“Told by an Idiot, Full of Sound and Fury, Signifying Nothing”…or Does It?
Strategic Income Outlook
April 2018
Written in 1606, Shakespeare’s words are just as relevant today. Tweets and eye-catching headlines dominate the news cycle and many conversations, but when you parse them for impactful content, you realize it’s mostly just white noise. Heated debates about whether the Federal Reserve (the Fed) will raise the fed funds rate three, four or more times this year, the constant bloviating by politicians, inflation fears, Twitter battles, grandstanding on North Korea, DACA or the belligerent posturing during the NAFTA negotiations have thus far caused mostly ephemeral reactions and carry no lasting economic impact – the final resolutions have generally been tamer than the brash and furious onsets. Despite these distractions, the economy continues to grow, and in general life goes on. Business leaders and many in government around the world get the joke and are acting rationally. Namely, they are controlling what they have the power to oversee and not focusing on what they cannot. Gross Domestic Product (GDP) growth is rising steadily and inflation is brewing but is not yet a danger. Tax cuts are feeding through the economy, and as the Fed hikes are pushing short-term interest rates higher, savers are finally earning a reasonable return on their cash. Investors would do well to ignore the false signals, tune out the noisy distortions of the facts and focus on what really matters.
As we pointed out in our January 2018 Outlook, the Fed is nonplussed about the causes of inflation and how to control it. Nonetheless, they have pumped the economy full of liquidity since the great financial crisis of 2008 in an attempt to prevent a further meltdown and to generate growth above their 2% target. Success is finally at hand, but rather than causing celebration it seems to have only engendered more hand wringing. As we mentioned last quarter, and our colleague, Eddy Vataru, highlighted on Osterweis.com, two statistical indicators the Fed utilizes – the Underlying Inflation Gauge (UIG) and the Fed Dot Plot – are both indicating continued growth. Heightened inflation often follows accelerating growth and since inflation is generally the single largest factor on the Fed’s watch list, given its dual mandate of stable prices and full employment, it bears further examination.
The widely followed Consumer Price Index (CPI) has risen 2.2% over the last twelve months, which is above the Fed’s annual inflation target rate of 2%. The UIG, which has some predictive elements in it, was 3.06% for February, an increase from the upwardly revised 3.01% seen in January. With both measures well above the 2% target, don’t be surprised if the Fed raises its inflation target! We are closely watching several factors that could contribute to a rising level of prices. One is transportation. Company after company has confirmed on year-end earnings calls that the rising cost of shipping goods to market is becoming a problem. Tougher regulations and a demographic shift away from trucking jobs have created a shortage of long-haul truck drivers in the U.S., and this has driven up costs. So far, companies have mostly absorbed this increase, but that can only last for so long. As they look to pass along these costs, their customers will have little recourse but to also pass them on to consumers in the form of higher prices.
Another dynamic that is raising some eyebrows is the rise in short-term financing costs, not only for corporations and banks but for all borrowers. The London Interbank Offered Rate (LIBOR), a proxy for short-term borrowing costs (which, according to Bloomberg, has about $350 trillion worth of loans and financial instruments tied to it), has been rising sharply. As the Fed continues to normalize short-term interest rates, this is to be expected. While it is not yet cited as a meaningful cost factor, it bears watching. For example, 90-day commercial paper (CP) rates have risen to levels not seen since late 2008, from a post crisis low of 0.06% in 2015 to the most recent reading of 2.21% as reported by the Fed. This measure is significant because commercial paper rates are also related to LIBOR and are the vehicle corporations and banks use to fund themselves in the short term.
The important question here is: What impact will this rise in short rates have on the cost of longer term funding? If the yield curve remains flat, then corporations and other borrowers, such as home buyers, will be fine. However, if longer term inflation expectations rise and the so-called term premium also rises, then we should see an increase in longer term rates as well. This is typically the precursor to a credit crunch caused by the Fed trying to slow the economy by raising rates more than the market will bear. If this is the outcome, longer dated investment-grade bonds, which closely track Treasury interest rates, could be at risk.
Full employment is the other Fed mandate, so we look at factors that may affect that as well. As companies raise prices to offset increased costs and profits grow, they are likely to increase wages. With the unemployment rate dropping (most recently 4.1% versus the cycle high of 10% in 2009), and tightening labor conditions, this is a real possibility. While the unemployment rate for millennials (aged 25-34) has not yet meaningfully dropped, it is starting to decline. We could see it follow the path of the 35 to 44-year cohort, where the unemployment rate has dropped from 4.1% to 3.1% over the past year. Another driver of rising consumption is household formation, especially when one looks at comparing those choosing to own vs. rent. Since mid-2015 we have seen a persistent reversal from renting to owning. As you know, this is a positive for spending and indicates heightened consumer confidence. If these trends continue, we should expect fuller employment, rising wages and higher consumption.
