Liquidity Insights: Market and Portfolio Commentary – Q1 2018 - J.P. Morgan Asset Management

Liquidity Insights: Market and Portfolio Commentary – Q1 2018

Contributor John T. Donohue

Quarterly review: Worries rise over pickup in inflation, softening economic momentum, global protectionism

In brief
  • Despite a generally positive economic backdrop, markets gyrated wildly as volatility returned in the first quarter, spurred by fears of runaway inflation, rising interest rates and political unrest in Washington. Unease rose over a possible U.S.-China trade war.
  • The U.S. Congress approved a substantially stimulative federal budget. Two- and five-year Treasury yields rose and three-month LIBOR soared in Q1. The fed funds rate rose 25 basis points. Investment grade credit spreads widened.
  • First quarter U.S. economic growth remained solid, though momentum moderated. A majority of companies beat fourth quarter revenue and earnings estimates.
  • A Brexit transition deal was reached in the UK; combined with improving wage growth and low unemployment, the BoE will likely have the confidence to raise rates, though we expect at a glacial pace.

Markets gyrated wildly as volatility returned in the first quarter. Despite a generally positive economic backdrop, global equities sold off sharply on fears of runaway inflation, rising interest rates and continued political unrest in Washington. As the quarter progressed, growing unease about a trade war came into focus as the U.S. said and it would impose import tariffs on steel and aluminum and then many other products, causing China to announce retaliatory tariffs on 106 U.S. exports including soybeans, autos and chemical products.

In Washington, Congress approved a federal budget incorporating substantial fiscal stimulus, adding $300 billion to the deficit over the next two years (in addition to $1.5 trillion over 10 years from tax reform). Higher government debt issuance to fund tax cuts and spending increases, combined with the unwinding of the Federal Reserve (Fed) balance sheet, is expected to exert upward pressure on rates. The fed funds rate rose 25 basis points (bps), to 1.50%–1.75%. While the dot-plot was unchanged (a median of three hikes in 2018), Fed expectations rose to three rates hikes in 2019 and two in 2020, and several committee members raised their forecasts from three to four hikes this year. The revisions reflect higher growth expectations for 2018 and 2019, given the impact of fiscal stimulus and a lower unemployment rate through 2020. Core inflation was revised higher in 2019 to 2.1%.

Firming U.S. inflation, strong growth, U.S. fiscal expansion and a less accommodative policy stance from central banks caused yields to steadily rise. Two-year Treasury yields ended Q1 38bps higher, at 2.27%, and five-year yields rose 35 bps to 2.56%. Three-month LIBOR soared 62bps to 2.31% over the quarter, due to a variety of factors including increased Treasury issuance, rate hike expectations and excess demand for U.S. dollar funding.


*Seasonally adjusted average rates.
Source: Bloomberg; data as of March 31, 2018.

Investment grade credit spreads widened, with the ICE BofAML 1–5 year U.S. Corporate Index spreads increasing 23bps. Spreads felt technical headwinds from rising hedging costs for foreign investors and lower demand for credit from U.S. corporations that have repatriated overseas cash, among other factors. However, strong credit fundamentals were supportive of spreads.

A majority of companies beat Q4 revenue and earnings estimates and leverage measures improved.

U.S. Market Commentary

Economic growth remained solid but momentum moderated in Q1, consistent with the seasonal pattern of weaker first quarters in the U.S. Compared to this time last year, the trend rate is notably higher at 2.5%–3% today vs. 2%–2.5% last year. While U.S. economic data generally has continued to surprise to the upside, Europe and other developed market (DM) nations, have not.

The labor market continued to tighten, pulling prime age people back into the labor force, although employment growth in March was softer, giving back some of February’s gains. Payrolls grew 103,000 in March, below the consensus expectations of 185,000. The three- and six-month pace of hiring is running at a solid 201,000 and 211,000 respectively. Unemployment remained steady at 4.1% while labor force participation declined 0.1% to 62.9%. Average hourly earnings gained 0.1% to end at 0.3% month-over month (m/m) and the year-over-year (y/y) rate accelerated to 2.7%.

