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Investing Commentary published on July 13, 2018

June 2018 Market Commentary

Strategy and Outlook

Inflation Kicks Higher

  • U.S. Treasury Curve: While the Fed continues to raise short-term rates, we think that higher wages and higher deficits (increased Treasury supply) have the potential to put upward pressure on inflation and the long end of the Treasury curve.
  • Tax-Exempt Municipal/Treasury Ratios: For tax-exempt municipals, short-end relative value has declined versus taxable alternatives.
  • Municipal Market Technicals: We continue to expect market technicals to be supportive over the summer, as maturity reinvestment over the next few months is approaching the high levels seen last summer. Negative net supply is expected to reach -$59 billion for July/August, versus -$43 billion for the same period in 2017, per J.P. Morgan estimates.
  • Corporate Credit Quality: Margins have improved and 1Q earnings were strong, but leverage remains high and companies continue to be aggressive in M&A and shareholder-friendly activity.
  • Corporate Supply and Demand: Foreign demand has softened some and weak year-to-date performance has also hurt demand. Supply was the highest for any calendar month of June on record, per BAML.
  • Securitized Trends: We believe ABS valuations remain attractive relative to corporates, with fundamentals normalizing off peak levels. MBS net supply/demand could be challenged by the Fed’s balance sheet unwind and lower bank demand; this is offset by the lack of market convexity.

Monthly Recap

Market Review

FOMC Continues Toward Goal

This year’s FIFA World Cup has shone a glowing spotlight on one of soccer’s most riveting displays: the “penalty kick.” As an offensive player’s feet dance toward the high-stakes shot, the goalie must somehow prepare for possible shots that span his or her widest peripheral vision, and beyond.

In their own playing field, markets continue to try to anticipate and prepare for various possible outcomes of macro data, Federal Reserve (Fed) actions and geopolitical news. Employment data remained extremely strong in June, with more wage inflation beginning to flow through. On the inflation front, CPI rose 0.2 percent in May, and is now up 2.8 percent year-over-year. Importantly, the Fed’s preferred inflation measure of core PCE showed a 2 percent rise year-over-year.

The FOMC raised its target range to 1.75 percent to 2 percent and revised its dot plot to reflect four hikes in 2018, versus the three that had been expected in March. However, their pace of rate hikes is expected to slow by 2020, as rates will begin to reach the Fed’s long-term target of 3 percent.

In its statement, the Fed said it now expects inflation to overshoot its target faster than it previously thought. The Fed modestly increased its 2018 GDP forecast and lowered its unemployment projections for 2018-2020. In addition, Fed Chair Powell announced that the FOMC would hold press conferences after every meeting (beginning in January) to better communicate policy.

Overall, markets were largely risk-off in June on trade war concerns and stronger economic data that may lead to a faster pace of rate hikes. U.S. Treasury bonds were volatile but ended about flat, while stocks rose modestly. Tax-exempt municipals had positive returns, while investment grade (IG) corporate bonds were weak on heavy supply.

Despite the stronger data and expectations for higher short-term rates, the 10-year U.S. Treasury traded below 3 percent over the month. One source of stability is likely relative value, as the U.S. Treasury bond still offers a more compelling yield for global investors. The 10-year Treasury yield is roughly 250 basis points (bps) higher than the comparable German bund as of month-end, up from a 10-year average of 90bps higher.1

Municipal Market Review

Short-End Ratios Slide Lower

The Bloomberg Barclays Municipal Bond Index finished modestly positive, with a 0.09 percent total return that modestly outpaced the U.S. Treasury Index return. June performance pushed year-to-date total returns to -0.25 percent for the broad municipal market index.

Unlike the Treasury curve, which flattened to multi-year lows over the month, the AAA muni curve bull steepened, which is evidenced by the 2s to 10s widening 16bps to finish the month at 82bps. Year-to-date, the 2s to 10s has widened 40bps. The outperformance in shorter maturities was partly due to higher demand for short-end bonds, while the long end continued to be negatively impacted by lower demand from banks and other institutional investors, per Barclays.

The outperformance of municipal bonds in shorter maturities pushed tax-exempt municipal/Treasury ratios down to 65 percent in the 1- to 2-year range, while the 3-year ratio fell to 68 percent and the 5-year to 73 percent in June. Notably, the 2-year ratio has dropped by 18 ratios since the beginning of the year to close the quarter near its year-to-date low. The 10- to 30-year ratios are hovering close to their one-year averages of 85 percent and 97 percent, respectively.

