Cash Management Portfolios - June 30, 2018

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

While far from serene, financial market volatility fell in the second quarter vs. the tumultuous first quarter, with U.S. equity markets showing gains - highlighted by the NASDAQ's healthy 6.33% advance. Increased tensions with key trading partners impacted markets, mostly to the negative. The Federal Reserve (Fed) continued to normalize monetary policy through rate hikes and balance sheet reduction at a self-described gradual pace. Global markets were temporarily roiled by May's Italian elections, which saw anti-establishment / anti-European Union (EU) parties make strong gains in Parliament and forced investors to revisit EU debt and growth problems.

Economic Activity - In the second quarter, analysts forecast GDP growth in the 3 - 4% range driven by gains in business investment, government spending and consumer consumption. June's ISM Manufacturing and Non-Manufacturing readings of 60.2 and 59.1, respectively, remained high vs. historical levels, signaling continued economic strength and expansion. Employment conditions continued to improve, highlighted by Non-farm Payrolls adding 632,000 jobs in the quarter. June's 4.0% U3 Unemployment Rate was actually higher than May's 3.8% reading. Rather than being a sign of waning demand for labor, the jump was entirely attributable to June's big 601,000 increase in the labor force, a positive development signaling potentially higher labor slack in the economy. Average Hourly Earnings - an increasingly important market focal point for building inflation pressures - rose only 0.2% in June, a touch below analyst expectations. Inflation measures have essentially reached the Fed's 2% target, as May's Consumer Price Index reached 2.8%, while the Fed's favored inflation measure - the Core Personal Consumption Expenditure Index - was up 2.0% year-over-year (yoy). Given the consistent strength in ISM data and employment conditions, we feel the risk of recession remains low through 2019. Unexpectedly higher inflation, increased debt levels in the system and an overly-aggressive Fed are the principal threats to sustained growth and equity valuations.

Credit Markets - In line with the lower volatility in most risk assets, credit spread movement was relatively well contained in the quarter. After jumping 61.7 basis points (bps) in the first quarter, three-month LIBOR ended the second quarter at 2.336%, a mere 2.4 bps higher than March's final 2.312% reading. The tempering of LIBOR movement implies bank funding demand has stabilized and the market has seemingly absorbed the double-barrel disruption of tax code changes and the massive increase in T-bill issuance.

Credit Spread Changes

Corporate Credit Relative Performance

Corporate credit and spread product outperformed comparable-duration Treasuries in the quarter. The relative stability of spreads allowed lower-quality debt to outperform higher-quality issuers, primarily on its embedded coupon income advantage. Headline risk in the form of mergers and acquisitions impacted large issuers including AT&T, Disney and Comcast. Ratings actions remained rather muted, with issuer downgrades generally restricted to one notch. Year-to-date (YTD) through May, there has been $555.4 billion in investment-grade corporate debt issuance, a decline of 14.8% from 2017 levels.

Yield Curve Shift

Duration Relative Performance

U.S. Treasury yields rose across the curve in the quarter, allowing short-duration strategies to outperform their longer-term counterparts. The continued move upward in rates was not unexpected given the June Fed rate hike and growing anticipation for two additional hikes in 2018. The yield curve flattened in the quarter, as the Fed-induced increase in short-term rates outpaced the rise in longer-term rates, which tend to move more on overall growth and inflation outlooks.

Monetary Policy - As expected, at the June 13th meeting the Fed raised the target range for the federal funds (fed funds) rate 25 bps to 1.75% - 2.00%. The Fed raised the Interest on Excess Reserves (IOER) only 20 bps in an effort to push the fed funds effective rate lower in the target range. In addition, the Fed Dot Plot raised expectations for a total of four 2018 rate hikes vs. March's projection of three. The Fed remains upbeat on employment conditions in the medium term, forecasting a 3.5% U3 Unemployment Rate for 2019 and 2020 - far below the expected longer run rate of 4.5%. Core PCE Inflation is projected to increase 2.1% in 2019 and 2020, reflecting the Fed's confidence in meeting its 2% longer run goal while downplaying the risk of meaningfully higher inflation. In an effort to increase transparency into the Fed's decision-making process, Chairman Powell announced he will be holding a press conference after every Fed meeting rather than the current every-other meeting pace. The change would also give the Fed greater flexibility to accelerate the pace of policy normalization, although the Fed retained language in the June 13th statement stating it expects "further gradual increases" in the fed funds rate - which the market has interpreted as maintaining the current pace of every other meeting. The Fed continued to taper principal re-investments of maturities and mortgage pay downs in its portfolio with a second quarter cap of $30 billion per month, growing to $40 billion per month next quarter. Since the Fed's balance sheet reduction program began, "securities held outright" and "reserve balances" have fallen $138.4B and $237.9B, respectively, since September 27, 2017.

