Where You Are Depends On Where You Came From

Imagine it is the end of 2016,1 and a forecaster predicts that equities will return nearly 8% per annum for the next two years, while bond indexes will return 1.5%-3.5%, ranked roughly by credit quality. She also predicts that the 10-year U.S. Treasury yield will rise 24 basis points2 (bps) by the end of 2018, credit spreads will back up to levels consistent with the summer of 2016, and oil will end the two years roughly flat. You might have thought this a boring forecast. Unlike most real-life pundits, our imaginary forecaster would have been correct, yet her prediction might have missed the most important feature of markets in 2018: the journey was a lot more interesting than the destination.

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The S&P 500 Index reached a peak annualized return (measured from December 31, 2016) of over 18% before its 13% drop in the fourth quarter. Within the fixed income universe (Exhibit B), bank loans scrubbed off most of their class-leading returns in the fourth quarter, but still finished the year with a positive return. Along with loans, asset-backed securities (ABS), an area of significant emphasis in our portfolios, also outperformed similar duration Treasuries (i.e. produced positive excess returns). Other credit sectors lagged, making this the worst year for credit since 2011. Treasury rates, which had been up for the year by 0.91% in the two-year note and 0.66% in the 10-year note at the end of September, retraced their steps in December to up 0.60% and 0.28%, respectively. The Treasury yield curve (Exhibit C on the next page) inverted from 1-6 years. While the year-end levels themselves aren’t astonishing, markets ended the year with massive bearish momentum, and volatility has carried into the new year.

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Process-reinforcing results; focus on ABS helped returns

Our clients will know that we spend every day looking for new credit values to buy. The dearth of attractive valuations over the course of 2018 brought client portfolios to historically low levels of spread duration (i.e exposure to credit spread-widening) in a representative Core account (Exhibit D).You can see a direct correlation between our corporate exposure (Exhibits D and E) and the level of opportunities available in the corporate credit universe. Corporate credit reached a state of over-valuation not seen since before the Credit Crisis (Exhibit F on the following page), but all sectors of credit still rallied until early last year. Many of our previously-acquired bonds matured or were sold as spreads tightened, bringing down our exposure until a few more opportunities emerged in the second half.

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We found good value in ABS throughout the year, as we have documented in detail over the past few quarterly strategy updates. We continued to buy ABS at new issue and enjoy the additional yield and low volatility of this sector.

We’ve been cautious going into year-end with commercial mortgage-backed securities (CMBS). As late as October, the sector was trading near its tightest post-crisis spreads. As spreads widened in the last two months of the year, new CMBS issuance still seemed too expensive to us, and we found little available in secondary trading. Many of our existing CMBS positions were refinanced over the course of the year, thereby decreasing our portfolio allocations to CMBS in portfolios as is visible in Exhibit E.

We end the year with our corporate credit exposure increasing from a low base, a steady-to-increasing ABS exposure, and a much diminished exposure to the CMBS sector.

Going into the fourth quarter accounts were more conservatively positioned than they had been for a long time. If the current market volatility continues, we will continue to use our reserves of Treasury bonds, and “extension trades” (where we sell a short-duration bond and buy a long duration bond in the same credit), to increase credit exposures.

Valuations coming off all-time tights

We review 2018 not just to repeat our skepticism of past market forecasts and to pat ourselves on the back for our sector exposures. It is a good reminder for us to keep looking to valuation changes over time, not  market forecasts or sentiment, as our guide to investing. What really matters is to us is the number of durable opportunities and the intensity of their value. Volatility produces new opportunities and deprives us of others.

We’ve been well-served by our valuation-based allocations. Our security selection also contributed to performance. The credit portfolio (ex-Treasuries/agencies/cash) in the above representative account contributed 1.87% to the above account’s performance in 2018, while the credit portion of the Bloomberg Barclays US Aggregate index subtracted (0.97%) from the performance of that index.

