What's the Rush?
No question, 2017 has been a good year for those who enjoy stable credit conditions, low market volatility and stellar equity returns. We sure do. But market serenity can also create a whole new set of risks which must be identified and managed. Not to mention, strong market gains can create investment strategy dilemmas, as increased asset valuations make risk / return calculations less compelling. But cash must still be invested and identifying current cycle risks is a critical component in developing investment strategies.
Certain risks exist in all cycles. North Korea-like geo-political risks always seem present in some form or another and can create Black Swan scenarios. But frankly, if investors only focused on worst case scenarios, they could quite easily become frozen and unable to purchase anything not issued by the U.S. Treasury. Likewise, we are not talking about the omni-present risk of higher interest rates, which at this point appears inevitable anyway. Interest rate risk is unavoidable, but also manageable. Besides, for short fixed-income investors, the negative impact on current holding valuations is offset by the opportunity to re-invest at higher income levels.
So What Are Some of the Key Risks Specific to the Moment?
At this point in the cycle, we see financial market instability as a greater risk to investors than a near-term economic slow-down. For investment grade debt markets, we'll take that equation almost every time. The tailwind credit quality receives from a stable and growing economy is powerful. But don't critics argue U.S. GDP growth is too soft? Actually, as debt investors, we prefer the moderate but sustained growth patterns we have experienced and are forecasting. Restrained growth provides a useful governor on excesses building up in the economy, which in turn moderates banking sector risks and allows expansions to extend beyond their typical shelf-life.
Which is why we are a bit ambivalent about the proposed tax code overhaul. Political and social considerations aside, the scale of these changes will almost certainly have the ability to move the economy in a different trajectory - probably higher, but with increased debt levels and certain sector dislocations. Private activity municipal debt and highly levered companies stand out as two sectors vulnerable to proposals in the current tax bills. We can and will deal with the implications of whatever policy comes out of Washington, but we simply prefer the economy stays on its current stable and predictable path.
Lost in the tax code shuffle is the fact current federal government funding runs through December 22, 2017, requiring a new spending bill to be passed to avoid a shutdown. We'd put this on the negative side of the stability ledger, but it's not a game changer. The debt ceiling has been kicked into 2018 - probably March - and we expect both issues to be dealt with as part of the broader tax and spending discussions. (Editor's note: see Jim Palmer's August 2017 commentary for an in-depth discussion of both the debt ceiling and government shutdown.)
Asset inflation is a well-documented risk in almost all capital markets. For our part of the investment universe, asset inflation translates primarily into tighter credit spreads which increase the vulnerability of current portfolio valuations to disruptive events - something like the oil price shock of late 2015 / early 2016. Managing through tighter credit spreads can be tricky and too many asset managers have underperformed by staying on the sidelines and missing out on incremental coupon income and credit spread roll-down. One key tactic in managing spread risk is to avoid locking in tight credit spreads over the longer term. Admittedly, "tight" and "longer term" are in the eye of the beholder, so let's break it down to this: when possible, avoid buying spread product which has only a marginal opportunity for future spread compression or where the risk of spread volatility outweighs the spread reward. By buying shorter-term debt, investors can improve the risk optics on credit quality and spread volatility while still clipping additional coupon income.
Growing corporate leverage certainly has our attention, both of our approved issuers and system-wide. There is no question low yields and high investor demand have increased corporate leverage in the global economy. While global growth remains steady, higher debt levels are probably manageable. It is when growth falls, interest rates rise and access to credit wanes that problems arise. Tactically, we strive to diversify holdings and avoid issuers with insufficient cash flow to service their debt (essentially those companies surviving only on their ability to pay off debt with new debt). Strategically, it is important to understand the scars from the financial crisis are still raw. Investor impatience and skittishness over any signs of financial distress should not be underestimated. Market liquidity could evaporate quickly and we strongly recommend maintaining a highly conservative approach to any liquidity planning.
Asset inflation and corporate leverage can also put stress on the banking system. Falling asset prices in a leveraged economy were at the heart of the financial and banking crisis. Bank sector risk is always high on our radar, due to both a significant sector allocation in our portfolios and our firm belief a strong banking system remains the best defense against another meltdown. Concerns about deteriorating conditions in sectors including auto lending and student loans are valid. But we feel the banks in our investment universe have generally sidestepped the worst of these problems and bank asset performance, liquidity coverage and capital levels remain quite robust. Further, we feel any bank regulatory reforms will be more focused on relief for small banks and simplification for large banks rather than allowing for a meaningful expansion of risk taking.
For the most part, the risks we cited - particularly financial market instability - are looking for a catalyst in order to be fully realized. We view the risk of an overambitious Federal Reserve (Fed) as that catalyst and the top risk facing markets in 2018. Currently, via its Dot Plot the Fed is projecting raising policy rates at the December 13, 2017 meeting and three more times in 2018. Some market analysts project four 2018 rate hikes. All the while, the Fed is accelerating the pace of its quarterly balance sheet reduction. The logic behind the stepped-up pace is Phillips Curve driven, where historically low unemployment levels are expected to translate into future inflation. The current U.S. Treasury yield curve is skeptical. We agree. Globalization, demographics, technology, fracking, deregulation, global excess capacity, Amazon-like business models and already tighter U.S. monetary policy create headwinds - perhaps insurmountable - to consistently meeting the Fed's 2% inflation target. Policy expectations should be dialed back as inflation fails to firm.
We would add one practical and slightly dark point regarding policy rates. Given the presence of inflated asset values and increased leverage, we would expect excessive interest rate hikes to crack the weaker links of the global economy and markets. Look, we get it. This is how capitalism works. But we just believe investors and policymakers remain so traumatized that financial stress of any kind will be met with a pause in monetary tightening at the very minimum. In a nutshell, higher rates will bring about market conditions that will prevent the need for much higher rates.
All of which leads us to forecast a December 2017 rate hike, two more in 2018 and ultimately a 2% terminal rate for this tightening cycle. We believe the pace of balance sheet reduction will remain firmly in place - only a truly disruptive event will alter those plans. Given the attractiveness of the short-end of the yield curve vs. our forecast, we have taken the opportunity to remove some - not all - of our short-duration strategy call. But it is worth remembering investors rarely go into an individual Fed meeting unsure of the outcome. Fed officials watch market expectations and calibrate their comments to move investor expectations toward their near-term policy decision. So, if the Fed remains silent as markets consolidate around three or four 2018 rate hikes starting in March, we will adjust accordingly. Investing for how we believe the Fed should act vs. how we ultimately expect them to act is highly unproductive. But it would not prevent us from asking, "What's the rush?"
Federal Open Market Committee, Dot Plot forecast, September 20, 2017