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Investing Commentary published on March 9, 2018

February 2018 Market Commentary

Summary

  • In February, the market grew increasingly concerned about inflation and a more-aggressive pace of Fed rate hikes.
  • U.S. Treasury rates rose across the curve, and IG corporate and municipal bonds posted losses.
  • Tax reform remains a net positive force for corporates.
  • Prime, short defensive ABS sectors have outperformed year-to-date, reflecting the market’s risk-off tone.

Market Review

A New Era for the Fed

February marked the end of Janet Yellen’s four-year stretch as Fed chair and the start of leadership from new chair Jerome Powell. This changing of the guard, along with strong economic data, rising growth expectations and hawkish comments from Powell late in the month, contributed to volatility in February for risk assets.

Stocks were down about 4 percent,1 and the VIX Volatility Index rose, as the market grew increasingly concerned about inflation and a more-aggressive pace of Fed rate hikes. Nonfarm payrolls rose 200,000 in January, which was above consensus estimates, and unemployment remained low at 4.1 percent. CPI increased 0.5 percent in January (2.1 percent year-over-year), while core CPI was 0.3 percent higher (up 1.8 percent year-over-year). The consumer remains strong, with personal income up 0.4 percent in January (up 3.77 percent year-over-year) and consumer sentiment up 4 points in February to 99.7. Also boosting growth expectations, tax reform is expected to be on-net positive for U.S. corporates, and in early February Congress passed a two-year budget deal that implied more fiscal stimulus.

Powell spoke to Congress at the end of February and his comments significantly impacted market expectations for rate hikes. The new chair said that recent data suggested a strengthening economy and improving inflation outlook, and he hinted at three to four rate hikes in 2018. The market now puts odds of a March hike at roughly 100 percent, odds of a June hike at 77 percent, and odds of a September hike at 51 percent.2 While the FOMC remains accommodative, market expectations are getting more closely aligned with the Fed’s forecast for rate hikes (Figure 1).

Credit markets were also weak in February. U.S. Treasury rates rose across the curve, although the increase was less than in January. Rates rose 13, 15 and 18 basis points (bps) in the five-, 10- and 30-year maturities. Year-to-date, rates are up between 44 and 47bps in the three- to 10-year range, and up just under 40bps in the 30-year. The Treasury curve has modestly steepened year-to-date.

Treasury, investment grade (IG) corporate and IG municipal bonds posted losses in February, but did better than stocks. IG municipals outperformed IG corporates and Treasuries in February and year-to-date.3

Municipal Market Review

Continued Steepening Trend

Despite outperforming Treasuries, municipals posted negative returns with the Bloomberg Barclays Municipal Bond Index closing the month down 0.30 percent, and the Index is now down 1.47 percent year-to-date. With the municipal curve steepening, the only positive municipal returns were in the shortest maturities, while the six- to 10-year range showed the worst total returns. Municipal yields declined in the two-year maturity and rose out longer, with five-year yields rising 14bps to near 2 percent, and 10-year yields up 12bps and approaching 2.5 percent to close the month. The 30-year yield closed at 3.06 percent, 15bps higher from the end of January.4 As a result, the municipal curve continued its steepening trend in February.

Given muni outperformance in the shorter maturities, relative value in the short end declined. The two-year ratio fell below 70 percent to close at 67 percent in February, and is notably down more than 15 ratios year-to-date. The five-, 10- and 30-year ratios were roughly flat versus the end of January, closing at 74 percent, 86 percent and 98 percent, respectively.

Municipal performance continued to be supported by low supply. February issuance totaled $17 billion, down 29 percent from February 2017, and supply is down 38 percent on a year-to-date basis. Refunding volume totaled $2 billion, a sharp drop from $6 billion in February 2017 (Figure 2), largely due to new advanced refunding restrictions (see: Municipal Market Supply: A Q&A with CIO David Madigan).

While primary supply has been constrained, heavy bid wanted activity from banks and property & casualty companies, along with elevated dealer inventories, helped to offset some of the drop. As the month progressed, the pace of secondary selling slowed, and dealer inventories have declined. Inventories are now 13 percent above the trailing one-year average, versus 49 percent above the average in December.5

Following five consecutive weeks of inflows, mutual funds posted outflows in the last week of the month. This $591 million outflow pushed the four-week moving average negative. The municipal market has seen aggregate inflows of $5.6 billion year-to-date.6

Municipal fundamentals remain stable, in our view. States are digesting tax reform including the $10,000 cap on deductions for state and local income, property and sales taxes. We note that since the $10,000 property tax cap is not indexed to inflation, states may begin to look for ways around that cap.

Corporate Market Review

Spread Widening

In February, the Bloomberg Barclays U.S. Corporate Investment Grade Index posted a decline of 1.62 percent. The OAS widened 10bps to 96bps, and IG corporates lagged duration-matched Treasuries by 62bps. Energy, Rails, Metals and Mining, and Cable and Satellite companies were the worst performers in February. Home construction and Lodging companies, REITs and Airlines fared best. AAA/AA had the best performance across the IG quality spectrum, while crossover bonds fared the worst.

