Cash Management Portfolios - September 30, 2017

What market conditions had a direct impact on the bond market this quarter?

During the quarter, corporate and asset-backed spreads continued to tighten on the positive environment for credit and risk assets. Treasury yields shifted during the quarter, as investors drove rates down on declining inflation concerns in July and August before reversing and pushing rates higher on stronger September data. The U.S. economy continued to show consistent if somewhat modest growth and is now being joined by strength in global economies, Europe in particular.

Economic Activity - After the second quarter U.S. GDP 3.1% growth rate surprised markets to the upside, third quarter growth is expected to ease closer to 2.0%, as Hurricanes Harvey and Irma negatively impacted consumer spending and economic activity in the southern states. While the near-term hurricane impact is decidedly negative, fourth quarter spending is expected to rebound - along with construction and employment - as the rebuild of impacted areas begins. Employment conditions remained solid in the quarter, although September's employment data was a mix of negative and positive developments. Non-farm Payrolls fell 33,000 jobs - the first monthly decline in seven years - and 1.47 million people reported they could not work due to bad weather. This weak hurricane-impacted data was more than offset by declines in the U3 and U6 Unemployment Rates to 4.2% and 8.3%, respectively. The improvement was due to robust September gains of 906,000 in Household employment, which swamped the 575,000 increase in the Labor Force to drive unemployment rates down. Average Hourly Earnings rose 2.9% year-over-year (yoy), partially driven by the hurricane-related 111,000 employment decline in the leisure and hospitality sector, which tends to have lower paying jobs. Core inflation measures continued to decline, as August's Core Personal Consumption Expenditure Index fell to 1.29% yoy from May's 1.47% reading. Headline inflation - which can be more affected by weather and supply chain disruptions - was steady, as August's U.S. Consumer Price Index matched May's 1.9% yoy reading. Given the consistent strength in employment conditions and a noticeable lack of broad sector bubbles in the real economy, the risk of a near term recession is low.

Credit Markets - Credit spreads continued to tighten in a measured and seemingly unaltered path, illustrated by the option-adjusted spread of the BofA Merrill Lynch 1-5 Year AAA-A U.S. Corporate Index tightening from 60 basis points (bps) to 52 bps during the quarter. Almost every factor worked in credit's favor in the quarter; low market volatility, minimal headline risk events, muted negative rating activity and positive supply / demand dynamics all added to the market's overall risk-on bias.

*Corporate index outperformed the Treasury index by 6.6 bps in the quarter

Lower-rated credit benefitted the most from the market's risk-on mentality, with the BofA Merrill Lynch BBB corporate index outperforming the AAA-A index by 40.0 bps in the one- to three-year space.

*Long index outperformed the short index by 4.8 bps in the quarter

Over the entire third quarter, the short-term U.S. Treasury yield curve flattened, with two-year yields climbing 10.1 bps while five-year yields rose only 4.8 bps. However, yields actually fell across the short-term curve from July 1st through August 31st as concerns over declines in inflation measures lowered the probability of additional 2017 rate hikes. Stronger September economic data and more hawkish signals from the Federal Reserve (Fed) jumped two- and five-year Treasury yields 15.7 and 23.4 bps, respectively. In general, longer benchmarks slightly outperformed shorter benchmarks, as the benefits from a flattening yield curve and incremental coupon income overcame the negative impact of overall higher yields.

Monetary Policy - As expected, the Fed declined to raise its target rates at either the July 26th or September 20th meetings. At the September meeting, the Fed formally announced its plan to begin the wind-down of its balance sheet through the gradual reduction of principal re-investments of maturities and mortgage paydowns. The Fed will begin tapering its purchases by $10 billion per month in the fourth quarter and gradually increase the amount quarterly until reaching a maximum of $50 billion per month by the end of 2018. The policy adjustment had been previously signaled and anticipated, resulting in virtually no market reaction to the announcement. The Fed's September Dot Plot for future federal funds rate expectations indicated the Fed would raise rates 25 bps one more time in 2017 - the December 13th meeting being the most likely - with three additional 25 bp rate hikes in 2018. Investors believe the Fed will be less aggressive, with quarter-end fed funds futures indicating a 70% probability of a single 2017 rate hike and only one additional hike in 2018. The composition of the Federal Reserve Board of Governors is in flux, with Chairperson Janet Yellen's term expiring in January 2018 and four open seats after Vice-Chairman Stanley Fischer retires in October. The number of vacancies gives President Trump a unique opportunity to shape the Federal Reserve while also complicating investor forecasts for monetary policy.

Fiscal Policy - The Trump Administration reached an agreement with Congress - after unexpectedly agreeing to proposals from Democrats - which extended government funding through December 8th and raised the debt ceiling to the level of outstanding debt on that date. The legislation allows the U.S. Treasury to use extraordinary measures, which should push out the government's ability to borrow additional funds for four to six months depending upon the level of tax receipts in early 2018. The urgent need for hurricane relief for Texas, Florida and Puerto Rico was one of the political driving forces behind the surprisingly quick resolution to the funding and debt issues. The other key force was the Trump Administration's desire to focus on tax cuts and reform. The details of any potential tax plan are still unclear, although some key points include a 20% corporate tax rate offset by the elimination of various - and popular - tax deductions and the repatriation of foreign corporate profits. The uncertainty over the final form and scale of fiscal stimulus and the degree to which it is baked into current market asset prices leaves risk assets vulnerable should policymakers fail to reach a meaningful agreement.

