Listening Through the Noise

Financial markets finished 2018 extending the volatility and pessimism from the beginning of the fourth quarter. To be sure, in 4Q18, the S&P 500 contracted more than 13%, the price of crude oil dropped 40%, investment grade corporate spreads widened 50 basis points1, and high-yield spreads widened 200 basis points. What happened? Markets struggled with elevated uncertainty stemming from monetary policy normalization, a potential economic slowdown in China and Europe, the unresolved trade dispute between the U. S. and China, and political gridlock in Washington. As we argue below, economic fundamentals, particularly in the U. S., remain strong and do not justify these levels of market pessimism. Listening through the noise, we hear a disconnect between market prices and fundamentals.

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As in previous “risk-off” episodes, in the fourth quarter of 2018, U.S. nominal Treasuries rallied, and TIPS trailed. Indeed, 5-, 10-, and 30-year nominal rates rallied 40, 35, and 20 basis points, respectively; while breakeven rates at the same tenors fell by 50, 40, and 30 basis points, respectively.

Turning to performance, most portfolios finished the quarter 3-to-5 basis points ahead of their benchmarks. They benefited from short duration positions early in the quarter and the tactical use of nominal Treasuries as breakeven rates fell. The absence of material roll-down in the yield curve and our breakeven overweight in accounts with Treasury futures authority detracted from performance.

Investors associate oil prices to market-implied measures of inflation expectations. This manifested across the breakeven inflation curve, particularly in the shorter tenors, as oil prices dragged breakeven rates down during the quarter. Falling oil prices, combined with elevated risk aversion in financial markets, caused TIPS to trade like a risky asset: In days with positive news, about trade for instance, equities rallied and breakevens rose, and in days with negative news, breakevens fell. We find this treatment of TIPS ironic and undeserved. TIPS are issued by the U.S. Treasury; hence have no credit risk, and provide compensation for unanticipated inflation.

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Risk aversion increased in part because of fear that the Federal Reserve (Fed) might tighten too much. As telegraphed, on December 19, the Federal Open Market Committee (FOMC) delivered its fourth interest-rate increase of 2018, bringing the upper bound of the Federal Funds Rate to 2.5%. Nevertheless, the Fed became less hawkish over the quarter. First, recall that on October 3 Chairman Powell said rates were “a long way” from neutral, a comment taken as a signal that several hikes were in the horizon. Second, on November 28, in his speech at the Economic Club of New York, Chairman Powell stated that rates remain “just below” estimates of the neutral rate. Third, the median projection of members of the FOMC for the number of interest-rate hikes in 2019 fell from three to two. The futures market suggests investors expect none. It is difficult to know whether the Fed will pause rate hikes or slow down the pace of balance-sheet run-off, but if the Fed wanted to slow down policy normalization, inflation running just below or on target will not deter them.

Let’s look at the fundamentals

The consensus estimate of U.S. real economic growth in 2018 is 2.9%, and the projection for 2019 is 2.6%. This is a natural progression of the economic cycle as the boost provided by the tax cut of early 2017 fades. In fact, for a concise but comprehensive view of the economy, we turn to our preferred indicator of U. S. economic activity, the 3-month moving average of the Chicago Fed National Activity Index. This index is centered at zero, a positive value denotes above-trend economic growth, and a negative value denotes below-trend growth. Although it has softened in December, it still shows modest above-trend growth and persistent strength in the employment and sales sectors.

Consider now the labor market. The U.S. economy added 2.6 million jobs in 2018, of which 760,000 were added in the fourth quarter. The national unemployment rate remains below 4%, and average hourly earnings have stayed above 3% for the last three consecutive months, a nine-year high.

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Measures of core inflation returned to levels near the Fed’s target of 2% and are likely to accelerate as wage growth exerts more pressure on goods prices (see the above chart on the right). The New York Fed’s Underlying Inflation Gauge, an alternative measure of core inflation that includes financial markets and economic data, is running close to 3%. Finally, although the U.S.-China trade impasse adds uncertainty to the day-to-day behavior of financial markets, over the longer term, tariffs on imports from China introduce upward pressure on prices and suggest higher realized inflation, a positive for TIPS.

Strong economic fundamentals, growing wage pressures on inflation, and below-average breakeven rates create attractive valuations. Indeed, as we often say, with volatility comes opportunity. The increased volatility in financial markets and the undeserved treatment of TIPS as a risky asset create a disconnect between the factors driving TIPS long-term performance and current pricing. The 2-year averages for the 5-, 10-, and 30-year breakeven rates exceed their current values by 40, 30, and 20 basis points, respectively. The discrepancy between market values and fundamentals provides an opening. It is time to capitalize and deliver returns for our clients with our time-tested strategies and disciplined investment process.

Sincerely,

James J. Evans, CFA
Portfolio Co-Manager

    
Jorge G. Aseff, PhD
Head of Quantitative Research

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Opinions, forecasts, and discussions about investment strategies represent the author’s views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be, interpreted as recommendations.
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1 Basis point is a unit that is equal to 1/100th of 1% and is used to denote the change in price or yield of a financial instrument.