Fixed Income Insights: Q3
October 28, 2020
Rich A. Consul: Thank you for joining the Incore Capital Management Fixed Income Insights for the fourth quarter of 2019. My name is Richard Consul. I'm a senior portfolio manager on the team and I'll be your presenter. The title of our presentation is the Fed and Trade Deals Reset Market Expectations. From an overview perspective, we're going to touch on three different areas, the macro viewpoint, the corporate viewpoint and monetary policy view. From a macro perspective, GDP estimates are for 2020 indicate modest but solid growth. This growth is going to be driven by US consumer demand, which is going to be boiled by continued strength in job openings and income gain. One of the wildcards that we have for 2020 is really the trade deals. We believe that some of these trade deals have the possibility of shifting the US economy into another gear and we'll focus on that in the presentation above bullet.
Rich A. Consul: The key thing to focus on is PMI and CapEx will be the indicators to watch, to gauge the impact these trade deals are really going to have on the US economy's ability to shift into a higher gear here. From a corporate credit perspective, corporate credit spreads remain near low end of historic range and leverage remains elevated, but profitability remains it's cycle highs and we're seeing high yield and triple B issuers continuing to focus on balance sheet repair. From a monetary policy perspective, the Fed is signaling a pause for 2020, indicating no rate hikes or decreases for the year. What we're really questioning whether they'll stick to that forecast and I think, towards the latter end of this year that the Fed may start either talking rates up or talking rates down depending on the evolution of the economy for this year.
Rich A. Consul: One of the things that we really are glad to see is the Fed's responsiveness last year in uninverting the curve with their mid cycle adjustments. It's going to be interesting to see how that plays out through the remainder of 2020, but the Fed was successful on inverting the curve, which they absolutely had to do. The other thing they really focused on from a monetary policy perspective is the FLMC is back expanding their balance sheet. Now I know the Fed is saying and Paul is saying this is not QE but for all intensive purposes, it looks and smells like it. This chart looks at the different composition components of GDP and what we can see in, I want you to focus on is the red aspects of GDP here on the graph below, which is indicative of personal growth and consumption.
Rich A. Consul: And what you can see is it's the main driver. It's 70% of our GDP and is the main contributor growth for 2019 and looks to be the main contributor of growth for 2020 and we believe it's likely to be both stable and positive in the quarters ahead. Personal consumption remains really the primary economic driver and it's all encompassed on, is the consumer feeling confident about their job prospects? If they don't feel confident, do they feel like they have an ability to switch into another suitable career path and is do they have a reasonable expectation of making more tomorrow than they do today? We believe the answer to all three of these questions are yes. As a result, we really believe that personal consumption should be and a remain the primary driver. The one thing, and we've mentioned it in the overview that we have a feeling, is though these trade deals could really see an increase in CapEx and if we're going to shift growth from this modest 2% growth territory into maybe even high twos to low threes CapEx is really going to be needed to increase those growth accurate estimates.
Rich A. Consul: So focusing back on consumption, we've got two charts here. The one on the left looks at job openings versus unemployed workers and the blue line there is job openings. And what you can see is for 22 consecutive months we now have been in a situation where we have more job openings in this country then unemployed workers. And this is important because employment growth remains supportive of income and consumption growth. When you're in a constrained labor environment like we find ourselves in today, what it really does is put upward pressure on wages, especially wages at the bottom end of the consumer demographics, and those are good because the people at the bottom, take, 50% of the United States population, those individuals really aren't big savers. They're big consumers.
Rich A. Consul: When you grow their wages more, what they tend to do is spend more and the graph on the right really shows the relationship between year over year personal income growth, which is at 4.9% and the retail sales growth at 5.8%. You can see that when incomes grow, personal consumption usually grows in line with one another and we're continuing to see that and we believe that this job openings versus unemployed workers environment that we find ourselves in is very supportive for this continued to be positive for the year ahead, we should be positive for retail sales growth.
Rich A. Consul: Now let's pivot a little bit to some of the trade deals that have just gotten done. The two big ones are obviously the USMCA Trade Deal, which is a replacement for NAFTA and the second one is Phase One of the China Trade Deal. Now I know a lot of people are saying, they don't see significant impact from either one of these deals and we tend to disagree. When you look at the International Trade Commission study on their forecast for USMCA Trade, they believe that US GDP growth could be as high as over a third of a percent contribution to GDP growth and could create another 176 new jobs.
Rich A. Consul: Now their estimates are for this to be incremental growth every year for the next four years. This would be a very, very significant boost, so you just think about it. If we're growing at 2% this trade deal should grow at 2.35%. While that doesn't sound like a big number. That is an increase of almost 13% increase in growth percentage rate, which is pretty significant. The second part is the China Trade Deal could contribute up to a half a percent per year. When we put both of these deals together, now we're talking about a 2% of economy shifting up into a 2.85% economy. That is a meaningful shift up in growth. Now, obviously there's a lot of concerns about whether China will actually live up to the tenants of the agreement or not. But one of the thing that we do have to take into consideration is that if and the administration is saying this is as well, is that if China doesn't live up to their commitments, then the tariffs were going back in place.
Rich A. Consul: And I think China's desire to maintain compliance within certain bounds of this agreement will lead to if, they don't hit the targets, at least meaningful progress towards hitting these targets. I think it's fair to assume that these two trade deals together can be meaningful in their impact into increasing and shifting out the US growth curve for 2020 and the years ahead. I've listed some of the trade deal specifics here for people to look at and digest to see exactly what the big points are in each one of the deals. But one thing I want to focus on is that USMCA, that top point there, one of the big components of this deal is the country of origin rule specifically around automotive components. Automobiles, according to this new deal now have to have 75% of their components manufactured either in Mexico, US or Canada, to qualify for zero tariffs.
