Our Insights

December 31, 2017 — Market Insights
Market Review

U.S. Economy Shrugs off Hurricane Disruption to Post Strong GDP growth in Q3

  • U.S. GDP growth advanced by +3.2% in 3Q17, posting a second consecutive quarter of above 3% growth.
  • Growth during the quarter was driven by solid personal consumption, business investment and exports.
  • Employers added an average of 204,000 jobs per month over the quarter, bouncing back from hurricane-related disruptions in Q3. The unemployment rate fell to 4.1%
  • The Institute for Supply Management's (ISM) survey of manufacturing activity rose to 59.7 in December. Meanwhile, the ISM services index fell back to 55.9 from readings near 60 last quarter.

Tax Reform, Stronger Global Growth Spur Business Investment

  • Republicans passed significant tax cut legislation at the end of 2017. The tax cut package slashes the corporate income tax rate to 21% from 34% and provides for more modest cuts at the individual level
  • Global growth indicators point to a continuation of above-trend growth in U.S., Europe, and developed Asia. JPMorgan/Markit's global composite of purchasing manager indices (Global Composite PMI) rose to 54.4 in December.
  • The tight labor market, strong growth outlook, and expectations for tax cuts all spurred a rebound in business investment. Business investment in equipment rose at a +10.8% annualized pace over Q3, contributing nearly +0.6 pts to overall GDP during the quarter.

Fed Raises Policy Rate in December, Yield Curve Flattens Further

  • The Fed raised its policy rate by 25 bps at its December meeting, bringing its policy rate to a range of 1.25% to 1.50%. Policymakers' median forecasts for the policy rate calls for three more hikes in 2018.
  • Fed officials' median estimate of GDP growth in 2018 rose to 2.5% in December from 2.1% at the September meeting. Officials saw the unemployment rate declining to 3.9% over 2018, down from 4.1% in September.
  • Market reaction to the rate hike was muted. Over the quarter, front-end interest rates rose to price-in the hike, while yields on intermediate maturities were less affected. At the long-end (30-year maturity) yields actually declined, resulting in a significant flattening of the yield curve.

Inflation May Hold the Key to Fed Rate Path in 2018

  • Monthly readings for core consumer price inflation have rebounded from the first half of 2017, when declines in wireless phone services, used car prices and certain healthcare services contributed to a significant decline in the year-over-year figures.
  • The breakeven inflation level priced into 10-year TIPS rose sharply during the quarter, reaching 2.0% at the end of December from as low as 1.7% in June.
  • With the U.S. economy at full employment, we believe that inflation readings are likely to be more important than the pace of incremental job gains or rate of GDP growth in terms of the Fed's rate hike decisions this year.

Short-end Rates rise with Fed Hike, Corporates and CMBS Lead Spread Sector Rally

  • The Fed hiked its policy rate by 25 bps in December, to a range of 1.25% to 1.50%. FOMC participant forecasts showed policymakers anticipate three more hikes in 2018.
  • The two-year Treasury note yield rose 40 bps over the quarter, finishing at 1.89%, while the 30-year T-Bond yield declined by 12 bps, closing the quarter at 2.74%
  • The breakeven inflation level priced into TIPS rose during the quarter; 10-year TIPS breakevens rose 13 bps to the end of the quarter at 1.98%.
  • The market shrugged off the start of the Fed's balance sheet runoff plan, which commenced in October and will gradually ramp-up over the coming year.
  • Volatility remained near multi-year lows during the quarter as stocks continued climbing to new records and longer-term interest rates remained largely range-bound.
  • Investment grade corporate bonds outperformed U.S. Treasuries (+99 bps of excess returns). Lower quality (BBB, HY) outperformed higher quality (AA, A), while longer maturities outperformed shorter maturities. Industrial and utility names generally outperformed financials during the quarter.
  • Agency MBS posted decent excess returns during the quarter (+24 bps) as interest rate volatility remained benign. Within the 30-year segment of the market, Ginnie Mae MBS underperformed Conventional MBS (Fannie/Freddie) as faster prepayments and supply concerns have weighed on Ginnie collateral.
  • ABS posted modest excess returns for the quarter (+24 bps) as front-end swap spreads fell and new issue pricing remained firm. As a high quality alternative to corporates, CMBS benefited from the continued rally in credit spreads during the quarter. Non-agency CMBS posted +86 bps of excess returns vs. U.S. Treasuries during the quarter and +187 bps for the full year.

Goldilocks Moment for Credit Continues

  • The Bloomberg Barclays U.S. Corporate Investment Grade index returned +1.17% over the final quarter of 2017, outperforming similar-duration U.S. Treasuries by 99 bps. Over the full year, the index returned +6.42%, outpacing Treasuries by 346 bps.
  • The Republican tax package, which features a signficant cut to the corporate tax rate and provisions for immediate expensing of capital expenditures, boosted investors' outlook for corporate earnings and improved credit fundamentals.
  • During the quarter, energy, metals and mining, railroad issuers outperformed on a pickup in economic activity and firmer commodity prices. On the negative side, pharmaceuticals, healthcare and consumer products names lagged during the quarter.
  • The option-adjusted spread (OAS) of the IG Corporate index finished the quarter at +93 bps to Treasuries, making a new post-crisis low. The index's OAS remains 16 bps above the all-time tight level of +77 bps (Feb 2005).

Corporate Issuance Sets Another Record in 2017

  • Investment grade new issuance totaled $250 billion in Q4, according to SIFMA. Full-year issuance of $1.35 trillion was enough to set another record year (6th consecutive record).
  • Market expectations call for somewhat lower supply in 2018, although M&A activity could lead to higher-than-expected issuance volume.

Ginnie Mae Underperformance Weights on MBS Sector Returns

  • The Bloomberg Barclays MBS index returned +0.15% over 4Q17, outperforming similar duration Treasuries by 24 bps. For the full year, the index posted a total return of +2.47%, outperforming Treasuries by 52 bps.
  • Ginnie Mae 30-year collateral, which makes up ~28% of the overall index, posted negative excess return of -11 bps for the full year, while 30-yr Conventional MBS (Fannie Mae and Freddie Mac programs) had excess returns of +86 bps for 2017. Ginnie Mae collateral underperformed due to faster-than-expected prepayment speeds and excess supply concerns.
  • Despite a series of rate hikes by the Fed this year, 30-year mortgage rates remain low. The Freddie Mac Weekly Survey Rate of 30-year mortgate rates finished the year at 3.99%, 33 bps lower than where it started the year. Housing demand remains strong, and housing inventory remains tight.

ABS Sees Strong Supply, CMBS Conduit Issuance Flat in 2017

  • ABS new issue supply in 2017 was robust at over $220 billion, a 34$ increase over 2016's supply levels. Equipment Trust and Credit Card ABS supply posted the strongest year-over-year increases in supply.
  • CMBS new supply for 2017 was $87 billion, representing a 25% increase over 2016's level. Conduit issuance was flat with 2016, while the volume of single-asset/single-borrower transactions rose significantly in 2017.

The information contained herein reflects the views of Galliard Capital Management, Inc. & sources believed to be reliable by Galliard as of the date of publication. The views expressed here may change at any time subsequent to the date of publication. This publication is for informational purposes only. For institutional investor use only.