Housing activity was solid in Q1 after strong growth in real residential investment of 12.8% in Q4. Home prices continued to rise steadily, due partially to a lack of affordable existing home supply. The Federal Housing Finance Agency (FHFA) Home Price Index rose a stronger-than-expected 0.8% m/m in January and the previous month was revised upward. The y/y rate popped from 6.7% to 7.3%, the fastest pace since 2013. The S&P CoreLogic Case-Shiller Home Price Index was also stronger than expected. The 20-City Index rose 0.75% m/m, its strongest gain since 2013.

Manufacturing activity data was mixed, with the most recent regional manufacturing surveys suggesting a slowdown but continued upward price pressure. The March ISM Manufacturing Index declined from its cycle high of 60.8 to 59.3 (above 50 indicates expansion). After two disappointing reports in December and January, February’s durable goods report pointed to a notable improvement in activity.

Inflation gradually reaccelerated, with improved 3- and 6-month run rates. February core CPI rose 0.2%; y/y CPI was stable at 1.8%. The 3-month annualized pace of core inflation reached 3.1%, a cycle high with contributions from housing, apparel and motor vehicle insurance, communication, autos and medical care goods were softer. Core PCE, the Fed’s preferred inflation measure, ticked up from 1.5% y/y in January to 1.6% y/y in February. The 6-month annualized rate rose to 2.3%, the fastest pace since 2008. Leading indicators continued to signal that consumer inflation should be able to maintain a trend pace at, or slightly above, 2%. Anecdotal and survey-based reports of labor shortages in some sectors indicated employers plan on raising wages.

Federal government spending is expected to increase over the balance of the year after passage of stimulative budget and tax bills. The growth boost from additional spending could add 0.5 percentage points or more to growth during the next two years.


Source: Bloomberg; data as of March 31, 2018.

We preferred credit risk to interest rate risk in our Managed Reserves strategy and saw little value in adding duration beyond one year. Front-end credit spreads widened in the wake of corporations repatriating cash held offshore, making valuations more attractive. Bank fundamentals remained strong, while potential M&A activity in other sectors, such as pharmaceuticals and telecommunications, caused us to refrain from buying certain issuers. We focused our purchases on one-year and shorter fixed-rate corporate bonds and money market instruments and maintained our floating-rate note exposure, buying one- to two-year floating rate Yankee certificates of deposit to prepare for higher rates. We maintained our asset-backed securities (ABS) allocation, buying attractively priced secondary offerings.

We remained marginally short duration relative to benchmarks in our Short Duration strategy. While we continue to believe that synchronized global growth, combined with monetary policy normalization, will guide rates higher, short rates have already moved up approximately 100bps and the market is pricing in two more Fed hikes for 2018, showing that risks are becoming more balanced. We remain constructive on credit fundamentals. However, we have become more neutral on market technicals (supply/demand dynamics), given reduced demand from corporate cash investors and lighter foreign demand due to increased hedging costs. This dynamic has widened spreads on the short end of the curve, which could continue. Nevertheless, we have added some short corporate notes where we feel the recent spread widening has created value. Our outlook for agency mortgage-backed securities (MBS) is neutral. Valuations remain stable although increased supply from Fed balance sheet unwind poses a risk. We are being selective in ABS where spreads are tight. Commercial mortgage-backed securities (CMBS) continue to be a strong diversifier in portfolios, where permitted, although supply has been difficult to source.


Source: Bloomberg; data as of March 31, 2018.


*Currently showing the most recent published number as of February 28, 2018.
**Currently showing the most recent published number as of February 28, 2018.
Source: Bloomberg; data as of March 31, 2018.

Tax-exempt strategies

Our Tax-Aware Liquidity strategy suffered from a tax-reform hangover early in Q1 as the issuance frenzy from Q4 led to a huge drop off in new supply in January. We saw municipal bond funds dip into the variable rate market to invest their excess cash, causing the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index rate to bottom out at 0.98% at the beginning of February—down from 1.71% at year end—before market expectations about the Fed raising rates, the actual rate hike in March and fund flows drove rates higher to finish the quarter at 1.58%. Our strategy remained unchanged as we sought to focus on the very short part of the curve, from overnight to 60 days, mainly investing in variable rate demand notes (VRDNs) and municipal commercial paper.

Short-term municipal yields rose but less than taxable yields. Municipal two-year yields rose 9bps, outperforming Treasuries while longer municipal yields rose 30–40 bps, underperforming. We expect technicals to continue driving the market, with demand expected to continue, while issuance should be muted compared to 2017 levels. In the Tax-Aware Managed Reserves portfolios, we added to our allocation of longer securities as bonds matured, while continuing to look for attractive spreads and ratios.

