Powell’s First Cut

We can always count on the Federal Reserve to offer some stimulus when the economy become the least bit wobbly, or inflation misses target, or unemployment get too high, or financial stability looks a little less stable.

On July 31st everyone expects the Fed to lower the fed fund target rate 25 bps. We, and many others, believe rate cuts can keep this slow and weak economic recovery alive for a little while longer. And the Fed is not only the only central bank talking about cutting rates. Even the European Central Bank last week was talking up rate cuts or further stimulus to boost their economy, inflation, employment and stability.

The Fed Funds Rate and Recessions

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But how necessary are rate cuts and how much will they help? Let’s start with the arguments for rate cuts.

Is the economy wobbly? Last week the IMF came out with their latest “World Economic Outlook Report”. Growth was revised down citing tariffs, supply chain interruptions, Brexit uncertainties and rising geopolitical tensions. Advanced economies came in the weakest with anticipated growth of 1.9% in 2019 slowing to 1.7% in 2020. The IMF also notes risks are to the downside. Additionally, last week US 2Q GDP came in at 2.1%, which was slower than last year but above consensus. Slowness is not a disaster, but the Fed can likely check the wobbly box.

Is inflation meeting target? In the US Personal Consumption Expenditures recently faded to 1.6%, below the 2.0% Fed target. It is clear the Fed targets are not being met and they are more afraid of deflation than inflation. So, check this box.

Is unemployment too high? Hard to see how the Fed can check this box. US unemployment is at a 50-year low and income for the lowest wage earners are rising faster than overall wage growth.

What about financial stability? One can argue this point, but we see equity markets reaching new highs, capital markets are wide open to all types of companies, consumer credit is available and banks ready to lend. This looks solid. Negative factors include higher levels of volatility and policy risk which are hard to ignore. But on average it is difficult to check this box at the moment.

The next question is: how long can the Fed extend this economic expansion?

We do not believe the Fed has the ability to abolish recessions. Yet we also believe it is hard to have a recession when the Fed (and all other central banks) is very accommodating. The next recession will eventually come and could be caused by any number of policy mistakes or geopolitical shocks. When it does happen we are concerned the Fed will have exhausted its rate cutting and stimulus options by keeping this expansion alive.

We may yet check that box, but not today.

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

No Repeat of a Credit Crunch Expected for the State of California as its Surplus Cash used for Utility Wildfire Fund

The news about California’s wildfire liability crises has focused on steps that could be taken to limit future wildfire liabilities for investor-owned utilities (IOUs), such as Pacific Gas & Electric and Southern California Edison, serving millions of California residents. However, legislation intended to stabilize the delivery of electricity to California residents and businesses could also have an impact on the future availability of funds used to repay the state’s general obligation (GO) and lease debt. Provisions of AB 1054, signed by Gov. Gavin Newsom on July 12, require the state to make a $2 billion contribution in the current fiscal year from state surplus funds to help capitalize the wildfire fund. The bill authorizes the state to lend up to $10.5 billion for the fund.

Standard and Poor’s reported after AB 1054 was enacted that they believe the State of California has sufficient resources to fund its contributions to the wildfire fund, and we have not seen any concerns reported by Fitch or Moody’s. We note that the state’s credit quality has continued to improve in the current economic cycle, which is reflected in current GO ratings from Moody’s, Aa2 with a positive outlook, and AA- ratings from both Standard & Poor’s and Fitch. Furthermore, the legislation “intends” for the state’s contributions to be repaid within one year using proceeds from a new California Department of Water Resources (DWR) bond issue.

Despite the state’s current credit stability, the new legislation may bring back bad memories for seasoned California investors, who may recall the precipitous decline of the its credit quality and liquidity after it began to use state resources to bail out the same IOUs during the power crises in the early years of the new millennium. Although the state had reached its credit peak in 2000, achieving AA ratings, by 2004 the use of surplus cash to purchase power for utilities led to a cash crisis. This was followed by a budget crippling recession, the recall of a sitting governor, and downgrades to the state’s BBB rating. There were even concerns that state GO bonds would fall into junk category.

While we do not expect deterioration of the state’s credit quality at this time, monitoring the amount of contributions and repayments to the state will be a critical aspect of evaluating the California’s economic and financial performance. We also note that there are several mitigating factors as well as changes in the state’s governance that should provide more cushion for the state this time around.

Sources: Standard & Poor’s, AB 1054

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