Fixed Income Commentary
1st Quarter 2018
The U.S. economy expanded at a better than expected 2.9% pace in the fourth quarter to bring full year 2017 GDP growth to 2.6%. It’s now been close to nine years since the United States was last in a recession. Consumer spending and business investment drove the improvement in the fourth quarter. GDP growth for the historically slow first quarter is expected to be below 2.0%. The current economic expansion is on pace to become the longest on record.
Job creation slowed in the final month of the first quarter, but employment growth in the quarter remained strong overall. The three-month average gain of 204,000 was viewed as quite robust, with improvements in manufacturing employment helping to support job growth. The reported unemployment rate of 4.1% stayed the same throughout the quarter. Holding around this level helps provide some comfort to the Federal Reserve (Fed) and is in line with its preference for gradual improvement in the employment numbers.
The housing market reported mixed data during the quarter. New home sales showed some decline due in part to buyers rushing to complete purchases in the fourth quarter, motivated by expectations of reduced mortgage deductions related to tax reform. Housing starts data was more encouraging, as momentum started to build for further growth despite colder-than-average weather. Existing-home sales showed improvement even as inventory remains tight. Relatively low mortgage rates should continue to help support demand amid rising home prices.
The momentum for inflation is starting to build. For the first time in over a year Core-CPI (which excludes food and energy) is back above 2.0%. Part of the recent rise is due to an unusual drop in mobile-phone service costs causing less of a drag on the year-over-year Core-CPI number. The Fed’s preferred measure of inflation, core personal consumption expenditure (PCE), came in at 1.60% for February, still below the Fed’s target of 2.0%. While inflation may be below the Fed’s target for now, inflation expectations appear to be rising, pushing inflation closer to that target. Some upward pressure on inflation is developing from the shelter cost component of CPI.
Incoming Fed Chairman Jerome Powell demonstrated continuity with former Fed Chair Janet Yellen and raised the federal funds rate 25 basis points to its current 1.5%-1.75% target at the March 2018 meeting. This was the sixth-rate hike in this economic cycle. Economists expect a total of at least three rate hikes in 2018 as job growth continues and inflation remains stable. Fed balance sheet reduction operations continue.
Bond Market Update
Bond investors were confronted with volatility in the first quarter as the possibility of a trade war with China developed. Inflation made a gradual move upward and job growth continued, helping provide some calm to the bond market. The United States still has some of the highest interest rates among developed economies, resulting in steady investor demand from abroad.
U.S. Treasury rates moved higher across the yield curve over the first quarter. The 10-year Treasury yield moved to 2.74% from 2.41% at the beginning of the quarter. The Treasury yield curve has grown flatter as yields have risen more in the intermediate (i.e., 2- to 10-year Treasury) portion of the curve than the long end (i.e., 30-year Treasury). Short maturity Treasury yields have shown a significant increase over the last year with the 2-year yield finishing the quarter at 2.27%, a level not seen since the third quarter of 2008.
Returns were down across all major investment grade bond sectors in the first quarter. While negative, returns for Treasuries were still better than Corporates. Widening credit spreads (i.e., risk premiums over U.S. Treasury yields) along with rising interest rates led to losses in the Corporate bond sector. High Yield was not hit by the same degree of spread widening and was able to outperform investment grade Corporate bonds. Emerging Market bonds were negatively impacted by the Fed rate hike and finished the quarter down. The overall U.S. bond market return, as measured by the Bloomberg Barclays Aggregate Bond Index, decreased -1.46% in the first quarter.
Fixed Income Outlook
If the current economic expansion continues into the second half of 2019, as the consensus forecasts, it would mark the longest period of U.S. economic expansion, surpassing the period of growth that occurred in the 1990s. Possible trade wars and geopolitical instability could make it difficult to reach this milestone.
Further job growth improvement from the recent tax cuts is expected in the coming quarters. In addition, the unemployment rate has a chance of dipping below 4.0% in the coming quarters. Labor-market strength is expected to keep housing demand rising throughout 2018 as economic growth continues to accelerate. However, housing supply remains scarce and rising real estate prices may make affordability a growing issue. The inventory of existing homes for sale hit its lowest level on record at the end of 2017.
Inflation has been slowly reaccelerating, but it still has some room to move upward before the Fed becomes concerned. Barring a significant jump in inflation, the Fed is on pace for at least two more Fed funds rate hikes in 2018, with the next hike anticipated in June. As we enter the second quarter, the impact of fiscal stimulus will begin to be felt more by the economy. GDP growth should be above a 2.0% growth rate for the rest of the year.
Fixed income returns for the coming quarter are likely to be flat due to the threat of rising interest rates offsetting an expected slight improvement in spreads. Corporate health remains strong and improving manufacturing activity should help maintain spreads at current levels or tighter. In the past we have had long periods of time when spreads have moved in a narrow range (e.g., from April 2003 to October 2007). With companies reporting good earnings, in part due to the recently received tax break, we could see that pattern for most of this year. Emerging Market bonds will continue to face headwinds from the expected Fed funds rate hikes.
We did not see tighter spreads last quarter, but have a better chance of seeing them this quarter as some positive earnings momentum is anticipated in the second quarter. We plan to maintain our overweight allocation in corporate bonds, but will look at other sectors (MBS, Taxable Municipal bonds and ABS) when putting cash to work. Portfolio durations will be held slightly short to neutral relative to the corresponding benchmarks in anticipation of a slight pick-up in inflation and interest rates.