Fiscal Policy - The Trump Administration aggressively pursued revised trade agreements through both enacting and threatening large scale tariffs on key trade partners including China, Canada, Mexico and the EU. Recent U.S. tariffs include 25% on steel imports, 10% on aluminum imports, a 25% tariff on $50 billion in certain Chinese imports, a proposed but yet to be implemented tariff on an additional $200 billion in Chinese imports and a 25% tariff on car imports from the EU. President Trump clearly believes tariffs are an effective tool to bring trade partners to the negotiating table and that the potential impact on GDP growth (estimated to be -0.25%) and inflation (estimated to be +0.20%) is relatively small. Financial markets and risk assets have been increasingly influenced by trade war headlines - both U.S. proposals and the in-kind retaliation. Recent corporate tax reductions continued to work their way through the economy and financial markets, supporting equity markets with higher expected after-tax returns and impacting corporate capital flows, including new issuance.

What strategic moves were made and why?

Taxable Portfolios - Stability in credit markets positively impacted USBAM's strategy of focusing on coupon income through higher allocations to credit and spread product. On the margin, increased trade tensions with Canada have sent credit spreads wider on Canadian bank debt - a significant sector focus in our portfolio construction. Market liquidity was solid as the pressure from the influx of early 2018 investment-grade secondary market sales abated. Quarterly absolute portfolio performance was negatively impacted by the general rise in rates across the short-term yield curve. On a relative basis, our short to benchmark duration strategy was a positive driver of performance in the quarter. Overnight to three-month commercial paper, certificates of deposit and agency discount notes offered competitive yields as a store of liquidity for anticipated higher-yielding extension trades. Targeting maturities on these instruments around the Fed's June 13th meeting was particularly effective in repricing portfolio book yield higher.

Tax Exempt and Tax-Efficient Portfolios - Market conditions remained supportive of muni bond prices as new issue supply continued to come in well behind last year's pace (-20% YTD). Most of the decline in issuance (-61% YTD vs. 2017) was attributable to fewer refunding deals, which lost their access to the tax-exempt market following the recent tax reform legislation. We have not been aggressive buyers of muni securities in this rich environment. Variable-Rate Demand Notes (VRDNs) have been used for liquidity and cash management purposes and we have also captured some value with taxable munis at yields in excess of 2.50%. For tax efficient accounts, we continued to increase allocations to the corporate bond sector which offered the best yields on an after-tax basis. Portfolio durations were kept short, as we expect interest rates will continue to increase over the coming quarters.

How are you planning on positioning portfolios going forward?

Taxable Portfolios - While market consensus argues the U.S. economy is in the late stages of the market cycle, the sentiment is likely driven more by the extended life of the expansion rather than the likelihood of an imminent slump. In general, corporate and consumer credit conditions should benefit from stronger GDP growth, increased after-tax cash flows resulting from tax reform and high demand for labor. Headline risk remains an ever-present threat for investment-grade non-financials, but we feel the threat is to spread levels and public ratings rather than to principal. Given this outlook, we will continue to focus on generating higher coupon income through elevated exposure to credit. We continue to favor securities maturing in less than two years given the relative flatness of the yield curve. Overall, the banking sector offers greater return opportunities than industrials on higher absolute spreads, lower event risk and strong balance sheet fundamentals. Regarding the yield curve, we remain wary of forecasts for an aggressive path of Fed tightening and feel the ultimate pace and magnitude of future hikes will be lower than Fed projections and more hardline street forecasts. With the Fed Dot Plot forecasting two additional rate hikes in 2018 - likely in September and December - we anticipate very short yield curve rates will be higher at the end of 2018. Over time, the yield curve should flatten further, as skepticism over aggressive Fed policy projections and muted increases in inflation mean longer rates should not rise at the same tempo as Fed rate hikes. Given our outlook, we will continue to be short duration to benchmarks and migrate toward a more bulleted portfolio structure, increasing our ability to re-invest portfolio cash flows into higher-yielding instruments. A limiting factor to portfolio construction and re-balancing is the jump in yields, which has created unrealized losses for most legacy fixed-rate positions. For portfolios with sensitivity to realized losses, maturities and other cash flows are the best options for re-balancing portfolios, which can limit the scale of any adjustments, particularly in duration management.

Tax Exempt and Tax-Efficient Portfolios - We do not expect to make any significant changes in strategy, as many of the recent market themes should remain in place. Municipal market technical factors should be especially strong in July and August, as net-negative issuance is forecasted. Treasury yields, however, are likely to continue grinding higher as further Fed moves are priced in. Economic data are supportive of gradual rate hikes and have solidified our own views on Fed policy as the year evolves. Municipal VRDNs are likely to see lower resets next quarter due to limited supply; however, variable-rate exposure will still be a significant component of tax-efficient portfolios, either through taxable VRDNs or corporate floating-rate notes. Taxable municipals and corporate bonds will be part of the recipe for extension trades. We will strive to take advantage of the higher yields to increase book yields, while keeping overall durations on the shorter side.





Federal Reserve Statistical Release, June 28, 2018

FOMC Press Release, June 13, 2018