Yields on long-maturity Treasuries hit record lows in January driven by a strong U.S. dollar and developments in Europe.
February 2017 Market Commentary
The Ides of March Takes on New Meaning
February started with all eyes on the January 31-February 1 Fed meeting, where the Fed left interest rates unchanged but acknowledged strong consumer confidence, improved business sentiment, solid job growth and low unemployment.
Rather poetically, February ended the way it began – with the Fed at the top of investors’ minds. While William Shakespeare’s “Julius Caesar” refers to the ides of March with a foreboding declaration to beware, it is not yet clear what story this March 15 – the date of the next Fed meeting – will tell for fixed income investors. FOMC members will face countervailing forces when deciding whether to raise rates.
On one hand, strong recent economic data reflects an economy near full employment (Figure 1). ISM manufacturing data jumped to 57.7 in February, versus 56 in January, and the Empire manufacturing index jumped twelve points to 18.7, which indicates solid manufacturing data from the New York area1. January payrolls showed robust gains of 227,000 and the unemployment rate was little changed at 4.8 percent. On a seasonally adjusted basis, the CPI rose 0.6 percent in January, the largest increase since February 2013.2
On the other hand, core PCE inflation grew 1.7 percent year-over-year in January3, still below the Fed’s 2 percent target. Also, markets still face significant uncertainty with respect to fiscal stimulus, tax reform, healthcare changes and a host of other policy questions in the hands of President Donald Trump’s new administration. A potential border adjustment tax, in which imports are taxed while exports are not, and an implementation of tariffs both have winners and losers among corporations. Effects from tariffs, such as harm to certain U.S. companies or retaliation from targeted countries such as China, could impact the Fed’s rate hike decisions.
Indeed, macroeconomic reports and potential Fed rate hikes impacted the Treasury, corporate and municipal markets throughout the month. In the first full week of February, U.S. Treasury rates were rangebound or slightly down, as investors fled to safety primarily due to uncertainty regarding Trump’s infrastructure plans and rising uncertainty related to French presidential elections, in which candidate Marine Le Pen supports “Frexit” – France’s exit from the European Union – and is one of many populist politicians high in voter polls across Europe.
In the 10-year Treasury, the bond reversed its rally the following week, closing as high as 2.5 percent midmonth following strong CPI and retail sales reports, along with hawkish comments from Fed Chair Janet Yellen in her testimony before the Senate Banking Committee. Yellen mentioned that the Fed would consider raising rates at “upcoming meetings,” indicating that a March rate hike was “live.” 10-year municipal yields briefly touched year-to-date highs in sympathy with higher Treasury yields. However, municipals’ underperformance was even more punitive than Treasuries across the curve, due to uncertainty regarding tax reform. That same week, due to improving sentiment for U.S. economic growth, U.S. equity markets soared to record highs and investment-grade (IG) and high-yield (HY) corporate bond spreads broke out of a tight year-to-date range and fell to lower levels.
Late in the month, municipal markets continued to be negatively impacted by potential delays in policy decisions on corporate tax reform. In particular, tax reform could be delayed by congressional pushback on the border adjustment tax, which is a large component of the financing for the reduction in corporate taxes. A further delay could result from the protracted Affordable Care Act (ACA) repeal/replace debate, which is Congress’ first priority. While lower corporate taxes could ultimately be negative for municipal markets, ongoing policy uncertainty continues to cause softening in municipal markets, particularly at the long end.
Overall for the month, the risk-on trade remained in place, with corporate and municipal bonds further down the credit curve outperforming higher-rated, less-risky credits. The Treasury curve flattened, municipal yields declined modestly and IG corporate spreads dropped 7 basis points (bps).4
March begins on the heels of Trump’s speech to Congress on February 28. Risk assets reacted well to the speech: The S&P 500 rose to a new record, the dollar increased and Treasury rates rose despite Trump providing no new information on corporate interest rate tax deductibility or border adjustments. On February 27, Federal Reserve Bank of Dallas President Robert Kaplan increased market expectations for a March rate hike by making hawkish comments at an Oklahoma speaking engagement, where he reiterated his view that interest rates should be raised “sooner rather than later.”5
Tax-Efficient Market Review
Awaiting the Tax Debate Denouement
For the month of February, the Bloomberg Barclays Municipal 1-10 Year Blend Index posted returns of 0.66 percent. Municipal yields fell at the start of February, but as the month went on municipals took on a weaker tone due to higher Treasury rates and tax reform uncertainty. Nonetheless, 5-year AAA GO municipal yields fell 13bps, 10-year yields fell 3bps and 30-year yields fell 3bps overall. Paltry primary activity and positive fund flows supported the market. Ratios fell at the front end, reflecting elevated interest in the short end of the municipal curve. Ratios rose slightly at the long end. At the end of February, the 5-year, 10-year and 30-year ratios stood at 80, 97 and 103, respectively.
In terms of credit fundamentals, improving housing data and modest economic growth will benefit state and local tax revenues. For the third quarter of 2016, only New Mexico and Alaska —two states with oil as a large component of the economy—saw their economies shrink quarter-over-quarter.6
We do not see a major catalyst for improvement in municipal fundamentals and the market faces several policy-related uncertainties. In addition to tax reform, Congress plans to tackle a potential repeal/replace of the ACA. This might entail converting Medicaid to a per capita grant program and scaling back federal subsidies to purchase insurance. Hospital spreads continue to move wider relative to the index (Figure 2).
In terms of supply, February municipal volume was $20.7 billion, down 35 percent from February 2016. Year-to-date volume is $55.4 billion as of February 28, down nearly 4 percent from the same period a year ago. Year-to-date refunding volume is $13.7 billion, 46 percent lower than the same period in 2016. New money volume is $27.3 billion so far in 2017, up 18 percent from the same period in 2016.
