-free municipal market has been on quite a run. Driven by a solid technical backdrop, where inflows into the market have outpaced net supply, municipal valuations have reached extreme levels. One common way to judge the attractiveness, or lack thereof, of municipal bonds versus taxable bonds is to compare the yield levels between the two. For example, when analyzing the yield of a AAA-rated municipal bond versus a U.S. Treasury of a comparable maturity, we get a sense for how much investors are paying for the tax-free interest munis generate.

As seen in the chart below, this Muni/Treasury yield ratio has declined rapidly over the past several months, particularly for bonds with longer maturity dates.

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This market action has helped support the solidly positive returns in our municipal strategies this year. It has also led us to take profits in munis in our Blend strategy, by selling munis and reinvesting the proceeds into taxable bonds such as US Treasurys and corporates.

We are expecting the positive environment for munis to remain throughout the summer as June, July and August typically have the largest disconnect between supply and demand. However, for investors in mid-level tax brackets or for those without a state income tax to contend with, selling munis now and investing into taxable bonds provides added portfolio diversification without much of an after-tax income hit, making it an attractive trade for us.

Source: Barclays

Impact Insights: Curious About How to Begin Incorporating ESG and Impact Investing into Your Portfolio? Try Munis

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.

You often hear it said that the first step is the hardest. But for investors and financial advisors looking to step onto the path to ESG and Impact investing, the first step can be an easy one—municipal bonds. Municipal bonds serve as a low-risk, tax efficient asset class that can dampen overall portfolio volatility and provide income. In addition to these favorable investment characteristics, when evaluating ESG and Impact opportunities, municipal bonds should be one of the first sectors that springs to mind.

Asset Class Characteristics

Most sectors of the municipal bond market, including tax-backed general obligation (think states, cities and counties) and various revenue-backed sectors (think utilities, hospitals, etc.), are amenable to ESG and value alignment investment approaches. Sectors such as education, healthcare, housing and utilities all have positive impacts, which investors pursuing such strategies will find attractive. The ability to invest directly in communities, in school systems, in renewable energy products, in clean water and in scores of other initiatives financed through the municipal bond market is a strong motivator for those seeking to achieve positive social and environmental outcomes with their investments.

That said, not all municipal bonds are impactful or ESG positive. Bonds financing prisons, detainment centers, fossil fuel power generation, hotels, shopping complexes and the like are also included in the municipal bond market. Even in sectors where a positive impact is possible, it takes a robust data collection and analytical effort to select bonds that achieve exceptional outcomes for the communities they serve. It takes an experienced team to evaluate the opportunities available and find those that are best suited for an ESG and Impact investing strategy. ESG factors that are material and relevant to the credit profile of an investment opportunity are integrated into any strong credit analysis; beyond this, identifying opportunities where financed projects can have a demonstrable positive effect on the surrounding community takes experience.

Investment Performance

One common question we receive around ESG and Impact investing pertains to the amount of performance sacrifice for incorporation. Based on our experience, when managed properly, the answer is none.

For bond investors, keeping the primary risk factors (interest rate and credit risk) consistent between the ESG/Impact and non-impact equivalents in each of our strategies has resulted in comparable performance and volatility metrics. At its core, other than the ESG and impact focus of the securities selected, the strategies are almost identical, making it easy to use this asset class as an initial entry point into ESG and Impact investing.

Source: OFI Global, 4/30/19. SNW composite information is net-of-fees and covers the 5-year period from 4/30/14 - 4/30/19. The Sharpe Ratio Calculation is shown gross-of fees. The performance information presented constitutes supplemental information for purposes of the Global Investment Performance Standards (GIPS®). Past performance does not guarantee future results.

Source: OFI Global, 4/30/19. SNW composite information is net-of-fees and covers the 5-year period from 4/30/14 - 4/30/19. The Sharpe Ratio Calculation is shown gross-of fees. The performance information presented constitutes supplemental information for purposes of the Global Investment Performance Standards (GIPS®). Past performance does not guarantee future results.

Market Growth

ESG and Impact investing is a growth area, having seen a CAGR of 13.6% since 1995. As US SIF reported in its 2018 Report on U.S. Sustainable, Responsible, and Impact Investing Trends, "Total U.S. domiciled assets under management using SRI strategies grew from $8.7 trillion at the start of 2016 to $12.0 trillion at the start of 2018, a 38 percent increase. This represents 26 percent—or 1 in 4 dollars—of the total U.S. assets under professional management." As successful advisors already know, understanding the trends in the market and helping to lead client conversations to determine whether they are interested in participating are key.

Municipal bonds give financial professionals an easy way to begin the conversation, particularly when there are minimal differences in performance and volatility between the strategies. And for advisors using such strategies from SNW Asset Management, there are no differences in fees between the two options. This makes ESG and Impact investment grade municipal strategies an easy choice for that first step down the ESG and Impact investing path.

Source: SNW Research

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