What market conditions had a direct impact on the bond market this quarter?
2017 ended with an eventful and upbeat fourth quarter. Sweeping tax legislation was signed into law slashing corporate tax rates, doubling the standard deduction and limiting state and local tax deductions for individuals. For its part, the Federal Reserve (Fed) increased benchmark rates 25 basis points (bps), began the gradual wind-down of its balance sheet and saw Jerome Powell move toward confirmation as the new Fed Chairman beginning at the January 31, 2018 meeting.
Economic Activity - In the quarter, the U.S. economy reflected real strength and investor optimism drove the S&P and NASDAQ indexes up over 6%. The third quarter's U.S. GDP 3.2% growth rate beat initial estimates and provided momentum for an expected 3+% growth rate for the fourth quarter. Employment conditions - a consistent strength of this economy - continued to improve with Non-farm Payrolls adding 611,000 jobs in the quarter and a healthy 2.055 million for all of 2017. The U3 and U6 Unemployment Rates continued to decline, ending the year at 4.1% and 8.1%, respectively. Year-end ISM Manufacturing's robust 59.7 reading was the third highest over the past 13 years. December's ISM Non-Manufacturing reading of 55.9 missed estimates, but still reflected solid expansion for the largest sector of the economy. Entering 2018, consumer confidence and spending will likely receive a boost after scores of large employers announced plans to utilize part of their tax cut windfall to offer higher wages and / or cash bonuses to their employees. Despite the abundance of positive growth data, inflation indicators remained stubbornly subdued. Average Hourly Earnings - a widely followed indicator of future inflation pressures - rose a benign 2.5% year-over-year (yoy) in December, defying analyst expectations and high employment levels. November's Core Personal Consumption Expenditure Index rose 1.50% yoy, higher than August's two-year low reading of 1.30% but still noticeably below the Fed's 2.0% target. Given the consistent strength in employment conditions, additional stimulation from the tax cuts and a noticeable lack of broad sector bubbles in the economy, the risk of a near term recession is low.
Credit Markets - Credit spreads continued to grind tighter, albeit at a slightly slower pace vs. previous quarters. The ICE BofA Merrill Lynch (ICE BAML) 1-5 Year AAA-A U.S. Corporates & Yankees Index's option-adjusted spread tightened from 45 bps to 41 bps during the quarter. Low market volatility, muted negative rating activity, positive supply / demand dynamics and the market's overall risk-on bias continued to support credit and spread product. The deceleration of spread compression is most likely due to the historically rich levels currently priced into bond spreads, which leaves little room for further tightening.
*Corporate index outperformed the Treasury index by 16.4 bps in the quarter
The ICE BAML BBB U.S. Corporates & Yankees Index outperformed the AAA-A index by 11.7 bps in the 1-3 year space, continuing a general trend of lower-rated credit outperforming its higher-rated counterparts. Lower-rated issuers typically outperform in low volatility / solid growth environments, but are also more sensitive to financial market stress.
*Short index outperformed the long index by 13.4 bps in the quarter
Driven by stronger economic data and a Fed rate increase, short-term U.S. Treasury yields rose and the yield curve flattened during the quarter with one-year yields rising a hefty 44.2 bps and five-year yields rising 27.0 bps. For the year, the one- to five-year U.S. Treasury spread fell to 47.4 bps from 111.6 bps. Despite the relatively large magnitude of interest rate movement, the increase in yields was both orderly and uniform with each month in the quarter contributing to the overall increase.
Monetary Policy - As expected, the Fed raised benchmark rates 25 bps at the December 13th meeting. The Fed Dot Plot remained unchanged with policymakers forecasting three additional 25 bps rate hikes in 2018. Minutes from the December meeting suggested most members supported the Fed's gradual rate hike path, which can be reasonably translated into an every other meeting schedule for further hikes. Federal Open Market Committee (FOMC) participants acknowledged the flattening of the yield curve as a risk worth monitoring, but not necessarily a deterrent to additional rate hikes. The Fed began tapering the principal re-investments of maturities and mortgage paydowns in its portfolio. The Fed reduced its purchases by $10 billion per month in the quarter and will gradually increase the amount quarterly until reaching a maximum of $50 billion per month by the end of 2018. While Jerome Powell's ascension as the next Fed Chairman will provide continuity to Fed policy, the FOMC will see a dramatic change to its make-up in 2018. Including the vacant Vice Chair slot, there are presently four open seats on the Board of Governors. New York Fed President Dudley has also announced his intention to retire in mid-2018, creating another opening for a permanent voting participant. Further, Fed Presidents Kashkari and Evans - currently the most dovish voting members - move off of the voting rotation in 2018. On the margin, the turnover in FOMC voting membership appears to trend more hawkish and rules-based vs. previous committees.
Fiscal Policy - The Republican Congress and the Trump Administration passed the most sweeping tax reform package since 1986 without a single Democrat vote. The centerpiece of the plan was the cut in the corporate tax rate from 35% to 21%, which should boost corporate cash flow and after-tax earnings. The legislation reaped some immediate benefits after several employers utilized the opportunity to announce bonus programs for employees and minimum wage increases for more entry level positions. Much of the stock market rally can be attributed to the tax changes, as analysts raised earnings estimates on lower company tax bills. While most individuals should see some form of tax relief, the benefits will not be evenly distributed. Limitations on the deductions for state and local taxes disproportionally impacted traditionally Democratic states - such as New York and California - and further cemented resentment between the two parties. This disharmony will need to be overcome in the beginning of 2018 in order for Congress to pass legislation increasing the debt ceiling and avoiding a shutdown of the federal government.
What strategic moves were made and why?