While the high yield market has in the past been a refuge from rising rates (but not from economic weakness), it could react a bit differently this time. As we have previously discussed, the long period of near zero interest rates has caused a general decline in the cost of borrowing. This has been a boon to lower-rated companies that fund in the high yield market. However, because of this, about 30% of that market now sports coupons below 6% with maturities over 5 years. This means that this cohort of bonds, which we have been mostly watching from the sidelines, carries more interest rate risk than in past cycles. As rates rise, these bonds will likely drop in price faster than bonds with higher, more typical coupons. As the 10-year Treasury yields have risen from 2.41% on 12/31/17 to 2.74% on 3/29/18, we have seen many of these recently issued longer-maturity bonds quoted well below their issue prices. More importantly, when companies need to come to market to raise capital or refinance existing debt, they will be facing higher costs to do so. It was nice while it lasted…
The Fed Dot Plot, to be read only with a large grain of salt given the Fed’s past forecasting prowess, represents the Fed governors’ estimate of where the fed funds rate will be in the future. It shows rates rising until they peak in 2020 and was revised slightly higher at their last meeting. While economic growth has been steadily improving, albeit at a slower pace than past recoveries, we are nowhere near overheating. This leaves us with the question: When and from what level will the party end? The Dots say 2020. Our friends at Cornerstone Macro* and others seem to agree with the Fed Dot Plot, and have also triangulated on 2020 as the peak of the cycle. Assuming they are correct, it appears that we will have a constructive backdrop for a few years. We feel that while having a base case for when to expect an economic peak is important, it will be equally important to know how it will end. Will it be a collapse of the pillars of our financial infrastructure like in 2008, or will it take another form? We will need to wait for a definitive answer.
Economic growth consists of a combination of higher output and rising productivity. The latter has been conspicuously absent in this cycle. While not a perfect gauge of future productivity, we have seen rising corporate sentiment in both private and government surveys. When we try to isolate why that is the case, obviously a better economy is one answer, but another may be gleaned from The Federal Register, which is a compendium of all government actions, including rule-making, both enacted and proposed by the Federal Government and its agencies. Our thanks to Nancy Lazar at Cornerstone Macro for pointing out the negative correlation between the number of pages in the Federal Register and U.S. non-farm productivity over time. When the number of pages of regulations was nearing its peak, productivity dropped and when the number of pages shrank, productivity grew. Under recent administrations, the Federal Register page count rose to the highest since 1960 at almost 100,000 pages! This may have been in part due to increased security measures following 9/11 and other factors, but in the past year this has dropped to just over 54,000 pages. While one cannot accurately tabulate the economic/financial cost of all these regulations, nor the benefit from less regulation, history would show that productivity should accelerate. This is yet another piece in the mosaic of a strengthening economic backdrop.
We would be remiss if we did not address the Tax Cuts and Jobs Act of 2017. According to Cornerstone Macro, the tax cuts and the recently-agreed-to U.S. budget are the largest late cycle fiscal stimulus ever. They estimate that this stimulus will add 1.2% to U.S. GDP in 2018 and 1.6% in 2019. We have already seen some large companies share some of their tax savings with their employees in the form of wage increases and one-time bonuses. Shareholders are also benefitting in the form of dividend increases and share buybacks, although the latter’s benefit can arguably be short-lived. Coincident with this increase in the return of capital to investors, companies are encouraged by measures in the bill to make capital investments, which were long-delayed after the financial crisis. The U.S. manufacturing capital stock is old, so investment in new equipment should be stimulative not only to manufacturers of such equipment, but also to the corporate bottom lines as productivity improvements take hold. In fact, the Philadelphia Federal Reserve Bank Future Capital Expenditures Diffusion Index is at highs not seen since the 1980s!
We believe there is enough evidence to support a growing economy for the next several years. Markets will likely be more volatile as the volume of the naysayers’ chorus rises to triple forte. Inflation is rising slowly enough that we can deal with it by absorbing some costs while passing some along. Rising wages should buffer that. Interest rates are normalizing on the short end of the yield curve, but so far haven’t caused much damage to longer rates. Corporate borrowing costs are rising, but so far not enough to imperil profitability. The duration of the Bloomberg Barclays U.S. Aggregate Index (a proxy for the investment grade market) is high, and rising interest rates, possibly combined with widening spreads, could create a headwind for longer dated bonds. The confluence of this “Sound and Fury” signifies to us that some changes in the investment climate are, in fact, afoot, necessitating cautious, disciplined investing. However, we welcome the opportunity that the rise in short-term rates has provided us to invest our cash in U.S. Treasury bills and 30-day commercial paper. It is always nice to find new areas of the market where we can earn a good risk-adjusted rate of return in higher quality assets while maintaining a defensive posture. In this slow growth economy, we continue to look for attractive investments in the high yield and convertible bond market and hope to continue to take advantage of any future bouts of volatility by putting capital to work prudently. We thank you for your continued faith in us and welcome any comments or questions that you may have.
Sincerely,
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Carl Kaufman Bradley Kane Craig Manchuck
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* Cornerstone Macro is an unaffiliated provider of financial research.
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Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
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The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance.
Philadelphia Federal Reserve Bank Future Capital Expenditures Diffusion Index forecasts the change in capital expenditures over the next six months for reporting manufacturing firms. The diffusion index is calculated by taking the percent reporting increases and subtracting the percentage reporting decreases.
The Bloomberg Barclays U.S. Aggregate Bond Index (BC Agg) is an unmanaged index that is widely regarded as a standard for measuring U.S. investment grade bond market performance. This index includes reinvestment of dividends and/or interest income. The index does not incur expenses and is not available for investment.
Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period.
Underlying Inflation Gauge (UIG) is a measure that captures sustained movements in inflation from information contained in a broad set of price, real activity, and financial data.
Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.
London Interbank Offered Rate (LIBOR) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. It serves as the first step to calculating interest rates on various loans throughout the world.
Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g., depreciation) and interest expense to pretax income.
Duration measures the sensitivity of a fixed income security's price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.
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© Osterweis Capital Management
© Osterweis Capital Management
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