Municipal credit fundamentals remained benign in June. Credit conditions have been buoyed by strong tax receipts, low unemployment and still-rising home prices. Also, fewer states suffered protracted FY19 budget debates this year. Most completed their budgets by June 30. Still, structural risks pose a challenge to many issuers, including a weaker federal government partner, growing pension and retiree healthcare costs, and deferred infrastructure maintenance. BBB-rated bonds outperformed higher-rated bonds over the second quarter, boosted by strong performance from Illinois state general obligation bonds. BBB-rated bonds have posted a positive 0.40 percent return year-to-date, while AAA-rated bonds have posted negative returns of -0.48 percent.

Two landmark rulings from the U.S. Supreme Court came down in June, including South Dakota v. Wayfair and Janus v. AFSCME (Figure 1). Our blog post Judging the Janus Decision gives greater detail on that case.

Corporate Market Review

Some Demand Still on the Sidelines

June issuance was $119.4 billion, per Bank of America Merrill Lynch (BAML), which is the highest supply for any calendar month of June on record. June 2017 supply was $94 billion. In addition to hefty M&A supply, a difficult credit backdrop in Europe has led to increased European Yankee bond supply in the U.S.

Foreign demand has been weak due to high hedging costs. Going forward, higher all-in corporate yields could lead to some improvement in demand from foreign investors, as U.S. corporate yields are now higher than what’s available in the euro market. Pension fund and insurance company demand could also tick up with higher yields. In addition, the rebounding dollar is attracting more unhedged foreign money. Retail demand continues to be negatively impacted by weak total IG corporate returns year-to-date, along with high interest rate volatility.

In June, the Bloomberg Barclays U.S. Corporate Index had a total return of -0.58 percent, and an excess return of -0.60 percent. The option-adjusted spread (OAS) increased to 123bps versus 115bps at the end of May, mainly due to risk-off stance in the market. The OAS is now at the same level as the start of 2017 (Figure 2). Due to negative trends in IG corporates, IG excess returns have underperformed high-yield (HY) ones quarter-to-date and year-to-date.

In June, lower-quality IG bonds underperformed, although all ratings categories had negative excess returns. On a sector basis, the worst performers for June were Telecommunications, Rails, Energy and Restaurants. On the flip side, more defensive sectors such as REITs or Commercial & Consumer Finance companies outperformed.2

Due to organic growth and tax cuts, 1Q18 earnings were strong. Margins have improved, as EBITDA expanded on both revenue growth and increased efficiencies year-to-date, per J.P. Morgan. However, leverage remains high and we are still mostly seeing buybacks, M&A and other shareholder-friendly uses of cash from repatriation, rather than any material debt reduction or capex.3

Securitized Market Review

Cash Outs Roll In

Agency MBS spreads widened further in June to reach the year-to-date wides of 83bps. However, this is still tighter than levels reached when the Fed announced its balance sheet unwind plans last September (see The Fed’s Shrinking Balance Sheet and MBS Opportunities). The Fed reinvestment caps jump up to $16 billion in 3Q18, before reaching a $20 billion terminal level in 4Q18. The Fed’s net takeout4 is on track to be zero by late summer given the path of rates.

The widening is due to lower bank demand, partly because of the sharp MBS sell-off this year triggered by available-for-sale balance sheet losses. However, some dealers are reporting that demand may be turning back upward. Net supply is running below market forecasts, with organic net supply about $43 billion lower year-over-year for June.

As a sign of the housing market heating up, cash-out activity has risen to the highest level since 2008. Based on Freddie’s Quarterly Refinance Statistics, total cash-outs as a percentage of aggregate refinanced originations (UPB) rose to 18.3 percent in 2018, a significant increase from its historical low of 2.9 percent in 2012. While the level of cash-out activity is still well below the pre-crisis level, it represents the highest level since 2008.

We believe ABS remains attractive, but the sector has moderated in June after started out 2018 strong. A total of $129 billion of ABS has priced year-to-date, up 3 percent versus the same period last year, per BAML. Credit card fundamentals have normalized as issuers seek to diversify against low-risk users and into revolving balance customers. Weakness in the auto sector is primarily due to the subprime, lease and retail segments, as both a glut of supply from cars coming off fleet and falling used car values have weighed on the sector.

 

[1] U.S. Treasury and the Federal Reserve, as of June 2018. 

[2] Barclays, as of June 2018.

[3] Bloomberg, Company filings, Breckinridge Capital Advisors, as of June 2018.

[4] The ratio of the Fed’s monthly purchases to one-month forward issuance.

DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.

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