Still avoiding Mortgage-Backed Securities

The performance of our credit selections is why our zero-to-negligible position in mortgage-backed securities (MBS) did not harm account performance. As rates rallied, MBS that had extended and underperformed through the first three quarters, performed well relative to index credit, but still underperformed Treasuries by 0.53%. Both our own credit portfolio, which outperformed Treasuries, and our Treasury holdings contributed more to performance than any allocation to MBS would have.

We remain unimpressed with valuations in MBS. They offer little compensation for the rate risk embedded within them and have a clearly negative supply dynamic with the end of quantitative easing. Furthermore, as interest rates have been volatile, MBS change duration. Mortgages contributed nearly all of the +/- 0.5 year fluctuations to the Bloomberg Barclays US Aggregate Index in 2018 (Exhibit G). This volatility, in turn, can induce a lot of trading, which is expensive in volatile markets, and impairs available liquidity for credit opportunities. For all these reasons, we’d like to be paid much more to own MBS.

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Renewed new purchase activity in Q4; big increase in secondary purchases

We became increasingly active in response to the fourth quarter’s market volatility, executing about 40 different Buys in the Representative Core Account. We added to many higher quality corporate names such as Amgen, Apple, Daimler, and Microsoft. Our opportunities came as the market spreads on those four issues roughly doubled. For instance, Daimler’s 2.3% 2021 bonds were trading at a spread of 45 bps at the end of the third quarter, and we were able to pick them up at a spread of 102 bps in December. We also picked up newly issued single-A rated bonds of Dow Dupont (4.21% yield to maturity [YTM]) and Caterpillar (3.66% YTM), both with maturities in 2023.

In addition, we added to positions in a few BBB/crossover credits like Alliance Data Systems (6.00% YTM), Centene (5.75% YTM), Kinder Morgan (4.24% YTM), and Sirius Group (6.12% YTM) and we took advantage of good values at the short end of bank issuance with ANZ Bank (3.77% YTM), BB&T (3.78% YTM), Capital One (4.05% YTM), Svenska Handelsbanken (3.86% YTM), and US Bank (3.47% YTM).
Fourth quarter ABS issuance was $48 billion, reaching a full year total of $227 billion, the highest issuance since 2007. Familiar obligors continued to offer attractive yields at short durations and high credit quality. We added triple-A rated tranches in Nextgear (3.71% YTM) and Cazenovia Creek (3.88% YTM), and double-A rated tranches in Mariner (4.24% YTM) and Nationstar (3.93% YTM). Single-A rated Elm Trust came at an attractive 4.61% yield and triple-B Oportun Funding at a yield of 4.76%. Newly added ABS obligors include triple-A rated servicer advance Finance of America (3.38%YTM) and single-A venture lender Hercules Capital (4.61%YTM).

Why the bearish sentiment?

In addition to the accelerating bearish tone in credit at the very end of the year, the Treasury yield curve sagged and inverted from 1-6 years (as seen in Exhibit C). As we start 2019, the market-implied path for Federal Reserve (Fed) policy suggests that not only have rate hikes ended, but also greater than 50% probability of a rate cut by January 2020. While credit is somewhat gloomy, Treasuries are pricing in a recession.

We recently read a research piece from JPMorgan4 reaching the conclusion that the pricing of stocks, IG Credit, Treasuries, and base metals suggested a 50% or greater odds of recession.
While we do not rely on forecasts in our investment process, we do have some perspective on today’s gloomy financial markets. It seems to us that markets are doing what they have always done, which is to extrapolate the most recent news long into an unknown future. We were skeptical of the unbridled optimism in the stock and credit markets in 2017, and we are similarly skeptical of today’s pessimism.
In 2017 and early 2018 we thought markets were underestimating the threats from:

  • erratic trade actions
  • increasing global debt
  • credit losses from an overheated direct-lending market in the US
  • debt reckoning in China/China slowdown
  • rapid growth of US student and automobile debt

These things remain existential threats that have not yet materialized, although perhaps markets are putting greater odds on one or more of them.

Economic data remains largely positive

As far as the U.S. is concerned, economic data still seems to be telling a positive story. Two aggregate indexes of economic activity and growth that give a big picture of what economic data may be telling us are the Chicago Fed National Activity Index and the Conference Board Index of Leading Indicators. Neither of these indicators indicates recession, and both are at the favorable end of their range in the post-crisis era.

