Download march 2017 market commentary economic update

 MARCH 2017 MARKET COMMENTARY
ECONOMIC UPDATE
March 6, 2017
INVESTMENT MANAGEMENT GROUP
[email protected]
800-752-4628
Robert Perry
Principal, ALM & Investment Strategy
214-451-2432
[email protected]
Jason Haley
Managing Director, IMG
214-451-2395
[email protected]
Hafizan Hamzah
Director, IMG
214-451-2427
[email protected]
Ryan Bridges
Associate, IMG
214-451-3922
[email protected]
Chris Eckhoff
Senior Analyst, IMG
214-373-3481
[email protected]
The political realm has monopolized the recent headlines from a
financial markets perspective, particularly as it relates to the success of
anti-establishment movements and the potential for significant policy
changes. In the last 12 months, we’ve seen a successful Brexit vote
and a Donald Trump victory; and in France, the anti-establishment Le
Pen campaign is gaining momentum. All of these events present some
degree of uncertainty as it relates to future economic growth and
financial market stability. That said, monetary policy returned to the
forefront in the last week of February, with even the most dovish Fed
leaders publically stating that a March rate hike was a likely outcome.
Prior to these statements, the markets were pricing just a 25%
probability of such an action. In this economic overview, we will discuss
tax reform proposals, the recent data trend, and the current tone from
the Fed.
U.S. Tax Reform
President Trump made many promises on the campaign trail, and his
administration seems motivated to move forward on many fronts,
regardless of how ambitious the agenda may appear. The financial
markets have been more concerned with tax reform, deregulation, and
infrastructure spending, but there have been seemingly few details on
each policy item. Additionally, the White House’s initial focus on
controversial immigration issues left some market participants
concerned that the aforementioned “big three” would be delayed
indefinitely. However, President Trump’s address before Congress on
February 28 appeared to reassure market participants that these issues
were still very much a priority for the administration.
One particular issue investors have been keenly focused on is U.S. tax reform, both corporate and individual.
After reviewing the current drafts from Republican leaders, one commentator suggested that the proposed tax
reforms would be far more comprehensive than those passed during the Reagan administration, and any
substantial changes to U.S. tax policies could have far reaching implications for the global economy/markets,
particularly as it relates to trade policies and currency valuations. As such, there would likely be counter
measures enacted by other countries. Of course, the key word in all of this is “proposed.” What actually passes
Congress may be a mere shell of the current Republican framework. That said, as it relates to the primary
objective of tax reforms, all parties involved seem to be united in saying job creation, but the devil is always in
the details.
The most contentious item within the current tax reform proposed by House Republicans is the inclusion of a
border-adjustment tax (BAT), which President Trump has publically criticized (he’s not alone). The significant
tax reforms proposed would deeply cut the government’s aggregate tax revenue, depending on how the impact
is scored (“static vs. dynamic” in political parlance). House Republican leaders know that any plan that
materially worsens the deficit projections will be difficult to get passed through both houses of Congress, so the
BAT is intended to be at least a partial revenue offset to the tax cuts. It would effectively be a 20% tariff on
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imports. Businesses that import goods would not be able to deduct those costs, but companies that export
goods would not have to count revenues received for those exports as income.
This seems like a very reasonable way to incentivize more U.S. production and manufacturing, but it’s not so
simple. Large U.S. retailers have naturally been critical of a BAT, given their reliance on imports, and these
companies (Walmart, Amazon, etc.) are concerned that it would increase corporate taxes greatly. With lower
earnings, these companies may have to reduce staffing, somewhat defeating the initial objective – job creation.
One could argue that these workers could just go work for an exporter, but that would mean changing
companies and may not be in the same geographic location (or even have the same skill requirements).
However, House Republican leaders proposing the BAT would argue that such measures would narrow the
trade deficit and boost the dollar, the latter largely nullifying the impact of import tariffs. But what is true in
theory is not always so in practice and there are many assumptions in play here. In the end, there will have to
be some form of compromise with the BAT, perhaps along the lines of gradually phasing it in down the road,
which could still have the effect of a revenue offset in the long-run budget deficit forecasts and provide political
cover for the proponents (lots of gamesmanship in budget calculations). Without such changes, it’s difficult to
imagine the comprehensive tax reforms being passed by the Senate, particularly considering that Arkansas has
two Republican senators (think Walmart).
