SHORT FIXED INCOME MARKET COMMENTARY, MAY 2017

Some Things to Think About - Tweets, Shutdowns and the Debt Ceiling

Despite the ever-present threats facing today's investors - random tweets, a Federal Reserve (Fed) on the move, disappointing Q1 U.S. Gross Domestic Product (GDP) growth, North Korea, tax / healthcare / regulatory reforms, government shutdowns, debt ceilings, cyber attacks, extremely random tweets - we are relatively comfortable with the current state of the investment-grade fixed income markets. No environment is perfect of course, and printing those words almost ensures a disruptive event will soon make this commentary seem ridiculous. But the optics into the key components of our investment strategy of emphasizing coupon income through spread product and positioning for higher interest rates seem pretty straightforward.

First, the U.S. economy is on a decidedly durable - though not rapid - 2.0% to 2.5% growth path, which for investment-grade credit and continued Fed tightening should be good enough. We discount the sluggish U.S. Q1 GDP print of 0.7% given the government's inability to properly adjust for seasonality in first quarter GDP data. Besides, the sluggish consumer spending component seems out of line with robust consumer confidence numbers and higher employment levels, probably setting the economy up for a rebound in consumption. Further, we just don't see overheated sectors in need of deflating, which could in turn trigger a sharp downturn in broader economic activity. Given this sanguine outlook, we believe the economy remains supportive of credit and spread product while allowing the Fed to continue to raise interest rates ...

... but not too quickly. Starting with the December 14, 2016 meeting, the Fed has raised rates 25 basis points (bps), paused, raised rates 25 bps and paused - all while expecting economic conditions "will warrant only gradual increases in the federal funds rate." Leading us to the simple conclusion: "gradual increases" = every other meeting. Further, we believe the Fed has earned greater market confidence through its demonstrated conviction to normalize policy and would be reluctant to squander its credibility by revisiting its 2015-era reliance on "recent global economic and financial developments" to drive decisions. Making reactive sell-offs - like the May 17th swoon - less relevant. Given this outlook, we are forecasting June and September rate increases before the Fed pauses and begins socializing the concept of balance sheet reduction in earnest. Which leads us to another simple conclusion: yield curve rates will be higher by year-end and a short to benchmark strategy will add value to client portfolios. Our 2017 Fed forecast is basically in line with market expectations - not all that unusual for most Wall Street forecasts. It's not because we are all sheep afraid to look foolish with a contrary forecast. It's because the Fed has become quite accomplished at signaling its intentions and when market forecasts diverge outside of its plans, the Fed can jawbone markets back in line. So far, policymakers have neglected to do so, giving us confidence in our outlook.

So what are the risks to our outlook and strategies? Brexit seems so 2016. French elections have come and gone with a market-friendly conclusion. Rating agency downgrades can widen spreads but, in our view, won't threaten principal. Headline risk for industrials is elevated, but it exists in all markets and can be partially mitigated through proper portfolio diversification. North Korea is concerning but investors would be paralyzed if they constantly assumed war for every geo-political dispute. The impact of repatriation on corporate debt markets and credit spreads is uncertain, at least until the details, timing and likelihood of future tax-reforms become more concrete. One area of concern for market valuations that could translate into a threat to our core strategies basically comes down to U.S. political risk. Or, more precisely, can Washington deliver on significant fiscal and regulatory reforms while avoiding destructive legislative blunders?

President Trump (Do Tweets Even Matter?)

Either financial markets live in a blissful world without Twitter and 24-hour news channels, or they have grown comfortably unworried with some of President Trump's more unconventional tweets and actions. Fire the FBI Director? Watch the S&P 500 hit an all-time high the next day. Threaten Mexico with trade sanctions? Watch the peso rise 13% since Inauguration Day. Tweet basically anything? Watch the VIX Index (see sidebar) hit 20+ year lows. Our favorite tweet - NOT! - refers to the latest budget resolution deal and the 51-49 Senate split. On May 2nd, President Trump tweeted "Our country needs a good shutdown in September to fix mess!" That's the spirit ... nothing fixes a mess like another mess. So, investment wise, should we take our cue from risk assets and not take such statements too seriously? For the most part, we are already there and worry less about the President's rhetoric than we do about his ability to enact proposals already baked into asset valuations. His influence could certainly wane if supporters grow weary of accumulated perceived missteps or begin viewing President Trump's tweets and actions as veering from "draining the swamp" toward awkward rudeness. The tipping point, if it exists at all, is impossible to know. So our best guess - fingers crossed - is the President remains a dealmaker at heart and his tweets and off-the-cuff remarks are instinctively about positioning and when the time comes to cut a deal, he'll hit the bid and move on. 

Government Shutdowns and Debt Ceilings

Which leads us to believe a disruptive government shutdown or a calamitous debt ceiling crisis is not in the cards. There is simply no upside for anyone in the alternative. But handicapping politics is a dicey game at best - just ask any Presidential pollster. For our portfolios, a government shutdown is far less odious than a debt ceiling crisis. In a government shutdown, markets will continue to function and government debt obligations will continue to pay coupon interest, mature as scheduled and be issued in the primary market. However, a government shutdown would reflect dysfunction in the U.S. political process and likely lead to lower GDP growth and broad market declines - the latter a partial reflection of increased skepticism over the likelihood of promised fiscal stimulus. In such a scenario, it would not be a stretch to assume credit spreads would widen and the Fed would delay or forego anticipated policy tightening, both of which would be detrimental to current portfolio strategies. 

The impact of a federal debt ceiling crisis - or worse, a technical default of U.S. debt obligations - would be far more harmful for investors. During the August 2011 debt ceiling debate, traders grew skittish over Treasuries scheduled to mature near the time the government was expected to hit the federal debt ceiling and the S&P 500 fell over 16% in the weeks bracketing the last minute August 2, 2011 budget deal. And that was just on a close call, not an actual default. It is important to remember a default by the United States has never occurred, so no one can truly claim to know all of the implications and outcomes. We believe even a short-lived technical default would erode confidence in the creditworthiness of the U.S. and have long-term implications for the safe haven status of the dollar and U.S. Treasuries. For these reasons, no asset manager can really make a U.S. government default the base case for their outlook. We assume, instead, a deal will be struck. At the same time, we will monitor comments from the U.S. Treasury to identify the more precise dates when the debt ceiling is expected to be reached - currently some vague point in Q4 - to better assess the risks. All the while hoping against hope Washington just gets rid of the stupid thing. 

Like we said, no market environment is ever perfect. And we want to emphasize the comfort we have with current market optics is not the same as complacency. We spend a great deal of time seeking contrary opinions to current investment themes and risk assessments and will continue to monitor markets and adjust accordingly should events alter our views. 

Sources:

Bloomberg

Federal Reserve, Chair's FOMC Press Releases, December 14, 2016 and September 17, 2015

Trump, Donald (@realDonaldTrump), "either elect more Republican Senators in 2018 or change the rules now to 51%. Our country needs a good ‘shutdown' in September to fix mess!" 2 May 2017, 6:07 a.m.