What strategic moves were made and why?

Taxable Portfolios - USBAM continued to overweight credit and spread product in its strategies. Key factors - global economic growth, positive supply / demand dynamics, low volatility and strong bank fundamentals - remain supportive of credit and limit the potential for significant spread widening. Our overweight credit strategy includes allocating a greater portion of portfolio assets to credit vs. the benchmark, having a higher duration in credit vs. Treasuries and / or moving portfolio allocations toward investment policy limits. The strategy benefited portfolios, as credit spreads tightened on strong investor demand for income, adding price return to the incremental coupon income of credit. Benefits from our duration and yield curve strategies were more mixed. While interest rates rose during the quarter, which overall supports a short-duration strategy, the flattening of the yield curve aided the total return of a committed barbell strategy more than the bulleted structure which was closer to our bias. Both strategies were effective in positioning portfolios for re-investment at higher levels in a rising rate environment. Also, our short duration strategy was ineffective in the first two months of the quarter as interest rates fell on inflation, debt ceiling and hurricane concerns, before the strategy recovered with the sharp jump in yields in September.

Tax Exempt and Tax-Efficient Portfolios - Undeterred by the recent natural disasters and renewed chatter on the prospects for tax reform, municipal valuations continued to be well supported by favorable supply and demand dynamics. During the quarter, the front end of the municipal yield curve (one- to five-year maturities) reached the most pronounced levels vs. comparable-duration U.S. Treasuries with relative yields near 65% at times. In our view, variable rate demand notes (VRDNs) offered the best value for reinvestment needs and our allocations to these securities have increased significantly. We like VRDNs in what we suspect will be a rising rate environment, as muni seasonal factors begin to fade and the Fed continues to tighten policy. A flat yield curve with a mere ten to 15 bp difference in yield between a VRDN and a two-year, AA-rated muni only adds to our conviction that VRDNs will outperform over a longer horizon. Broad market municipal credit conditions remained fairly stable in the aftermath of the hurricanes. We saw no evidence of increased trading activity of either Florida or Texas bonds that would indicate concern from investors. This confidence is centered on the expectation that we will see a good response from insurance companies and federal and state governments in getting necessary funds to affected areas. As a general policy, we have preferred to avoid investing in smaller municipal issuers located within 20 miles of the coast as a way to minimize disruptions to client portfolios.

How are you planning on positioning portfolios going forward?

Taxable Portfolios - We expect the Fed will raise benchmark policy rates 25 bps at the December 13th meeting and look for two additional hikes in 2018. Consensus seems to be the Fed's gradual reduction in principal re-investment will - on the margin - push yield curve rates higher, an opinion we share. However, a balance sheet wind-down of this scale is unprecedented and we will remain watchful of the potential for increased volatility in all markets as monetary accommodation is removed. Taking these factors into account, we believe the short end of the yield curve - five years and in - will be higher by year end, leading us to continue our overall short duration strategy. The degree of "shortness" will be adjusted by individual portfolio duration limits, with shorter duration portfolios likely closer to benchmark durations than their longer duration counterparts. For all strategies, we will strive to position portfolios to more rapidly react to anticipated Fed tightening. LIBOR-based floating-rate notes, commercial paper and certificates of deposit will continue to play prominent roles in portfolio construction to accomplish this goal. Portfolios will remain biased toward a bullet structure, but we do understand market dynamics could flatten the yield curve further and will opportunistically add positions to move portfolios toward a barbell structure where appropriate. Based on a solid economy and reasonably quiet credit market conditions, our overweight to credit and spread product will continue in the coming quarter, although the strategy could evolve as the cumulative tightening of credit spreads has reduced the potential for incremental price gains on further tightening. We continue to believe the banking sector offers greater return opportunities than industrials on higher absolute spreads and yields, lower event risk and strong balance sheet fundamentals. While we always strive to maximize participation in the new-issue debt markets whenever possible, the relative lack of product and tighter spreads seen in the secondary market make this tactic even more beneficial in the current environment.

Tax Exempt and Tax-Efficient Portfolios - We are not locked in to an ultra-short duration strategy; however, any alterations to this mindset would likely require a substantial change in municipal market conditions and / or reduced expectations for Fed tightening into 2018. Our allocations to VRDNs provide us with a great deal of flexibility to make adjustments. We anticipate less pressure on municipal front-end yields in the coming quarter, as new issue supply becomes more of a net positive against reinvestment demand. This may present us with more compelling opportunities to add fixed-rate securities and extend portfolio durations. In the meantime, we feel the incremental yield available from longer investments is not worth pursuing. For tax efficient accounts, we will likely continue to prefer corporate securities based on higher current yields. We also see value in reducing the potential impact on this taxable equivalent calculation from significant tax cuts should tax reform progress.

Barclay's, Municipal Market Update, October 6, 2017
Bureau of Labor Statistics, Databases, Tables & Calculators by Subject,
Federal Reserve, Addendum to the Policy Normalization Principles and Plans, as adopted effective June 13, 2017
Federal Reserve, Chair's FOMC Statement, September 20, 2017
Federal Reserve, Chair's FOMC Press Conference Projections Materials, September 20, 2017, (¬cprojtabl20170920.pdf)