Data Trend
The domestic economic data trend has been solid so Exhibit 1
far in 2017, with overall data surpassing expectations
Citigroup Economic Surprise Index
at an increasing rate in recent months. Exhibit 1 is the
80
Citigroup Economic Surprise Index, which measures
60
actual, reported economic data relative to
40
expectations. A positive index reading implies that the
20
actual data trend has exceeded expectations, as a
0
whole; and the higher the number, the greater the
upside surprise. It is currently at the highest level -20
since early 2014, with the recent upswing beginning in -40
early November. Eventually, expectations will likely -60
catch up with the actual trend, and the index will -80
reverse for some period of time. Additionally, the
overall data trend continues to be led heavily by
survey-based measures of growth. Sentiment has
Source: Citigroup Global Markets, Bloomberg
been much improved post-election, particularly in the
business sector amid the talk of tax reform and deregulation.
Exhibit 2
NFIB Small Business Optimism Index
110
105
100
95
90
85
80
Source: NFIB, Bloomberg
The Small Business Optimism Index is perhaps the
clearest illustration of increased hopefulness postelection. As Exhibit 2 shows, the index surged in
December to the highest level since 2004 and held
steady in January, largely attributable to survey
respondents’
expectations
for
better
business
conditions. These expectations are based on
anticipation of business-friendly policy changes from the
new administration and Republican-led Congress, and
sustained optimism will require progress on that front. In
other words, survey-based optimism must eventually
translate into stronger hard (activity-based) data.
January retail sales and CPI are recent examples of
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hard data that did come in above expectations, but this was true for those two measures prior to the election
and GDP growth is still trending at 2%. Real progress on the big three policy issues (tax reform, deregulation,
and infrastructure spending) will be necessary, and all three face a tough battle in Congress.
Fed Update
Up until the week of February 27, nothing substantial had changed on the Fed front to start 2017. Most Fed
speakers essentially repeated guidance from the December 2016 FOMC meeting, which called for three rate
hikes this year. In her testimony before the Senate Banking Committee February 14, Fed Chair Janet Yellen
did assert that a March rate hike is still on the table, reiterating that any future policy changes will be datadependent (March included). Her comments were largely balanced with regard to upside and downside risks;
and regarding uncertainty in the Fed’s outlook, the Fed Chair acknowledged “possible changes in U.S. fiscal
and other policies, the future path of productivity growth, and developments abroad.” Again, this was right in line
with the Fed script for many months. If growth and inflation accelerated beyond the current trend, the Fed would
have to be more aggressive. If not, it will continue normalization at a gradual pace, assuming the data doesn’t
deteriorate going forward.
Despite the consistent tone from Fed leaders, markets were still pricing in a less hawkish Fed, particularly as it
relates to a March hike. Fed leaders apparently have something else in mind, though, and Vice Chair Bill
Dudley granted an unexpected television interview February 28 that was notably hawkish. Dudley was asked
specifically what “fairly soon” meant from the recent FOMC minutes regarding the timing of another hike. He
responded, “It doesn’t say it’s a week, a month, a couple months. Fairly soon means in the relatively near
future.” Within a matter of hours, the market pricing of a March rate hike went from a 35% probability to a 75%
probability. This was no accident. It’s uncommon for the Fed to schedule an unexpected interview at the last
second and have one of its most dovish leaders make such hawkish comments, and it was meant to forewarn
the markets that a March hike was a near certainty, barring a major unexpected risk event. If the Fed decided to
not hike at this point, it would be a major hit to the credibility of their guidance.
While a March hike would be a modest surprise for the markets, it’s still within the Fed’s most recent guidance
(December 2016 SEP). They have made it clear that a gradual normalization process is desired, and the only
thing that would change this path would be some of the items Fed Chair Yellen mentioned above, assuming no
major changes in Fed structure/leadership in 2018 (The Trump administration seemingly has bigger fish to fry at
the moment). Regarding the Fed balance sheet, Yellen’s testimony also reiterated no desire for selling assets
outright (Treasuries and MBS); and any shrinking of the balance sheet will be done in “an orderly and
predictable way.” This suggests a desire to simply taper reinvestments at some point and gradually reach the
previously-stated desire of holding only Treasuries on the balance sheet. Anticipation of MBS reinvestment
tapering has weighed somewhat on MBS spreads to start the year, but slower-than-expected progress on the
fiscal reform front will likely push the timing expectation of any such action further into the future.
CURRENT MARKET THEMES
Rates, Volatility and Spreads
The rate trend for much of February was lower and flatter, with markets focused more on global political
concerns; however, the trend began to reverse at the very end of the month. The hawkish comments from
Dudley sparked a bear flattening of the yield curve, and front-end Treasury yields finished the month 6-11
basis points (bps) higher. On February 28, President Trump delivered his first address to Congress, which was
well received by risk markets, and the sell-off in Treasury prices extended beyond the front-end of the curve.
