Strong Momentum for Growth in Q3
- After muted first quarter growth of 2.2%, the U.S. economy grew at an accelerated pace of 4.2% in 2Q18. Growth during the quarter was marked by a strong rebound in personal consumption growth.
- Consumer driven momentum continued during the quarter. Control Group Retail Sales rose 0.8% and 0.1% m/m in July and August respectively, and confidence surveys remain at or near historic highs.
- Business activity also continues to expand, with the ISM Economy Weighted Index increasing from 56.0 in July to 61.4 in September, marking a multi-decade high point.
- The Atlanta Fed’s GDPNow forecast for GDP growth in the third quarter stands at 4.1% (as of 10/1/18).
Trade Tensions Continue as Mid-Term Elections Near
- As the Trump administration escalated the trade war with China throughout the quarter, developed and emerging market economies continued to lag the U.S., as evidenced by year-to-date equity and currency returns.
- In September, the U.S. initiated a 10% tariff on $200 billion of Chinese goods that will increase to 25% by year-end, and indicated that it could implement tariffs on another $267 billion of goods in the event China continues to retaliate.
- On a positive note, the U.S., Canada, and Mexico have announced a new trade agreement, the United States-Mexico-Canada Agreement (USMCA), which primarily impacts issues in the auto, labor, intellectual property, and agriculture markets.
Fed Raises in September and Stays on Course for 4th Hike in 2018
- The Fed raised its policy rate during the quarter via a single 25 bps hike at its September meeting. The policy rate now stands at a range of 2.00% to 2.25%.
- Policymakers continue to react to the strong incoming data, signaling their intent to stay the course with an additional rate increase in the fourth quarter. The Fed’s official statement removed the phrase “policy remains accommodative,” indicating policy is moving to a more neutral stance.
- Looking ahead, the market is pricing in two rate hikes in 2019, while the median of FOMC members’ official projections still calls for a high-water mark for the Fed Funds rate of 3.4% by the end of 2020.
Continued Strong Labor Market and Near Target Inflation
- Headline inflation readings have measured in the 2.7% to 2.9% range since early this spring; more importantly, core inflation measures (ex food and energy) have remained between 2.2% and 2.4% during the same timeframe.
- Notably, the Fed’s preferred inflation gauge, the Personal Consumption Expenditures Core Price Index (Core PCE) has struggled to reach/remain at the Fed’s target level of 2.0%.
- Job creation remained robust during the quarter, adding 165k, 270k, and 134k jobs in July, August, and September respectively. The September unemployment rate reached a near-50 year low at 3.7%.
- Average hourly earnings rose 2.8% y/y in September, a slight decrease from the 2.9% y/y post-crisis high in August, largely due to base effects.
Interest Rates Continue Upward Trend on Fed Hike, Growth Expectations – Spread Sectors Outperform
- The Fed unanimously raised its policy rate during the quarter via a single 25 bps hike at its September meeting. Policymakers continue to react to the strong incoming data, signaling their intent to stay the course with an additional rate increase in the fourth quarter.
- Interest rates rose modestly across the yield curve, with shorter maturities rising 25-30 bps and longer rates increasing around 20 bps, resulting in continued curve flattening over the quarter.
- Spread sectors generally outperformed Treasuries over the quarter, led by high yield and investment grade corporate bonds. As such, IG corporates reversed last quarter’s poor performance. September new issue volume of $140 billion (SIFMA data) was the strongest month year-to-date and M&A-related activity continued during the quarter. Intermediate corporate bonds outperformed similar-duration Treasuries by 96 bps, while long corporates outperformed Treasuries by 328 bps. BBBs and crossovers outperformed AA/A rated bonds.
- Agency MBS posted 17 bps of excess return vs. U.S. Treasuries during the quarter, similar to the previous quarter. Net Agency MBS supply remains fairly benign and interest rate volatility has once again ground down to an all-time low level, but shifting demand dynamics as the Fed reduces/stops purchases could be problematic for Agency MBS spreads.
- ABS outperformed similar-duration Treasuries by 31 bps over the third quarter, supported by continued tightening of short swap spreads (10-15 bps year-to-date). Auto ABS returns slightly outpaced credit card receivables during the quarter.
- After posting flat excess returns last quarter, CMBS generated a whopping 77 bps of excess return during the third quarter. Single Asset/Single Borrower (SASB) deals continue to make up a larger share of supply than in years past. Commercial real estate values remain stretched versus year-over-year NOI growth that has slowed. Commercial property values are now ~26% higher than the 2007 peak.
Corporate Bonds Outperform, Retrace 2Q Widening
- The Bloomberg Barclays U.S. Corporate Investment Grade index returned 0.97% over the third quarter of 2018, outperforming similar-duration U.S. Treasuries by 169 bps.
- Long corporates posted the strongest excess returns for the quarter, outperforming like duration Treasuries by 328 bps. Year-to-date, however, longer maturities have underperformed by 84 bps. Shorter corporates (1-3 year and 3-5 year maturities) have posted positive excess returns for the quarter and year-to-date.
- During the quarter, Communications, Energy, and Transportation were among the strongest performers, while Natural Gas Utilities, Finance Companies, and Other Industrials were among the weakest. BBBs and crossovers outperformed AA/A rated issuers for the quarter.
- The option-adjusted spread (OAS) of the IG Corporate index tightened 17 bps during the quarter, to 106 bps over Treasuries, retracing the widening of the previous quarter.
September New Issue Strongest YTD; Issuance Remains Down vs. 2017
- September new issue volume of $140 billion (SIFMA data) was the strongest month year-to-date. M&A-related activity continued in the third quarter, with two deals of particular note. Cigna issued $20 billion in September (acquiring Express Scripts) and in August, United Technologies issued $11 billion (acquiring Rockwell Collins).
- Investment grade new issuance totaled $277 billion in the third quarter, according to SIFMA. 2018 year-to-date total new issue volume of $939 billion is approximately14% below 2017 year-to-date new issue volume.
Net Agency MBS Supply Remains Muted but Changing Demand Dynamics Ahead
- The Bloomberg Barclays MBS index outperformed similar duration Treasuries by 17 bps during the third quarter. After a lackluster start to the year, Agency MBS have had two strong quarters of positive excess returns.
- Net Agency MBS supply remains fairly benign ($165 billion year-to-date through August, ~80% of August 2017 year-to-date), but shifting demand dynamics as the Fed reduces/stops purchases could be problematic for Agency MBS spreads. On the flipside, after spiking briefly earlier in the year, interest rate volatility has once again ground down to an all-time low level: low interest rate volatility bodes well for Agency MBS returns.
- 30-year fixed mortgage rates, as measured by the Freddie Mac Weekly Survey Rate, ended September at 4.72%; the highest since April 2011. Coupled with home prices that have increased at an annualized rate of 6% for the last five years and that have cumulatively surpassed pre-crisis highs, higher mortgage rates are making housing less affordable.
Tighter Swap Spreads Aid ABS Returns; CMBS New Issue Still Dominated by SASB Deals
- The Bloomberg Barclays ABS index outperformed Treasuries by 31 bps over the quarter, supported by continued tightening of short swap spreads (10-15 bps year-to-date). At ~$166 billion, ABS new issue supply remains flat year-to-date with 2017.
- The Bloomberg Barclays CMBS index generated a whopping 77 bps of excess return during the third quarter. At ~$60 billion year-to-date, CMBS primary supply remains flat with 2017. Single Asset/Single Borrower (SASB) deals continue to make up a larger share of supply than in years past.
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.