Europe Market Commentary

The European Central Bank (ECB) kept policy unchanged in the first quarter. Key interest rates—the refinancing and deposit rates—were held at 0% and -0.4%, respectively. The ECB is still purchasing assets under its quantitative easing program at a rate of EUR 30 billion per month, a pace it will continue until September, at least. Forward-looking indicators of growth in the eurozone, such as the Purchasing Managers’ Index business surveys, have dipped recently; if they stabilized at these levels, that would still be consistent with eurozone growth of over 2%. Eurozone consumer confidence remained buoyant as the unemployment rate continued to decline.

The ECB appeared in no rush to raise interest rates. Over the past 18 months, the Governing Council has consistently revised down its inflation forecasts, despite revising up its growth forecasts. While the ECB’s removal of quantitative easing (QE) by the end of this year still seems likely, we expect a lengthy pause before it begins to raise interest rates. In sum, Europe’s pace of growth is slowing only slightly and monetary policy remains accommodative.


Source: Bloomberg; data as of March 31, 2018.


Source: Bloomberg; data as of March 31, 2018.

Europe portfolio commentary

We continue to target a long weighted average maturity (WAM) in a range of 50 to 55 days. The portfolio remained highly liquid over the first quarter, holding around 25% to 30% in weekly liquidity and 40% to 45% in monthly liquidity. EONIA averaged -36bps and 3 month Euribor averaged -33bps. Taking into account government exposure and eligible agency paper, weekly liquidity remained comfortably above the 30% Fitch requirement.

United Kingdom market commentary

The Bank of England (BoE) kept interest rates at 0.5% and the Asset Purchase Program at GBP 445 billion during Q1. UK business surveys remain consistent with continued moderate GDP growth. Although retail sales remain weak, there is some cause for optimism about a pick-up later in the year. Wage growth edged up to 2.8% in the three months to January, and inflation in February fell to 2.7% y/y. Real wages are starting to increase as a result. With sterling’s rally since the start of the year, UK inflation could fall quite quickly, further easing the squeeze on real wages.

The backdrop of improving wage growth and low unemployment, combined with the recent good news that a Brexit transition deal has been reached, is likely to give the BoE the confidence to raise rates in May. Two members of the Monetary Policy Committee wanted a hike in March but were outvoted. If Brexit negotiators reach a full withdrawal agreement by October, the BoE may feel comfortable raising rates again in November. We view UK monetary policy as tightening, but at a rather glacial pace.

United Kingdom portfolio commentary

The WAM of the strategy was positioned at around 45 to 50 days over the quarter. The portfolio remained highly liquid, carrying 25% to 30% in overnight liquidity and around 30% to 35% maturing within one week. Three-month GBP Libor increased from 52bps to 71bps and Sterling Over-Night Index Average (SONIA) increased from 41bps to 44bps.

China market commentary

Market-driven interest rates trended down during Q1 as the People’s Bank of China (PBoC) kept liquidity conditions relatively normal. Shibor, Treasury bills and financial policy bank bond yields all ended lower. Repo yields were stable, although the market spiked ahead of Chinese New Year. CNY appreciated by 3.69% m/m, to 6.2755 vs. the USD. The PBoC increased its open market operation rates by 5bps following the Fed’s March rate hike. Overall, economic data remained robust. Although Q4 GDP growth printed a slightly lower-than-expected 1.6% y/y, 2017 GDP growth was still a robust 6.9%, well above target. Exports, consumption and investment were all contributors. January– February economic activity data were broadly stronger: Industrial production and fixed-asset Investment were better than forecast, while retail sales remained softer than previously and under expectations. FX reserves declined for the first time in 13 months. Exports jumped while imports increased more slowly than expected. Inflation was pushed up by a jump in food prices. PPI eased further from its Feb 2017 peak.

The overall trend of economic data remains solid, although the pace of growth has slowed. With regulatory and monetary policy tightening measures making headway in curbing the growth of debt, the PBoC was slightly less hawkish and committed to maintaining liquidity at reasonable levels. Trade uncertainties between China and the U.S. should leave policymakers’ stance one of relative caution. Interest rates will likely remain at current levels and volatility muted.


Source: Bloomberg; Wind; currently showing the most recent published data as of March 31, 2018.