With the move in short Treasury yields at month-end, the slope of the curve (2-year/10-year spread) flattened
12 bps in February, to 1.12% (lowest since the day after the election), although half of that move has retraced
in the first two days of March following Trump’s speech.
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Short-term implied rate volatility (vol) fell further in the first two weeks of February to pre-election levels, but vol
bounced higher in the second half of the month to finish the period essentially unchanged. Longer-dated
implied vol (e.g., 5yr/5yr swaption) has trended sideways so far in 2017.
Exhibit 3
10yr Swap Spread
20
15
10
5
0
-5
-10
Widening swap spreads has been a somewhat
overlooked market theme so far in 2017, but it has
had a discernible impact on fixed-income valuations,
particularly securitized sectors that typically
price/benchmark versus swaps. Year to date, swap
rates are approximately 10 bps wider relative to
Treasuries for 2-year and longer maturities, and the
move has been a partial reversal of the late
2015/early 2016 trend that saw swap rates trade
below Treasuries across much of the term structure.
-15
The change in short-term repo rates relative to LIBOR
has been a major driver of swap spreads during this
timeframe. Short-term repo is largely a funding
Source: Bloomberg
vehicle for Treasuries, and new bank capital rules and
regulations contributed to higher repo rates relative to LIBOR in the second half of 2015. One year later, new
money market reforms pushed LIBOR higher; and for much of 2017 thus far, treasury repo rates have fallen.
This has contributed to wider swap spreads, although spreads have tightened a bit in recent days, given the
increase in short Treasury yields in anticipation of a March rate hike. Asset spreads were tighter in February for
most investment-grade sectors relative to swaps, with much of the move attributable to tighter swap spreads.
Floating-rate spreads have tightened even more due to a combination of both lighter supply and higher
demand on expectations of an ongoing Fed tightening cycle.
-20
Agency MBS/CMBS
MBS spreads have trended sideways to be slightly wider since mid-January, and with rate volatility subsiding
and prepays slowing, solid carry has offset any modest widening in the basis. Globally tight credit spreads and
slower progress on reforms in Washington have contributed to the stabilization in MBS spreads despite
relatively low demand from bank and overseas investors to start the year. The news from Washington
becomes more relevant because it affects the market’s expectation for the timing of any Fed balance-sheet
reduction. In that context, any good news on the
economic or political front is potentially negative for
Exhibit 4
MBS spreads, which is why ALM First (and most
FNMA 30yr 3.5% MBS
other sector participants) consider QE tapering the
40
biggest headwind for MBS performance in 2017.
30
The Fed’s MBS reinvestments have remained a
major technical for MBS valuations, and the curve
steepening also has impacted recent reinvestments
due to slower prepayment speeds. For example,
the Fed was reinvesting nearly $45 million per
month in September and October due to higher
refinance activity, and February purchases are
projected to have fallen to $22 million in February.
Of course, the reduction in refinance activity also
affects the supply side of the equation (timing will
differ); but some analysts are suggesting that the
20
10
0
-10
-20
OAS Swaps
OAS Treasury
Source: J.P. Morgan
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Fed overbought in January, which will have to be offset in the near term with fewer purchases. This could be a
“mini-taper” in the near term, but it could also be offset by more participation from banks and overseas
investors, particularly if the political headlines slow.
Widening swap spreads so far in 2017 have contributed to tightening in assets benchmarked versus the swap
curve, including MBS and CMBS. As noted in the previous section, swap spreads are approximately 10 bps
tighter year to date, which has pushed MBS spreads essentially equal relative to both swaps and Treasuries
for the first time since Q4 2015 (see Exhibit 4). This means spread tightening in the MBS/CMBS sectors over
the last two months is more attributable to higher swap rates than lower asset yields, and it’s important to keep
swap spreads in mind when assessing cross-sector relative value, given that some sources will show sector
spreads relative to Treasuries (corporate bonds) and others versus swaps (structured products).
Agency CMBS (ACMBS) spreads have tightened significantly over the last 12 months and are now below 5year averages. That said, front-end ACMBS still trade 20-30 bps over duration-matched agency bullets. For
longer ACMBS, Freddie K 10-year A2 spreads are now within 25 bps of non-agency CMBS counterparts,
which is the tightest spread differential in three years. This could boost demand for ACMBS from non-agency
conduit investors, given the relatively light new issuance pipeline in the non-agency space. ACMBS floater
spreads have tightened significantly as well, particularly in recent months. For investors who already have
adequate floater allocations, we generally wouldn’t recommend chasing spreads lower, as much of the recent
demand is more of a “rates” play with the Fed shifting to a more hawkish bias. That said, investors may still
need to use floaters for routine portfolio rebalancing, and we continue to favor ACMBS floaters versus similar
alternatives at the moment.
