A new tax code, strong muni supply and high economic growth expectations defined December in the market.
January 2018 Market Recap
Hello this is Natalie Baker, vice president of marketing here at Breckinridge and welcome to the Breckinridge podcast. Today, I'm joined by our co-head of portfolio management, Matt Buscone, and to chime in on the corporate side, we have Khurram Gillani, one of our portfolio managers. Today we will be discussing market moves in January and providing some thoughts on where the market stands and what we are looking out for moving forward. So let's start with the muni side. So Matt, last year we saw stellar returns for the equity market, flatter Treasury and municipal yield curves due to rising short-term rates, while long maturity yields didn't move all that much. What did we see the first month of 2018?
Well, there was certainly no shortage of activity during January. We had record-setting equity markets, higher yields globally, a dearth of municipal new issue supply, and a changing of the guard at the Fed all occurring during the month. January was the best month for both the Dow Jones Industrial Average and the S&P 500 since March of 2016 and they continued to set record highs throughout the course of the month.
As equities continued to perform well, what happened to Treasury yields?
Well, Treasury yields jumped higher across the curve in January as rates were pressured by a potentially more aggressive series of Fed rate hikes, an increase in higher inflation and a rise in U.S. Treasury Bond issuance due to higher deficits going forward. Treasury yields were higher by 25 basis points in two years, about 30 basis points from 3 to 10 years, and 20 basis points in the 30-year maturity, and the 10-year Treasury ended the monthly right around a 2.72%, so sharply higher than the low 240s we saw at the end of the year.
And the administration has been touting the benefits of tax reform and deregulation. Has that been translating into better economic data?
You know we certainly did hear several stories throughout the month of companies raising wages and giving out bonuses and it does seem to be translating into better growth. If you look at fourth quarter of 2017 GDP that was up 2.6%. And while that was slightly lower than the 3% consensus estimates, it was lower in part due to more tepid inventory growth and a wider trade gap, but for all of 2017, GDP was up 2.3% compared with only 1.5% during 2016. A couple of other measures the Fed looks at, one of which is the core PCE price index, that was up to 1.9% in the fourth quarter of 2017 after being up only 1.3% in the third quarter of 2017. So certainly seeing a little bit more on the inflation side. And oil prices are $60 a barrel by the end of the year and continue to hang on right in that range so we haven't seen those levels since around mid-2015, so there does seem to be a little bit more coming through on the inflationary side and we are starting to see higher estimates of growth and it looks like the first quarter of 2018 some of those advance estimates are still looking north of 3%.
Okay, and speaking of economic data, one important one, we also got a read on January employment last Friday. How did those numbers look?
So, it was a strong report for January. Another 200,000 worth of jobs were added and wage gains started to show signs of life. Average hourly earnings were up 0.3% for the month of January and are now up 2.9% on a year-over-year basis. And that has really been something that has been vexing the Fed over the last several years, is very low unemployment yet we haven't seen that flow through to wages which in turn has not flowed through to inflation. We may be starting to see signs of that turning with a higher wage growth last month.
Okay, and January was also notable for the changing of the guard at the Fed as it was Chairman Yellen's last meeting.
Yes, Chairman Yellen bid farewell to the Federal Reserve, certainly presiding over an extraordinary time in monetary policy and she turns over the reins to the newly elected Fed chair of Jerome Powell. During her final meeting, the Fed left its benchmark interest rate unchanged which was widely expected. However, there was a slightly more hawkish tone to the statement and the Fed did signal that more rate hikes are to be expected given the strong economic growth and the low unemployment that we have seen, again continuing to hover around 4%, and the more hawkish tone to that statement does increase the likelihood of four rate hikes this year as opposed to the Fed's initial projection of three. At the beginning of the year the market was only expecting two, they had been coming closer to three so there has been somewhat of an increase in expectations of a more aggressive Fed in 2018.
Okay, and I'm assuming that weakness that we saw in Treasury yields spilled over into the muni market?
Yeah, it certainly did. No January effect from munis this year. Typically, we come into a new year and there are very low levels of new issue supply, a lot of money back in the market so munis rally due to a scarcity bid. But there were a combination of factors that served as catalysts to push muni rates higher in January. Some of those include an increase in Treasury yields, reduction in purchases from banks and insurance companies, and dealers that were carrying very heavy inventories that remain from the elevated supply that came during both November and December. Three-year muni yields rose slightly, five-year yields climbed about 15 basis points, but yields from 10 to 30-years spiked higher by almost 40 basis points so the muni curve did steepen more than the Treasury curve did.
Well, that is interesting. Everyone was expecting that the muni market would see limited supply this month and it would aid performance. Did that actually come to pass?