Monetary policy is not unreasonably restrictive

In addition to market implied rates, we hear increasing complaints that the Fed needs to slow the speed of future interest rates increases. We suspect that some of the complainers may have forgotten that the Fed’s ‘dual mandate’ does not include maximizing corporate earnings or stock market valuations. Rather, the Fed’s job is to contain inflation and unemployment. One yardstick for the appropriateness of monetary policy is the “Taylor Rule”, the most famous of several reduced form rules for setting monetary policy given various employment and inflation indicators. If we set the non-inflation producing unemployment threshold (the “NAIRU”) to a low three percent, the Taylor Model suggests that monetary policy is still too easy - and the Fed should raise rates more than another half percentage point5. While the Taylor rule is only one perspective, it certainly doesn’t suggest the Fed has tightened too much, with real rates around zero today. Perhaps, once again, it isn’t the level of rates, but the recent rapid change that has investors spooked.
So what has changed? Global growth and a U.S. government shutdown
Two important elements of our investing environment did change in 2018: The end of (a brief period of) global synchronized growth, and the U.S. government shutdown.

Outside of the U.S., growth certainly does appear to be slowing over the course of 2018, most notably in Japan, although every other zone is still positive (Exhibit H). The U.S. stands out as accelerating, at least up until now. China is the area of greatest concern, given the combination of tariff uncertainties and slowing growth. As we start 2019, Apple has already warned of decreased sales, primarily out of China. China’s growth drivers are also shifting from investment to consumption. In aggregate this may not be a negative, but it should cause some dramatic changes in industries selling into China. While it may get worse, this risk from China is hardly new, and shouldn’t cast a huge pall over the markets.

We admit to becoming jaded about U.S. government shutdowns. President Trump sought this confrontation over immigration policies, motivated primarily by fulfilling a campaign promise. This won’t be a large economic event unless it stretches out for months. We remind our readers that the vast majority of government spending – defense, entitlements, and a variety of other essential functions – continues on schedule. This shutdown stems from political posturing, and a political compromise should emerge to resolve the matter.

As we start 2019, we do not anticipate systemic danger from these discussed market changes, given the much stronger and less leveraged financial system. What is evident to us is the substantial disagreement between U.S. economic indicators and market sentiment as reflected in market trends. Although the fourth quarter of 2018 was a volatile period, we welcome the more appropriate credit pricing heading into the new year.

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Some things never change

From our perspective, bearish momentum is feeding on itself and markets are beginning to overshoot. This is what markets always do. What we at BBH always do is spend every working day looking for the next durable opportunity that is priced to outperform, not over the next month, but over the next few years.

Happy New Year to all of you and thank you for investing with us.

Andrew P. Hofer
Portfolio Co-Manager
    

Neil Hohmann, PhD
Portfolio Co-Manager

Past performance does not guarantee future results, and current performance may be lower or higher than the past performance data quoted. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost.

This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries (“BBH”) to recipients, who are classified as Professional Clients and Eligible Counterparties if in the European Economic Area (“EEA”), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed can change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in EEA member states by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority (FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries. © Brown Brothers Harriman & Co. 2019. All rights reserved. 01/2019

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1 Why two years ago? Mostly because it isn’t so short term as one year, and marks a time when most agreed the economy was doing well in aggregate, but also because it is near the
beginning of both the Trump administration and when the Fed tightening program got underway in earnest.
2 A unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument
3 Our valuation framework is a purely quantitative screen for bonds that may offer excess return potential, primarily from mean-reversion in spreads. When the potential excess return is
above a specific hurdle rate, we label them “Buys” (others are “Holds” or “Sells”). These ratings are category names, not recommendations, as the valuation framework includes no credit
research, a vital second step.
4 J.P. Morgan, “Flows and Liquidity”, N. Panigirtzoglou, M. Inkinen, J. Vakharia, N. Poddar January 4, 2019.
5 Calculated on Bloomberg using the function “TAYL”.