Sector Performance
As shown in Exhibit 5, most investment-grade, fixed-income sectors performed reasonably well in February,
particularly relative to duration-matched swaps. Agency MBS have started the year off strong, particularly the
15-year sector. The BAML 15-year MBS index posted a gross return of 0.43% in February; and for the first two
Exhibit 5
Sector Returns
February-17
Gross
Net*
0.04
-
Cash1
Year To Date
Gross
Net*
0.08
-
2016
0.25
2015
0.02
2014
0.03
Average
Annual
0.10
Treasury 2
0.15
0.20
0.32
0.25
1.09
0.98
1.24
1.10
Agy Bullet & Callable3
0.17
0.21
0.36
0.30
1.12
0.97
1.30
1.13
CMO Floater
15 Year MBS 4
-0.18
-0.20
0.35
0.29
0.27
0.42
0.86
0.52
0.43
0.46
0.73
0.65
1.08
1.50
3.94
2.17
30 Year MBS 5
0.52
0.51
0.43
0.35
1.70
1.63
6.91
3.38
1-12 Year Muni AAA-AA 6
0.59
0.62
1.26
1.17
-0.15
2.20
3.72
1.91
3.5-6 Year ACMBS7
0.20
0.21
0.65
0.57
1.92
1.90
4.24
2.68
IG Credit 8
0.42
0.47
0.73
0.66
2.19
1.52
2.12
1.94
HY Credit 9
1.41
1.45
2.59
2.52
17.03
-5.23
0.76
3.77
S&P 500
3.97
-
5.94
-
11.96
1.38
13.69
8.87
KBW Bank Index
5.44
-
5.12
-
27.29
0.49
9.36
11.84
Sources:
1
2
3
4
5
BAML
BAML
BAML
BAML
BAML
Treasury Bills 0-3 mo
US Treasuries 1-5yr
AAA US Agcy 1-5yr
FNMA 15yr MBS
FNMA 30yr MBS
6
7
8
9
BAML Muni 1-12 Yr AAA-AA
Barclays Agency CMBS 3.5-6 Yr
BAML US Corp A-AAA 1-5yr
BAML US HY 1-5yr Constrained
* Excess vs. duration-matched swap rate ladder
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5
months of 2017, the index has bested duration-matched swaps by 65 bps. The relatively strong net
performance of fixed-rate sectors is partly attributable to wider swap spreads, which is negative for the
performance of the rates benchmark. The 30-year MBS index had a rough January but recovered nicely in
February. The CMO floater return was negative in February, which was attributable to wider pricing spreads
from the third-party pricing agent. However, for those actively trading the sector, spreads have not been
widening for well-structured CMO floaters, when you can find them.
Core Spread Portfolio
Our Core Spread Portfolio had another solid month of performance, posting a 0.23% gross return in February
and a 0.08% excess return over the BAML 1-5 Year Treasury/Agency Index. Exhibit 6 on the following page
provides a breakdown of each sector represented in the portfolio, and MBS was the top performer for the
month. Over a longer-time series, the strategy has bested the index by 55 bps over the last 12 months, and the
3-year average annual excess return is 54 bps. The portfolio’s OAS tightened by 12 bps in February; and given
that we use a swaps benchmark, much of that was attributable to tighter swap spreads. The portfolio’s effective
duration remains near the upper bound of its 2.25% to 2.75% target range, so our February reinvestments
were directed to ACMBS floaters. Additionally, 15-year 3% dollar rolls have traded more special in recent
weeks, with the Fed purchasing more of the coupon after the post-election curve steepening. As such, we
delivered low-payup, 15-year pools in the portfolio into the February/March dollar roll.
February trades:
 Reinvested principal paydowns into new issue ACMBS floater
 Delivered 15-year 3% MBS specified pools into February/March dollar roll
Enhanced Liquidity Portfolio
Exhibit 7 provides a snapshot of our Enhanced Liquidity Portfolio as of the end of February. The benchmark
used for this strategy is a 50/50 blend of the BAML 6-month and 12-month Treasury Bill Indices, and the
current portfolio duration is 0.95%. The portfolio’s return was essentially flat versus the benchmark in February,
with the bear flattener at month-end weighing on short fixed-rate ACMBS performance. Additionally, the triparty
repo holdings are structured as a 12-month ladder, and repo rates were higher across that term structure
month over month. We are beginning to add floating-rate bank notes to this portfolio, with a neutral allocation
range of 5-10% (currently 4%). This sector posted the highest gross return (0.22%) within the overall portfolio
in February.