Lipper reported $267 million in combined weekly and monthly net outflows for the period ending March 1, per Lipper. While fund flows were positive throughout February, inflows were meager. Year-to-date, municipal mutual funds have seen outflows of $1.8 billion, per Lipper.
Typically, March is seasonally weaker due to less redemptions and fewer coupon payments, along with a pickup in issuance. This year, March may be additionally challenged by continued concerns around tax reform and potential Fed rate hikes. That said, if new issue supply remains light, technicals could remain supported. New issues in February continued to come with oversubscription and tight spreads.
Government Credit Market Review
A Risk-on Story
For the month of February, the Bloomberg Barclays Credit Index tightened 6bps to 110bps. The Index had excess returns of 47bps versus duration-matched Treasuries.
The best-performing sectors were Metals, Sovereigns, Finance Companies and Media and Entertainment. The worst performers were Supranationals, Integrated Energy, Electric Utilities, Restaurants and Independent Energy, per Barclays. Crossover credits fared best across the ratings scale, while Aaa/AAA credits did the worst. The "down in quality" theme continues to perform well this year, given an overall supportive macro environment and search for yield. Illustrating this, the spread differential between HY and IG corporate credit has dropped to post-crisis tights (Figure 3) due to HY spread compression since February 2014.
Throughout the month, IG corporate bonds benefited from continuing economic growth and expected policy changes from Trump, such as lower corporate taxes or tax holidays for companies bringing cash back to the U.S., that could boost corporate earnings. In addition, higher rates have helped to encourage foreign buying, leading to tighter spreads. Fund inflows remain strong. Year-to-date for the period ended February 28, retail funds poured $18 billion into IG corporate bond funds, per ICI.
IG corporate bond issuance was $96 billion in February, versus $106 billion for February 2016.7 Year-to-date, roughly half of supply has been in Financials, as banks deal with TLAC requirements and front load issuance in advance of potential rate hikes. Technology companies finished a distant second in terms of issuance.8 Technology issuance was led by Microsoft Corp.’s $17 billion issuance in January to fund general corporate purposes, including the acquisition of LinkedIn Corp.; Apple Inc.’s $10 billion issuance in February to back general corporate purposes, including share buybacks; and Broadcom Ltd.’s $13.5 billion offering in January to repay existing loans.9
March is typically a strong month for issuance. However, seasonal factors could be mitigated this year by the rising rate environment, supply that was front-loaded into February or policy uncertainty.
Longer term, the elimination of the tax deduction on interest could lower the cost of equity financing relative to debt financing and cause corporations to issue less debt. In addition, if companies plan to move cash back on U.S. shores to take advantage of Trump’s suggested tax holiday, these companies would have less reason to raise cash through debt capital markets.
Weak credit fundamentals, including high leverage, remain a headwind for IG corporate bond investors. A stronger dollar resulting from higher rates or new trade policies from the Trump administration, along with weak productivity, could continue to impede improvement in corporate earnings. Still, overall, we expect solid profit growth in 2017 because of potential tax reform, easier comparables and a resurgent Financials sector.
Much Ado About Rate Hikes
We continue to monitor policy decisions and interest rate activity. In February, we shortened the duration target for our short tax-efficient strategies to better align with our view on Fed rate hikes. We think the improvement in labor data and the moderate increase in inflation could mean a faster trajectory of rate normalization. We are duration neutral in all our tax-efficient strategies.
No changes were made to our sector allocations on the tax-efficient side. We remain high-quality in our municipal bond portfolios.
We continue to have a lower allocation to state GOs. Some oil states continue to exhibit budget stress. Revenue growth remains weaker than expected in several other states, and Medicaid reform and the president’s latest budget proposal suggest more federal austerity is on the way.
On the government credit side, we are constructive on Bank credit and valuations, and we maintain a modest overweight to the sector. Year-to-date, Energy has outperformed the market, Retail has underperformed and Banks have moved in line, despite significant Bank supply to start the year.
We remain modestly short duration in our government credit strategies relative to their benchmarks. We did not make any changes to taxable asset allocation targets in February. We continue to focus on high-quality banks, industrials and utilities that have conservative financial philosophies and leverage/rating targets.
A risk to markets is that the evident market reaction to Trump fiscal stimulus plans could be overdone. Investors are pricing in potential GDP growth, but other effects of Trump’s financial policies could include a possible trade war due to U.S. protectionism, an appreciating U.S. dollar that may slow multinational profit growth and/or rising interest rates that could prompt a faster FOMC rate hike trajectory. In addition, on the corporate side, a possible rollback of Dodd-Frank rules could increase credit risks in the Banking sector over the long term, given potentially looser regulatory standards for bank activities (see our blog post, Is a Dodd-Frank Rollback Good or Bad for Bank Bondholders?).
 Federal Reserve Bank of New York, Empire State Manufacturing Survey, as of February 2017.
 Bureau of Labor Statistics, as of February 15, 2017.
 Bureau of Economic Analysis, as of March 1, 2017.
 Bloomberg Barclays U.S. Investment Grade Corporate Index, Intermediate, OAS.
 Jason Lange. “Fed may need to raise interest rates in 'near future': Kaplan,” Reuters, February 27, 2017.
 Bureau of Economic Analysis, as of February 2, 2017.
 Bank of America Merrill Lynch, as of March 1, 2017. Numbers include Yankee issuer bonds.
 Thomson Reuters, as of February 2017.
 Microsoft Corp., as of January 30, 2017; Bloomberg, as of March 2017; and The Wall Street Journal, as of January 11, 2017.
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