So, one part of it did come to pass and the other did not. After the record-setting supply in December, if you remember, we had about $65 billion worth of new issue supply. New issue numbers for January plummeted all the way down to just below $17 billion. So, January which is typically a very light month anyways, but this was down more than 50% from what we saw in January of 2017 and the lowest January issuance since 2011 and notably January had only one deal exceeding $1 billion in issue size. And if you remember the tax-cut bill that went through or the tax reform bill that went through, eliminated municipalities' ability to issue advance refunding deals so refunding volume was down to under $2 billion versus almost $9 billion seen in January of last year. So that positive technical backdrop of low supply and inflows unfortunately were offset by very heavy selling in the secondary market and the liquidation of a large bank portfolio. And if you look at some of the bid-wanted activity that we saw in the muni market, it was particularly heavy averaging about $750 million a day during the month.
Okay, did we see any inflows into municipal bond funds from retail?
So we did. Municipal bond funds started off the year strongly. Weekly reporting refunds recorded four consecutive weeks of inflows including over $1 billion in each of the first two weeks of the year and the monthly flows totaled over $3 billion, so a good solid number on the flow side, but not enough debts to offset the selling that we saw in the heavy bid-wanted activity in the secondary and I think this will be really important to watch over the next coming months as retail tends to react negatively to a rising rate environment like we saw this month so if retail starts to get a little bit spooked about the rise in yields and losses we may see that start to pull back in the coming months.
Okay, so we will definitely keep our eye on fund flows and on the supply side, the heavy supply of November and December produced some very big swings in relative value. Where did we end up this month?
So municipal bonds were able to outperform Treasuries inside of 10 years while underperforming from 10 to 30-year maturities. The out-performance in the short end pushed ratios in 2 to 3-year maturities back into the low 70% range, versus the low 80 range at the end of 2017 and the five-year ratio fell to 73% down from 76. So the 10 and 30-year ratios rose to 87% and 99% by the end of the month, up from 83% and 93% at the end of 2017.
Great. So, the rise in yields produced negative returns for the month. What was notable about muni performance?
So, if you look at one of the main municipal bond indices which is the Bloomberg Barclays Municipal Bond Index, that posted a loss of 1.18% for the month of January, erasing all of the gains that were accrued during December 2017. If you look at the 1 to 10 blend index which has a duration of just north of four years, that index was down 68 basis points for the month. Returns were positive only in the shortest maturities as the month’s performance can be framed by sort of the longer the maturity/the worse the return mantra. The long bond index, which is comprised of bonds 22 years and longer had a loss of 1.84%. On the sector side, education, water, sewer and special tax bonds were among the weakest performing sectors, while resource recovery, industrial development, revenue bonds, and electric revenue bonds fared the best on a relative basis. Credit quality had a neutral impact last month as AAA rated bonds were down 1.2% and BBB bonds were down 1.3%.
Okay, so a lot happened this month. We talked a lot about technicals. Where do things stand with the overall municipal credit environment?
So municipal credit conditions remain largely stable. As the economy continues to grow and unemployment remains low, tax revenues should continue to come in on the positive side. We do see some signs of complacency particularly in sectors that have risk that may not be reflected in their spreads, somewhat like hospital bonds right now. And while infrastructure will be the next focus for the administration, we feel that there will not be a material increase in supply given the lack of bipartisan support. But one thing to keep an eye on is with federal deficits increasing given the tax cuts, it is likely that states will find a less willing federal partner and perhaps be forced to do more with less. As federal revenues are strained a little bit, that likely means less aid for states. If states get squeezed a little bit, that likely means a little bit less for local. So, you know, we continue to have a view that municipal credit quality is about as good as it gets. As long as the economy continues to do well those revenues will likely remain stable, but you don't want to get too complacent here with spreads where they are.
So as we are a few days into February now, what are the big items we are watching for the rest of Q1?
Certainly, the direction of Treasury yields is number one on everyone's list right now. Does that budding wage inflation lead to higher headline inflation that forces the Fed to raise rates faster than they currently have scheduled? That's really number one on everyone's mind right now. Specific to munis, it is really likely to be supply-driven. Upcoming new issue supply if you look at the 30-day calendar, continues to look very meager. So if the selling continues, munis are likely to continue to be pressured given the heavy dealer inventories, but if we start to see some of that secondary selling subside and dealers are able to work down their inventory, that continued low-level of new issue supply could spur some outperformance on the muni side as the year goes on.
All right, thanks, Matt.
So, Khurram, let's move over to the corporate side. Let's start out with our performance for IG corporates. How did they do to start the year?
