AAM Viewpoints: The magnitude of the fourth quarter
Fixed Income Market Performance
The return of volatility was the hallmark of the fourth quarter (Q4) as equity and fixed income markets were buffeted by mid-term election results, international trade politics, central banking activity, and uncertain domestic and global economic activity. As mentioned in our last commentary, investment grade and high yield fixed income markets experienced a resurgence of performance in the third quarter (Q3) as investors’ appetite for credit and duration risk rebounded. As a result, by the end of Q3, most high-yield fixed income indices had positive year to date returns. Q4 changed the performance landscape entirely.
While experiencing periodic spikes early in the year, U.S. Treasury volume averaged 5.03% higher than 2017 throughout the first three quarters of 2018. The dramatic aversion to risk assets in Q4 drove U.S. Treasury volume to be nearly 20% higher than the same quarter of 2017 with annual volume ending 8.44% higher. As a result, the ICE BofAML U.S. Treasury Index finished the year with 0.80% return, the only broad taxable bond sector to finish the year with positive performance.
Illustrating the rout experienced by fixed income markets in December, it is worth noting that the benchmark U.S. 10-year Treasury experienced only a 6bps (basis point) move from October 1 through November 30 while the 2-year Treasury fell by a mere 4bps. During this period, the S&P 500 Index had given up just over -5% but remained positive on a year-to-date basis. Overall, the flight to quality in the broad fixed income markets during the first two months of Q4 was not unlike that experienced earlier in the year. The ICE BofAML A-AAA Index fell -1.12% in October while the broad High Yield Index fell only -1.64% during the same month. However, risk aversion was becoming clear as CCC and lower rated credits gave up 281bps of performance in October alone. CCC rated credits alone would give up another 792bps of return in November and December as the flight from credit continued in earnest across both high yield and lower investment grade credits. As previously stated, only the broad U.S. Treasury Index finished the year with positive performance at 0.80%. The risk and duration recovery seen in Q3 had evaporate completely by year end.
Source: ICE BofA ML
Throughout this expansion, markets have witnessed periods of spread widening which affects lower rated credits more drastically than higher rated credits. However, while we notice that spreads have widened from 10-year lows, we remain cognizant of history and feel the markets capitulation in the final months of the year are notable but not yet alarming. Broad High Yield spreads ended 2018 at 533bps, their widest levels since 2016. For some time, we have opined that in their quest for yield, investors may not be adequately compensated for the credit risks which they have been assuming in some sectors of the high yield market. As a result of the rampant risk aversion in Q4, and the improvement in compensation for credit risk it caused, we feel there may be selected value to be found in some high yield sectors.
Source: ICE BofA ML
While there are some indicators in the economy which seem to point that we may be in the final innings of the current expansion, we do not favor making wholesale changes based upon single metrics. In and of themselves, spread levels provide little evidence of how near the economy is to the end of an expansion. The most recent spread widening may have corrected some of the disconnect between credit risk and yield which we have discussed in prior quarters.
Domestic Economic Activity
Though revised slightly lower in November, Q3 Gross Domestic Product (GDP) grew at a 3.40% annualized rate over the second quarter (Q2). The bulk of the improvement over Q2 was driven by continued strength from the U.S. consumer and, as expected, inventory rebounding from non-existent Q2 levels. The personal consumption figures from Q3 were on the heels of a robust Q2 and continued labor market improvements, coupled with improvements in average hourly earnings, likely drove some consumption strength into Q4. However, equity and fixed income market volatility in the last quarter of the year may have tempered consumption somewhat. While personal consumption accounts for nearly 67% of GDP, net import/exports (NetEx) usually provides a slightly negative contribution to quarterly growth. However, during Q3 NetEx contribution to GDP fell to its level since 1984 as a likely result of ongoing strength in the U.S. dollar. Continued trade issues with robust dollar strength may continue to present challenges to broad domestic growth as exports continued to suffer during Q4.
We remain optimistic about personal consumption but also remain concerned about developments in cyclically sensitive sectors of the economy. While a slower pace of rate increases by the FOMC (Federal Open Market Committee) may moderate some of our concerns, cyclically sensitive sectors such as housing and auto sales are being watched carefully. Auto sales recovered much of their lost ground during Q4, ending December at a 17.50 million annualized rate while November new home sales fell to their lowest level since 2016. There are some expectations that because of inventory levels as high as they have been since 2011, a moderate move lower in prices could result in the first quarter (Q1) of 2019. However, more attractive home pricing with a less hawkish FOMC may drive some recovery in home sales in the first part of 2019. The market volatility in Q4 is unlikely to assuage our concerns about housing as volatility is not friendly to cyclically sensitive consumption but we will continue to monitor developments in the housing market as we move into 2019 carefully because, “as goes housing, so goes the consumer.”
Domestic Labor Markets
Labor markets continued to build upon the strength seen throughout the year. In January we learned that 312,000 jobs were added in December and positive revisions to prior months were enough to keep the yearly average above 208,000 per month. The recovery in goods-related employment which began in 2017 continued in earnest throughout 2018. Labor market strength in both services-related and goods-related employment sectors clearly drove nominal wage improvements throughout the year as well. As mentioned in earlier commentary, the continued strength of hiring in these specific sectors continued to drive some expectations of mounting wage pressures. As a result, for the first time since 2009, year-over-year wage growth climbed above 3.00%. Combine this labor market strength with the expected taper of inflationary pressures in the final quarter of the year and real wages climbed 1% over the same time last year.
Source: Bureau of Labor Statistics
Interest Rates, Inflation and the Federal Open Market Committee
Near-term bias at the short end the Treasury curve continued to grind the 10-year/2-year curve narrower during Q4. As mentioned earlier, the flight to quality trade during Q4 trimmed performance from all broad fixed income sectors except Treasuries. However, the overall effect of this volatility was that fixed income assets moved into both the short- and long-end of the Treasury curve. At the start of Q4 the 10-year U.S. Treasury was yielding 3.06% and fell below the psychological barrier of 3% after Thanksgiving. The 2-year bond during this period continued to ruminate the possibility that the FOMC was moderating its approach to raising rates. With early quarter comments from FOMC Chair Powell that the United States was likely “some ways away from neutral (rate),” the short-end of the market continued to price in perhaps one more increase at the December meeting, but a much more dovish FOMC moving forward.
However, on November 28, Chair Powell’s speech to the Economic Club of New York clearly caught the markets flat footed as he reversed course saying that while rates are low by historic standards they are just below neutral. This was quite a reversal in posture from his early quarter comments and while they could be implied as being dovish, these comments also clearly suggested that policy was tighter than expected. Markets do not like inconsistency as much as they do not like uncertainty. As a result, spreads between 10s/2s narrowed to 12bps within the next week led by sharp declines in both term premium and inflation expectations.
As expected, core inflationary pressures moderated in Q4 though the FOMC remained unexpectedly hawkish at their final meeting of the year in December. Personal Consumption Expenditures Deflator grew at 1.80% over the prior year in December, its lowest rate since February while 5-year breakevens fell to 1.84% after averaging 2.18% through the end of Q3. While December’s FOMC meeting produced an expected 25bps rate hike, what wasn’t expected was the continued hawkish tone of the statement and Chair Powell’s lack of candor at the post meeting press conference. These mixed messages, combined with global economic uncertainty, drove the market to assume the FOMC may have made a mistake.
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.
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