Source: Wind; data as of March 31, 2018.
SSE: Shanghai Stock Exchange; IB: Interbank.


Source: Wind; data as of March 31, 2018.

China portfolio commentary

Despite the drop in market yields, the RMB Liquidity strategy’s yield remained steady for the quarter. We lengthened duration towards 60 days, buying a mixture of longer-maturity policy bank bonds and certificates of deposit. Liquidity remained good nevertheless, with 30%–-40% maturing within one week and 45%–55% maturing within one month.

Australia market commentary

Australian money market yields trended up during the first quarter of 2018 and the curve remained upward sloping. The AUD weakened by 1.6% quarter-over-quarter (q/q) to 0.7680 vs. the USD. A combination of solid economic data, a U.S. Fed rate hike and expectations that the next Reserve Bank of Australia (RBA) rate move would be upward all contributed to the rate increase. Q4 GDP increased by a weaker-than-expected 0.4% q/q, pushing the annual rate down to 2.4%, as positive consumption and public spending was offset by slower investments. Nevertheless, the 2017 growth rate remained robust at 2.3%. Unemployment was broadly stable at 5.6%, jobs growth continued to be positive and retail sales ticked slightly higher. Australian growth remains slow, but steady, supported by strong export demand for commodities and low domestic unemployment. Consumer confidence remained muted, however, due to low wage growth and still-high consumer debt levels. Inflation remained muted at 1.9%; food deflation offset higher transport costs. Business confidence remained very strong as exports and imports continued to hit new cycle highs on robust domestic demand and recovering commodities demand from China. The RBA left base rates unchanged at 1.5%. Muted inflation, a stable currency, low wage growth and high consumer debt levels imply the RBA will leave base rates unchanged for the foreseeable future.

BBSW (%)

Source: Bloomberg; data as of March 31, 2018.
BBSW: Bank Bill Swap Rate.

Australia portfolio commentary

We continue to focus on purchasing fixed maturity bonds with 3–6-month maturities and floating rate bonds with 9–12 month maturities. We kept the WAM of the AUD Liquidity strategy around 45–50-days. Liquidity remained good throughout the quarter with 30%–40% in weekly liquidity and 40–50% in monthly liquidity. The average credit quality of the strategy remained at AA-.

Singapore market commentary

Singapore Swap Offer Rate (SOR) yields increased across the curve during the Q1, however U.S. Libor yields increased across the curve by a greater magnitude, leaving SOR–Libor spreads wider. The Singapore dollar (SGD) strengthened by 1.87% in the quarter to 1.3140 vs. the U.S. dollar. Singapore economic data slowed, though remained generally robust. Annual GDP growth increased to 3.6% as the recovery extended from exports to domestic sectors.

First quarter data was more volatile due to the Chinese New Year but exports, industrial production and PMI trends remained strong. One area of weakness was domestic consumption; consumer confidence was low and retail sales weaker than expected. Singapore’s March headline inflation printed at a slightly higher-than-expected 0.5% y/y, driven by food and housing, a rate around the past year’s average. Core inflation edged up to 1.7% y/y, a 10-month high.

The broadening of growth to domestic sectors and a fiscally expansive budget were reflected in Monetary Authority of Singapore (MAS) expectations that 2018 growth should reach the higher end of its 1.5%–3.5% range. The MAS could tilt more hawkish at its April meeting, although muted inflation data could delay any tightening until later in the year.

SOR (%)

Source: Bloomberg; data as of March 31, 2018.

Singapore portfolio commentary

The SGD Liquidity strategy continued to buy fixed maturity bonds with 3 month to 6 month maturities, targeting a WAM of 40–50-days. Liquidity remained good throughout the period with approximately 25–30% maturing within one week and 45–55% maturing within one month. Average credit quality remained good at AA-.

U.S. bank sector

We remain positive on bank fundamentals, as above-trend economic activity aided by tax reform, higher short-term rates and a more market-friendly regulatory environment is likely supported by potential revenue and earnings growth. Spreads have widened year-to-date, driven by technical factors including repatriation-related programs and the banking sector’s greater trading liquidity, with some unanticipated supply, likely pulled forward from full-year funding plans. We think technicals should improve as the supply calendar abates into April and plans for lower issuance are realized. We expected first quarter earnings to be supportive for credit investors and favor the sector through periods of volatility vs. industrial sectors.