So, January was a rather impressive start to the year in terms of excess returns as firms reported generally strong earnings and boosted outlooks in response to tax law changes. A combination of higher interest rates and lower than anticipated supply continued the positive backdrop for high-grade credit markets. And the negative sentiment, such as U.S. government shutdown, did not have much of an impact. In January, corporate spreads tightened 7 basis points to end at +86 OAS, the tightest level since 2007 and outperformed Treasuries. Intermediate corporates returned -79 basis points of total return but generated 30 basis points of excess return while longer corporates returned -130 basis points of total return but 161 basis point of positive excess return. Based on those excess numbers you can surmise that the credit curve flattened during the month of January. Ten-year corporate's tightened 13 basis points, while 1-3-year corporates tightened only 1 basis point and underperformed the market. Within sectors, industrials generated 88 basis points of excess returns and they outperformed utilities, which generated 71 basis point of excess return and financials lagged, generating 41 basis points of excess return during the month of January.
Okay, so it sounds like the overall trend is that spreads tightened but returns were still down given Treasury moves.
That is right.
Okay so what were returns across the credit quality spectrum? Did lower quality outperform?
Yes, they did. So, BBB corporates outperformed higher-quality corporates this month. BBB spreads narrowed 12 basis points during the month and generated 105 basis points of excess returns that outperformed the market. While single-A’s tightened 5 basis points and generated 45 basis points of excess return and AA corporates tightened 3-4 basis points and generated 30 basis points of excess return. So, both single-A and AA corporates underperformed the market. The spread differential between BBB and single-A’s is now 40 basis points and that is the smallest difference since mid-2014.
Well, building on that, what sectors outperformed and in contrast which ones underperformed?
The best performing sectors for this month were metals and mining, telecom especially wire lines, and oil-related sectors such as refining, independent energy, and oilfield services. As WTI oil prices climbed 10% in January to a 2.5 year high. The laggards on the month include autos, so for example Ford bonds were 5-10 basis points wider across the curve. Moody’s shifted their outlook to negative on Ford as U.S. auto sales missed estimates for the month of January. Also finance companies lagged this month, that was largely impacted by GE Capital International Bonds. Their spreads widened significantly during the month. GE created some negative headlines due to significant charges on its legacy reinsurance business. Further adding to the volatility, of the company discussed a breakup and the SEC opened an investigation into its accounting practices and sell side analysts turned largely negative. So long GE paper ended the month 15 basis points wider but were traded down as far as 25 basis points wider during the month. And lastly, consumer products also underperformed the market due to company specific event risk. So, for example, Newell Rubbermaid cut 2018 forecast and was said to be exploring strategic options for some of its assets.
So what about healthcare and pharma?
So, healthcare names were negatively impacted but not as much as oil, consumer products, and autos. That happened been mostly at the tail end of the month. There was an unexpected threat from Amazon, J.P. Morgan, and Berkshire Hathaway. The trio announced that they are partnering to create an independent company free from profit-making incentives to address the healthcare needs of their U.S. employees. So, names like United Healthcare, CVS, Walgreens, Aetna, Anthem, Humana and Express Scripts, and others in the sector were all 5-15 basis points wider on the announcement. Despite the complexity and uncertainty of making any radical change to the U.S. healthcare system, the market found it difficult to overlook a trio made up of successfully, innovative, proven and powerful industry leaders. By the end of the month actually, names in the healthcare space actually ended up outperforming the market and pharma was largely unaffected and outperformed the market during the month.
And what about media and cable? I heard CBS and Viacom were in the news?
That is right, so details are few and far between at this point but on January 12th, Viacom and CBS... there was a rumor that the two companies were thinking about re-merging. So the two companies actually were combined in the early 2000's. They announced a split in 2005, only six years after they had merged, and now there was a market rumor that there were thinking of recombining. So, CBS which is rated Baa2/BBB, they ended the month about 15 basis points tighter on the news and Viacom, which is one notch lower rated, their bonds ended 30 basis points tighter on the news.
So switching gears now, corporate supply was heavy this time last year. Did that continuing in January 2018?
So this month, IG corporate bond supply was about $156 billion which was well below expectations and down 26% from January 2017. Financials made up about 50% of issuance. Financials dominated the early calendar as they exited blackout periods post earnings. Wells Fargo priced $6 billion of a two and three-year short paper at +43 and +50 G spread respectively. J.P. Morgan issued $4 billion of longer 10’s and 30's paper at +97 and 107 respectively. Morgan Stanley, B of A, Toronto Dominion, Citigroup, Goldman and many other financials issued within a one-week period. Outside of financials, Sempra energy brought a large seven-part $5 billion deal for their acquisition of Encore, the ten-year priced at +93 G spread.
Okay and what about the demand side? Have fund flows been strong?
So far they have. So in the month of January, investment grade inflows were strong, $13.5 billion. High yield on the other hand ended the month with a net outflow $3.1 billion.
Well thanks, Khurram. We hope that you in the field have found this informative and we look forward to you joining us on our next podcast. Thank you.
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