Last Week Today: Brett Kavanaugh was nominated to fill Anthony Kennedy’s Supreme Court seat. The announcement did not immediately impact markets, but Kavanaugh’s skepticism of regulatory agencies is consistent with President Trump’s goal of a small government and could prove beneficial to businesses in the long run. | Oil output in the U.S. topped 11 million barrels a day – 7.9mm barrels away from energy independence. | The NFIB Small Business Optimism Index rose 3 points in June to 107.8 (second highest level in the survey’s 45-year history) with high numbers in compensation, profits and sales trends. “For years, owners have continuously signaled that when taxes and regulations ease, earnings and employee compensation increase,” said NFIB President and CEO Juanita Duggan, supporting a key plank of President Trump’s platform. | The U.S. unveiled additional tariffs of 10% on up to $200B of Chinese Imports; unsurprisingly, given the nature of the relationship thus far, China promised (or are they negotiating Trump-style?) to impose additional tariffs in retaliation. On that topic, for those of you that didn’t see it, last week the New York Times produced a great infographic on the evolution of the trade war from 18 to 10,000 imported products (no subscription required).
Despite some intra-week volatility related to news on tariffs, it was a solid week for risk assets. The Nasdaq Index led domestic stocks with a 1.8% gain (a new high), and the broader S&P 500 Index notched a respectable gain of 1.5%. International equities followed closely with the MSCI All Country World Index rising 1.0%. The yield on the 30-year US Treasury bond didn’t budge, but the two-year yield climbed 0.04% (more on this below). The commodity complex experienced a rough week as a rising US Dollar (+0.8% for the week) and concerns about global growth pressured prices: Gold -0.9%, Silver -1.4%, Copper -1.5%, and WTI Crude -4.4% ($70.58 per barrel).
For detail on weekly, month-to-date and year-to-date asset class performance, please click here.
A Cautionary Tale: Changes in the maturity and credit quality profiles of investment grade (“IG”) bonds since the Great Financial Crisis (“GFC”) have led to increased volatility and lower risk-adjusted returns as compared to high-yield (“HY”) bonds. Generally considered to be the “safer” option relative to high-yield bonds, investors in IG bonds may not be adequately compensated for the risk they are bearing at this time.
Risks in the IG bond sector are higher along two critical dimensions:
- Duration (aka, interest rate risk) – Since the GFC, the duration of the IG bond market has been ratcheting higher as corporate management teams have taken advantage of the low interest rate environment to extend the maturity of their loans. Investors, seeking higher yielding instruments, have accommodated the corporations by snapping up the longer-dated bonds. The longer average maturity of the IG bond market combined with low yields on the loans have increased the sensitivity of the market to interest rates, raising the risk level should rates move higher. Interestingly, the duration of the HY bond market has declined since the GFC.
- Credit Quality – While higher interest rate risk can lead to increased volatility, this risk is far less critical to the safety of one’s investment (i.e., the return of invested principal) when compared to the declining credit quality of the IG bond market. Since the GFC, BBB-rated bonds (one level above a high-yield credit rating) have increased from 34% to nearly 50% of the IG bond sector. In contrast, the credit quality of the HY bond sector has been relatively stable. Similar to rising duration in the IG bond market, the low interest rate environment has allowed corporations at the bottom rung of IG credit quality to issue more debt to an investor base desperate for yield.
In both IG and HY markets, security selection is essential and can obviate some of the risks highlighted above. However, investors considering broad exposure to the IG market need to recognize that the combination of higher duration, and lower credit quality have increased risk in the sector relative to the high yield bond market.
The Yield Curve & the Real Economy: The yield curve continues to flatten, but why does it matter? Year-to-date the 2-year bond yield has risen 0.7% (to 2.58%), while the 10-year bond yield (2.83%) has only increased 0.42%, leaving a narrow 0.25% gap in the 2/10 spread. The flattening is even more notable in the longer-dated 30-year bond, whose yield is up 0.19% year-to-date, leaving only a 0.35% “term premium” for lending the government your money for thirty years (2.93%) vs. two years. In other words, the yield curve is becoming dangerously close to inverting. An inverted yield curve has predicted the last seven recessions dating back to the 1960’s… but it has also produced false positives.
Note: The solid blue line is the yield curve today; the dotted line reflects the yield curve as of December 31, 2017. It is clear that the entire yield curve has shifted higher. However, the shift has been uneven – the yields of shorter-dated treasuries (toward the left side of the chart) have increased more than the yields on longer-dated bonds (the bar chart on the bottom depicts the interest rate changes along different maturity dates of the yield curve). Sources: Bloomberg and Covenant Investment Research.
Although the yield curve has an imperfect track record, the Federal Reserve has openly stated they don’t want to invert the curve. Words are well and good, but actions speak louder, and the Fed’s monetary policy is on a collision course with the market. In practice, the Fed sets short-term rates, but the market sets long-term rates (absent the Fed directly buying longer-dated bonds, a la “Operation Twist” in 2011, and they are not in that business today). An inverted yield curve would suggest the market believes the Fed has raised rates beyond the neutral level, constraining future economic growth. Absent an increase in longer-dated yields, the next Fed rate hike (likely in September) is apt to invert the curve between 2-year and 10-year bond maturities.
Economists and investors pay close attention to the shape of the yield curve because it has a direct impact on credit creation by banks, the lifeblood of economic expansions. A bank’s cost of funds is determined by the overnight rates set by the Fed, whereas the market sets the interest rate that a bank can earn on making long-term loans (as reflected in the yield curve). An inverted curve puts banks in a position where there is a strong possibility that they will not earn enough from a loan to cover their cost of funds while earning a profit. A bank’s only upside in making loans is repayment of principal plus interest/fees earned while the principal is outstanding. Unlike purchasing equity in a company, with a loan, there is no potential for capital appreciation. Hence banks are conservative with their balance sheet. Therefore, an inverted yield curve discourages credit creation, dampening economic growth. Declining economic growth is a vector toward a recession. It is, for this reason, there is so much coverage in the media about the shape of the yield curve. It is important to recognize that an inverted curve does not guarantee a recession is forthcoming, but it certainly improves the odds of one occurring.