February trades:
 Reinvested principal paydowns into new issue ACMBS floater
 Rebalanced triparty repo ladder
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Exhibit 6
Core Spread Portfolio
Allocation
Agency MBS Fixed
Agency CMBS Fixed
CMO Fixed
CMO/ACMBS Floaters
Ex-Ante Analytics
1
Ex-Post Return
2
Neutral
25-35%
15-20%
5-10%
30-40%
Current
29%
17%
8%
33%
Duration
3.92%
5.23%
3.99%
0.13%
OAS
15
34
5
29
Yield
2.44%
2.42%
2.44%
2.37%
2/17 Gross
0.48%
0.15%
0.26%
0.00%
5-10%
5-10%
8%
5%
100%
2.42%
2.52%
2.71%
30
44
25
2.54%
2.36%
2.42%
0.37%
0.35%
0.23%
Agency MBS ARM
Bank Notes
Gross
February 2017
0.23%
Quarter To Date 0.46%
Year To Date
0.46%
Last 12 Months
0.65%
Since Inception 10.99%
3 Yr Avg Annual 1.56%
5 Yr Avg Annual 1.33%
3
Index
0.15%
0.35%
0.35%
0.10%
7.91%
1.02%
0.87%
Excess
0.08%
0.10%
0.10%
0.55%
2.83%
0.54%
0.46%
Percent Return
Return History
2.00
1.50
1.00
0.50
0.00
Last 12
Months
3 Yr Avg
Annual
Core Spread
5 Yr Avg
Annual
BAML 1-5yr UST/Agy
1
As of February 28, 2017
2
Market yield utilizing forward rate curve (floaters/ARMs reset at forward rates)
3
Portfolio benchmark is BAML 1-5 Year Treasuries/Agencies Index
Exhibit 7
Enhanced Liquidity Portfolio
Allocation
Agency MBS Fixed
Agency CMBS Fixed
CMO/ACMBS Floaters
Agency MBS ARM
Bank Notes
Repo
Neutral
5-10%
20-30%
20-30%
0-5%
5-10%
20-40%
Current
9%
27%
27%
4%
4%
30%
100%
Ex-Ante Analytics
Duration
3.09%
1.66%
0.12%
0.59%
0.19%
0.55%
0.95%
Gross
February 2017
0.05%
Quarter To Date 0.27%
Year To Date
0.27%
Last 12 Months
0.95%
Since Inception
3.94%
3 Yr Avg Annual 0.65%
5 Yr Avg Annual 0.59%
3
Index
0.06%
0.17%
0.17%
0.71%
2.07%
0.39%
0.33%
Excess
-0.01%
0.09%
0.09%
0.23%
1.83%
0.26%
0.26%
Percent Return
Return History
OAS
4
49
29
49
37
1
25
1
Ex-Post Return
2
2/17 Gross
0.31%
0.01%
-0.01%
0.17%
0.22%
0.03%
0.05%
3 Yr Avg
Annual
5 Yr Avg
Annual
Yield
2.17%
1.84%
2.36%
2.66%
2.17%
0.93%
1.78%
1.00
0.80
0.60
0.40
0.20
0.00
Last 12
Months
Enhanced Liquidity
50/50 BAML 6 & 12 Month T-Bill
1
As of February 28, 2017
2
Market yield utilizing forward rate curve (floaters/ARMs reset at forward rates)
3
Portfolio benchmark is a 50/50 blend of the BAML 6-month and 12-month Treasury Bill Indices
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DISCLAIMER: Returns are gross of fees, unaudited, and estimated using the Modified Dietz method. ALM First does not have complete discretionary trading authority over each account reflected in the
performance discussed herein. Investments in securities are valued based on quotations obtained from independent pricing services or independent dealers. With respect to securities where independent
valuations are not available on the valuation date, or where a valuation is not deemed reasonable by ALM First, ALM First will determine the fair value. The fair valuation process requires judgment and
estimation by ALM First. Although ALM First uses its best judgment in estimating the fair value of investments, there are inherent limitations in any estimation technique. Future events may affect the
estimates of fair value and the effect of such events on the estimates of fair value, including the ultimate liquidation of investments, could be material to returns. The production and delivery of this material
to any investor/recipient does not establish any express or implied duty or obligation between ALM First and any such investor/recipient, including (without limitation) any duty to determine fair market
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herein will be achieved in the future, as past performance is not a reliable indicator of future results. Certain assumptions may have been made in preparing this material which have resulted in the returns
and financial metrics detailed herein. Changes to the assumptions may have a material impact on any returns or financial metrics herein. Furthermore, ALM First gives no representation, warranty or
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