Taxable Portfolios - USBAM's focus on credit and spread product continued to add value to client portfolios through higher coupon income and price improvement from tighter credit spreads. Beneficial factors - stronger global economic growth, positive supply / demand dynamics, low volatility, strong bank fundamentals - remained in place and supported investment-grade credit. Further, investors generally viewed the corporate tax cuts as credit positive due to the expected lift to company cash flows. Headline risk remained elevated for non-financials, with issuers such as Qualcomm and CVS seeing their credit spreads widen on merger and acquisition news. Our short duration strategy was decidedly positive to relative performance, as interest rates rose meaningfully across the short-term yield curve. On the margin, the flattening of the yield curve aided the total return of a committed barbell strategy more than our slight bias to a bulleted structure. Both strategies were effective in positioning portfolios for re-investment at higher levels in a rising rate environment. Our exposure to floating-rate notes has been meaningfully positive to performance, through increased coupon income from higher resets, price appreciation from tighter spreads and immunity from the negative price impact from the surge in yield curve levels. Unlike the third quarter where the jump in interest rates was fully realized in September, the fourth quarter rise in rates was far more orderly and somewhat evenly spread across each month, allowing investors to efficiently average in extension trades.
Tax Exempt and Tax-Efficient Portfolios - Municipal investors had much to navigate during the quarter, as tax reform threatened to alter the landscape of the market. The ultimate tax reform bill's corporate tax rate reduction to 21% was somewhat expected. For tax efficient portfolios, we had preferred corporates over munis for some time with this outcome in mind. We did add several municipal positions in late November and early December as the details of the bill were still being debated. It appeared at that time there was some likelihood the lower rates would not be effective until 2019. We proceeded slowly with these late-year purchases which ultimately proved prudent, as the final bill called for the lower rates to become effective in 2018. For muni-only mandates, it was full steam ahead. Certain provisions of the tax bill, which curtailed tax-exempt market access for some issues beginning in 2018, came as a surprise and led to a surge in new issue supply into year end. Short-term yields on one- to three-year maturities climbed approximately 50 bps during the quarter. We were well-positioned to take advantage of these opportunities with shorter average portfolio durations and plenty of liquidity through higher allocations to variable-rate demand notes (VRDNs). This was one of our most active quarters in terms of new fixed-rate purchases for muni-only portfolios in quite some time. Our outlook for a decline in muni supply over the coming months - and for Fed hikes that may fall short of market expectations - provided motivation for these extension trades.
How are you planning on positioning portfolios going forward?
Taxable Portfolios - With the Fed Dot Plot forecasting three additional rate hikes in 2018 and several market analysts predicting four, market momentum is decidedly toward higher rate levels in the coming months. The arguments for appreciably tighter monetary policy are reasonable. Historically low unemployment levels and the injection of tax cuts into a 3% growth economy point toward lower unemployment levels and increased wage and price pressures. We are inclined to agree with the direction of rates but less so with the magnitude of the changes. The flatness of the yield curve and our "we'll believe it when we see it" view on inflation leads us to deem risks are skewed toward two to three rate hikes vs. three to four in 2018. While our opinion may be a bit lonely vs. the analyst community, the flattening yield curve seems to be equally skeptical of an overly aggressive Fed. Further, year-end 2017 fed funds futures predicted an average funds rate of 1.88% for December 2018, implying two rate hikes in the coming year. Regardless, the direction of interest rates (higher) and yield curve structure (flatter) seem fairly clear - at least for the next several months. Given our outlook, we will position portfolio duration short to benchmarks and migrate portfolios toward a more barbelled structure when possible. One limiting factor to portfolio restructuring is the jump in yields, which has created unrealized losses for most fixed-rate positions. For portfolios with sensitivity to realized losses, maturities and other cash flows are the best options for re-balancing, which can limit the scale of any adjustments. On sector selection, we will continue to emphasize credit product despite the relative richness of spreads. Market technicals and a solidly growing economy continue to support credit quality and the risk of severe spread widening in the near-term seems reasonably low. However, the declining probability of price appreciation from credit spread tightening leads us to tweak our credit strategy toward shortening the spread duration in the corporate and asset-backed security sectors. We continue to believe the banking sector offers greater return opportunities than industrials on higher absolute spreads, lower event risk and strong balance sheet fundamentals.
Tax Exempt and Tax-Efficient Portfolios - We envision the coming quarter may be a quiet one for municipal investors. New issuance is expected to decline significantly in 2018 and will make for some challenging reinvestment. Typically, new issuance in the first couple months of the year is slow and this year it may be to a larger extent, as so much issuance was pulled forward into 2017 to front-run tax reform. As a result of these market conditions, we anticipate muni bond prices will be relatively stronger and offer less in the way of value. The potential for a significant infrastructure spending program could change our view on supply, but doesn't appear to be much of a near-term consideration. We will likely continue extending duration in tax-efficient portfolios through purchases of taxable securities. U.S. Treasuries may become a more compelling option vs. both municipals (given the lower 21% effective tax rate) and possibly corporates (given tighter credit spreads). Municipal VRDNs will be used as sources of cash. We expect these rates to move lower in January, as investors look to park money with few alternatives.
Bureau of Labor Statistics, Databases, Tables & Calculators by Subject, www.data.bls.gov
Federal Reserve, Addendum to the Policy Normalization Principles and Plans, as adopted effective June 13, 2017
Federal Reserve, Chair's FOMC Press Conference Projections Materials, December 13, 2017, (www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20171213.pdf)
Federal Reserve, Chair's FOMC Press Conference Projections Materials, September 20, 2017, (www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20170920.pdf)
Federal Reserve, Chair's FOMC Statement, December 13, 2017
Fox Business, "Tax Reform Rewards: JetBlue Joins Southwest Airlines, Others in Giving Bonuses to Workers", January 4, 2018