European banks

Q4 2017 results were generally stable and similar to Q3, with capital generally improving at a modest pace and with asset quality and liquidity remaining stable. Profitability remains challenged. Revenue is up at most banks, with modest loan growth and net interest margin (NIM) appearing to have bottomed. Most large European investment banks reported lower Q4 revenue y/y for their capital markets and investment banking business, on par with their large U.S. peers. We expect improving profitability for traditional commercial banks in Q1. Asset quality and liquidity should remain stable.

Asia Pacific banks

The operating environment was generally stable. Japanese megabanks reported solid profits ahead of their profitability targets for the nine months ending March 31, 2018, mainly from better overseas earnings. There are signs domestic NIM is bottoming out, but underlying profitability measures are still below their global peers. Capital continues to improve and asset quality is stable. Liquidity remains strong.

In Australia, the Commonwealth Bank of Australia reported strong first half 2018 results with return on tangible common equity at 17.2%. Loan growth is modest but NIM is trending higher, mainly due to tightened interest only-mortgage lending through pricing. The other three major banks had a solid Q1. CET1 (Common Equity Tier 1) ratios are close to or above APRA’s (the Australian Prudential Regulation Authority’s) “unquestionably strong” mark of 10.5%. Asset quality remains good and liquidity is stable.

Large Chinese banks reported higher earnings for 2017, with higher net interest income from higher NIM. Healthy loan growth more than offset higher credit costs. Return on tangible common equity remains strong at around 14%. Reported asset quality improved and loan loss coverage remains very strong. Liquidity is stable.

Non-financial sectors

Balance sheet leverage continues to focus on shareholder-friendly actions and M&A activity; leverage ratios reflect moderate debt increases offset somewhat by growing earnings and cash flow. Q4 2017 results were solid on average, with y/y single-digit revenue growth and mid-double-digit earnings growth. The 2018 outlook is for similar or moderately better results, especially for earnings growth, with company fundamentals boosted by lowered U.S. corporate tax rates and the repatriation of overseas cash. That cash will tend to go toward increasing buybacks and M&A rather than debt reduction, according to management Q4 earnings calls. Spreads on investment grade corporate bonds in the U.S. have begun to widen from their post-crisis tights of January 2018. Moody’s Investors Service base case projects the default rate falling to 1.96% in 12 months’ time.

Outlook: Excerpts from our quarterly global fixed income views

During Q1, the macroeconomic environment played out much as we anticipated. Positive growth fundamentals, strengthened by U.S. tax reform and fiscal stimulus, supported higher yields globally. Yet the risk-on environment fell slightly short of our outlook. Central bank QE and current economic conditions have kept rates from rising materially higher, yet storm clouds continue to gather. The reduction in central bank liquidity will soon come to the forefront.

Strong global growth continues to be the familiar narrative. Our proprietary measure of key G4 economic indicators shows economic health continued to make new highs and wage growth stabilized at higher levels. Confidence surveys remain elevated, confirming our models suggesting rising consumer and business spending through 2018.

Favorable U.S. financial conditions, and stimulative fiscal policy, should support economic momentum—though the economy may not need such a large boost at this stage of the cycle. For now, the market seems unfazed by the need to finance a deficit that will exceed 5% of GDP by 2019. As rates rise to attract capital, net interest expense will also rise, creating its own headwind. Inflation is also beginning to show signs of life. Taken together, sustained growth, reemerging inflation, U.S. fiscal spending and a constructive view on China support a greater likelihood that markets will price in above trend-growth over the next three to six months.

Meanwhile, concerns about a trade war have added to risk-asset volatility, even as the announced tariffs appear modest and do not currently reflect a significant risk to the U.S. economy. However, retaliation from China and other nations could have a larger impact.

We believe the Fed will engineer a gradual normalization path with four rate hikes in 2018 and the U.S. two-year Treasury will end the year at 2.50%–3.00%. A sustained break above this level is still unlikely unless inflation rises above our expectations or Japan abandons yield curve control.

The wind up of QE, the rundown in central bank balance sheets and a rise in geopolitical risks are causing market volatility to revert to a higher and more normal mean. We must thoroughly understand the dynamics in play this year and position our portfolios to benefit from them. In our view, the normalization (rise) in rates has a long way to go.


Source: Bloomberg; data as of March 31, 2018.

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