The shorter maturities widened the most in February, continuing a trend of flattening in the corporate credit curve. Notably, new tax reform rules freed up cash held overseas, potentially contributing to selling and lower demand at the front end of the curve. The cost of dollar hedging has increased,7 hindering foreign investment. Meanwhile, with the rise in Treasury rates, pension funds or other yield-sensitive investors are attracted to higher all-in yields in the longer maturities – particularly given that tax reform has led to increased pension contributions for some companies.

Tax reform remains a net-positive force for corporates (see: Corporate Bond Market Outlook Q4 2017). Industrials' debt leverage is at a record high, but tax reform and repatriation may slow increases. And, earnings for the fourth quarter have been notably strong so far. The market is watching closely to learn where repatriated cash will be used. Capex and wage increases have been cited frequently by companies in fourth quarter calls, and mergers and shareholder enhancements are also probable uses. AT&T Inc. said that it will have a $1 billion incremental capital investment in 2018 due to tax reform. AT&T also said it would contribute $800 million in voluntary funding to medical plans.8

For February, issuance totaled $98 billion versus $133 billion in January and $96 billion in February 2017, per Bank of America Merrill Lynch (BAML). Demand remained strong overall for IG corporates and spread concessions were still small, although heavy supply in the last week of February caused some indigestion. For the month overall, the average new issue concession widened to 5bps from 1bps, per BAML.

Long-term IG bond mutual funds reported net inflows of over $4 billion in the first three weeks of February, down from $22 billion in January and $138 billion in 2017, per ICI. Net foreign corporate bond purchases slowed slightly in 3Q17 ($204 billion on a SAAR basis vs $464 billion in 3Q16), per Fed data.

Securitized Market Review

Fed Balance Sheet Unwind Still Weighs on Market

Agency MBS spreads widened further in February, and are now up 15bps year-to-date. Spreads ended February at 78bps, off the multiyear lows of 67bps in January, with spreads reaching as high as 82bps in the month. The widening is largely due to increased Treasury rates and higher implied volatility (see: What to Watch in Agency MBS: Our Top Five Themes). Spreads are expected to widen further as the Fed balance sheet unwind makes an impact.

Given higher interest rates, extension risk has come into full focus. However, in our view, this risk is fairly low. Approximately 90 percent of the coupons on the conventional MBS outstanding are not re-financeable, assuming a 50bps “hurdle” for the costs/inconvenience of refinancing, per Breckinridge data. This means that extension risk is fairly muted once those bonds are excluded, and on the flip side, a significant refinancing event is unlikely unless there is a significant rally in rates.

On the other hand, ABS has started out 2018 strong. Prime, short defensive ABS sectors have outperformed year-to-date, reflecting the market’s risk-off tone. Despite the spread tightening, we continue to see the asset class as attractive, particularly relative to Treasuries and given that the sector remains a safe haven, defensive asset class. In an increase of 27 percent over 2017, $43 billion has been priced year-to-date in ABS. Supply is expected to remain elevated, with issuers likely to push deals forward into higher rates later in the year.

Strategy and Outlook

Winding Up a Rough Month for Risk Assets

The Investment Committee continues to watch market forces that are impacting Treasury bonds, particularly inflationary pressures that could cause steepening. That said, the Committee acknowledges that higher Treasury yields could result in increased interest from investors, which could help stem significant rate increases.

On the tax-efficient side, the Committee did not change its duration targets in February, but we recognize that the front end of the curve has become more expensive versus Treasuries, and that the five- to 10-year part of the curve currently offers better relative value. This may warrant shifts in structure in the future. We are also closely watching dealer inventories and the balance between primary and secondary supply.

In terms of municipal credit fundamentals, Breckinridge remains defensive and we believe that our high-quality bias will be beneficial as we continue to work through the later stages of the municipal credit cycle.

For government credit, given lower supply and tight spreads, we are gradually moderating our taxable municipal allocation. The Committee continues to overweight AA-rated and A-rated bonds and underweight BBB-rated bonds, within its modest corporate overweight allocation.

We continue to view the corporate credit cycle as late stage and note high leverage across the IG non-financials space. However, we acknowledge potential benefits of tax reform to corporates. We continue to see opportunities in the Bank sector and note that regulatory relief may reduce compliance costs for U.S. banks.

 

[1] Proxy used is the S&P 500 Index.

[2] Bloomberg, as of March 5, 2018.

[3] Bank of America Merrill Lynch, as of March 2018.

[4] Thomson Reuters TM3, as of March 1, 2018.

[5] JP Morgan, as of March 2, 2018.

[6] Lipper, as of February 28, 2018.

[7] Bank of America Merrill Lynch, as of March 3, 2018.

[8] Barclays, as of February 2018, Various company filings, and AT&T Inc., as of January 31, 2018.

 

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