September saw another rate increase, but we think emerging market troubles, a noticeably flat U.S. Treasury curve and trade concerns will keep the Fed’s future rate hikes at a measured pace.
Strategy and Outlook
Summer Days, Summer Hikes
- U.S. Treasury Curve: We believe that strong labor data and the removal of the Fed as a major long-end Treasury buyer will lead to inflationary pressures that could reverse some of the current flatness.
- Tax-Exempt Municipal/Treasury Ratios: Tax-exempt municipal relative value has declined sharply for maturities five years and lower versus taxable alternatives, in line with our expectations.
- Municipal Market Technicals: Overall, we expect supportive technicals to continue. Muted new-issue supply and robust demand were major drivers of municipal performance for July.
- Corporate Credit Quality: 2Q18 earnings have been strong so far, but credit fundamentals remain a concern due to high leverage and the overhang from trade war uncertainty.
- Corporate Supply and Demand: The reprieve in corporate supply in July was a significant boost to performance. Demand improved and dealer inventories have come down.
- Securitized Trends: We believe MBS valuations are leaning richer after a strong July, but fundamentals remain firm. We are moving away from seasonal MBS trends, which could help curb net supply. ABS valuations remain attractive relative to corporates, in our view.
July was a strong month for risk assets, with equities up modestly, investment grade (IG) corporate spreads tighter, IG municipal returns positive, and strength in both higher-beta IG bonds and high yield fixed income. Markets benefited from the “Goldilocks” economy—with inflation still low (but rising), consumer data showing strength and U.S. GDP growth above-trend. Overall, markets were largely “risk-on” as trade disagreements de-escalated, corporate earnings were healthy and economic reports were solid. In terms of investor sentiment, these positive trends overtook trade war concerns, which remain an overhang across markets.
U.S. Treasury bonds rose between 10 basis points (bps) and 15bps in July, with most of the increase due to late-month speculation about tightening moves from the Bank of Japan. The Treasury curve continued its flattening trend with the 2’s to 10’s curve hitting a new decade low of 24bps mid-month, before closing the month at 29bps. However, recent labor data points to upward pressure on inflation that could run contrary to the flattening trend. Job availability is high, and the unemployment rate fell by 0.1 percent to 3.9 percent in July.
The FOMC voted to leave rates unchanged at a range of 1.75 percent to 2 percent, while noting that the economy is strong and inflation has reached the Fed’s target rate. June meeting minutes expressed members’ concern that letting the economy run too strong could “give rise to heightened inflationary pressures or to financial imbalances that could lead eventually to a significant economic downturn.” As a result, most government officials believe the Fed should continue to raise rates on a regular basis.
Municipal Market Review
The Bloomberg Barclays Municipal Bond Index posted a total return of 0.24 percent in July. Munis continued to benefit from strong technicals, with issuance coming in at $25 billion, a modest increase from July 2017, but 23 percent lower than June. Year-to-date, issuance has fallen 16 percent.
While issuance has remained muted, municipal bond funds posted three consecutive weeks of healthy inflows mid-month, including a $1.3 billion inflow for the week ending July 18—a year-to-date weekly high. Munis have seen more demand in the short end of the curve; this, along with the reduced supply, contributed to lower muni yields for maturities 10 years and shorter. However, the lower corporate tax rate has made tax-exempt municipal bonds a less attractive option for crossover investors (see Tax Reform: from Risks to Reality); the 30-year underperformed, finishing at 3.01 percent (up 7bps), and the AAA muni curve steepened over the month.
In terms of relative value, front-end municipal ratios dropped significantly in July, as Treasuries rose more than 10bps for maturities between 2 years and 10 years, while muni yields were slightly lower in that range. The 2-year ratio ended the month at 60.7 percent, the lowest level in four years. The 10-year ratio ended the month at 82.7 percent, and the 30-year at 97.6 percent.
The credit environment remains stable. In July, Moody’s Investors Service revised its outlook on California (Aa3) to Positive from Stable and changed its outlook on Illinois (Baa3) to Stable from Negative. We agree that the states’ credit fundamentals have improved versus a year ago, but we note that structural risks remain. Further credit repair is likely to be limited given Illinois’ still unresolved pension challenges and California’s still highly volatile fiscal structure. We note that all but two state budgets were approved on time this year, with exceptions being Massachusetts and South Carolina.
Corporate Market Review
Issuance Takes Time Off
This month, corporate performance snapped back from year-to-date weakness, benefiting from strong technicals, solid 2Q18 earnings performance and the overall strength in risk assets over the month. The Bloomberg Barclays Corporate Index option-adjusted spread (OAS) tightened 14bps to 108.9bps. Higher-beta sectors performed the best, including Telecom and Cable Satellite. Railroads outperformed due to the sector’s longer duration, as 30-year corporate bonds meaningfully outperformed the front end of the curve. The worst performers were lower-beta sectors and those with heavy exposure to trade, including Home Construction, Consumer Products and Autos. BBB-rated names fared best, while Aa+ names had the worst showing. Long-end corporates had the best performance, while the short end lagged.
High grade issuance totaled $67 billion in July, down from $94 billion in June, and a sharp drop from $125 billion in July 2017 when significant M&A was in play. Year-to-date, issuance is just under $800 billion, which is the slowest January-July pace since 2014, per Bank of America Merrill Lynch (BAML).
Declining supply was met with an uptick in demand. Higher Treasury yields has made the all-in yields of U.S. corporates more attractive, which has helped rekindle interest from foreign investors and others. Fund flows were $6.2 billion in July, which brings year-to-date inflows to roughly $77.2 billion.1 Also, shrinking dealer balance sheets have boosted technicals. Net positions in IG corporates declined to a multiyear low of $4.1 billion, according to Wells Fargo.
Credit fundamentals are still a concern, as gross leverage and corporate debt as a percent of GDP are at record highs (Figure 2). During recessions, leverage problems tend to be exacerbated, so we continue to pay close attention to shareholder-friendly activity and aggressive credit stances from corporate management teams. IG corporates also face significant uncertainty from trade negotiations (see Implications of Trade Uncertainty).
Securitized Market Review
Seasonal Trends in View
Agency mortgage-backed securities (MBS) had solid performance in July. Excess returns were 20bps in July, up from 3bps in June.2 However, excess returns are down 4bps year-to-date. Supply has reached $109 billion through June, down $40 billion year-over-year. Low convexity continues to point to contained MBS extension risk. While demand remains strong for MBS, one risk is that the relative value of MBS versus corporates has declined, as MBS valuations are leaning richer after a strong month. That said, we are exiting the part of the year with seasonally-high MBS originations, which should help manage net supply. The Fed’s net takeout3 is on track to be zero by late summer given the path of rates.
In asset-backed securities (ABS), supply has reached $154 billion year-to-date, 9 percent higher than 2017—which was a high year, per BAML. July saw excess returns of 11bps.4 While there were no major headlines in July, we note that credit fundamentals are normalizing in ABS, with subprime autos returning to the headlines. Credit card fundamentals have deteriorated on the margin, as consumer balance sheets start to exhibit higher debt levels, and issuers seek to diversify their business mix away from low-risk convenience users and into revolving balance customers. That said, we remain focused on the most prime sectors, where we believe credit risks are very low and structural protection is strong.
 EPFR Global, per Wells Fargo. MTD fund flows include data from weekly reporting funds only.
 Proxy used is the Bloomberg Barclays U.S. Aggregate Index.
 The ratio of the Fed’s monthly purchases to one-month forward issuance.
 Proxy used is the Bloomberg Barclays U.S. Aggregate Index.
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