Rich A. Consul: Now while it looks like a modest increase from the previous number of 62.5% on their NAFTA, one of the things that's really key is the applicable components list was also updated. And why this is important is when NAFTA was first written, a lot of the electronics that go into a car today when we're not in cars. And the way that NAFTA treated them is that if a new component was put onto a car, whether that component was sourced in Germany, China, or some other country around the world, if it wasn't on the list, regardless of where it was actually sourced, it's still got a hundred percent allocation according to NAFTA. And it was a loophole. And it's the obsolescence of that components list allowed for new components to be excluded for our percentage of or origin calculations.
Rich A. Consul: And when you really look at what was actually being produced in the NAFTA region, you're talking about almost 40% not the 62.5% that NAFTA had actually dictated. This 75% increase of components manufactured in the area with an updated component list is very, very meaningful and that's one of the reasons that we're seeing the low end estimates for new job creation at 176,000 jobs just in the United States alone. I think the other component on the China deal that we really want to focus in on is that first bullet point there that looks at $200 billion in US products and services over 2017 estimates, focusing specifically on an increase in $77 billion in manufacturing goods. That is a meaningful number.
Rich A. Consul: I know a lot of people focus on the agricultural good increase and there are a lot of people that are suspect on whether: a), we can actually produce at the levels to meet the China demand and whether: b) China would actually increase their levels to those targeted levels, but if they can actually even maintain the $77 billion provision for manufacturing goods, this would be a significant increase in manufacturing jobs in the United States.
Rich A. Consul: And one of the other parts that's really addressed in this deal is IP theft protections. China is going to be mandated to commit to improve protection and enforcement of intellectual property rights. The new deal requires China to actually increase penalties for copyright threat theft to levels where they are actually act as determined and if the agreement gives procedures and penalties and standards are set that if they don't live up to the tenants of the IP protections embedded in the agreement, it actually triggers punitive tariffs that can be levied. A lot of people are talking about it not being really strong, but there are a number of provisions in that deal to allow an aggressive administration, much like the Trump administration is here, to actually use the provisions within that policy to actually increase tariffs if IP theft remains elevated.
Rich A. Consul: One of the things that's really important and it's another factor that people are looking at that is a big concern is US ISM Manufacturing PMI. And what this graph illustrates is the relationship between manufacturing Purchasing Managers Index and US GDP. And you can see that we had a significant and meaningful downturn in PMI below the critical 50 level there and it's showing in contractionary levels. Well, the relationship here between PMI and GDP is strong and the current PMI readings are the lowest that we've seen since 2009 but when you listen to a lot of the earnings calls with a lot of the CEOs and CFOs for the fourth quarter of 2018, a lot of them have been concerned over the last two years about uncertainty around trade. Now with USMCA through in a first level, the China trade deal through, we might see an unleashment of CapEx in US manufacturing activity and we believe one of the key indexes that we're going to have to follow to see if this will actually flow through to GDP is PMI.
Rich A. Consul: One of the biggest concerns as we shift to into the credit component of the fixed income markets is really Credit Spreads. And what this chart looks at is it buckets out the historic credit spreads by rating. You can see high yield and blue triple Bs in orange and the gray highlight is the A rated corporate credit. You can see that all intermediate corporate credit spreads are near the low end of historic range, low corporate defaults and positive economic growth continue to drive these spreads lower. The problem is after a really fantastic year for credit as 2019 was, the problem is you have little room for further spread compression from here, which means that you're going to have to hope that spreads remain at the lower end of the range here and that most of your benefit by owning corporate credit is going to come through. Kerry.
Rich A. Consul: It's one of the reasons why we believe you're not really incentivized this year to take an inordinate amount of corporate credit risk and one of the reasons that we have A, decreased our corporate credit risk holdings from where we were 18 months ago to where we are today and started to increase our US government holding specifically on the mortgage backed security side of the balance sheet. The next part here then we're going to look at from a corporate credit risk is more on the corporate fundamentals and what we're seeing in the corporate fundamentals is a continued slow downward progression in credit metrics. And the one that we're looking at, the two charts here, the one on the left looks at leverage and coverage, interest coverage deterioration and the one on the right looks at profitability.
Rich A. Consul: Leverage remains elevated at cycle highs and interest coverage, which is the amount of earnings used to the interest on the debt continues to show weakness. Corporations continue to take up more leverage as they do continue to share buybacks and other financial engineering through M&A and that's taken the leverage off. And with interest rates shifting up a little bit over the last two years, what we've seen is that the interest coverage has also weakened because the interest rate on the debt has gone up marginally over the last two years.
Rich A. Consul: The good part and the bright part really is profit margins remain strong and revenue growth is expected to accelerate in 2020 but as we stated in the previous slide, valuations remain tight, but demand for corporate bonds still remained strong. The other thing to focus in on is one of the issues that we hear so often is that the triple B index is the highest it's been as a contribution to percentage of the overall credit index, of all times. And one of the best ways to look at this corporate deterioration is how many triple B issuers are falling into high yield or transitioning into high yield and how many high yield issuers are actually transitioning up into investment grade triple Bs. And the chart left is what's called the Fallen Angels versus Rising Stars. Rising stars are companies that are transitioning from high yield into investment grade.
Rich A. Consul: And the gray is the fallen angels, the ones falling from triple B into high yield. And what you can see is that over the last three years, the transition up from high yield into investment grade has been the highest it's been since these metrics have been tracked since the early two thousands and we continue to believe that rising stars are going to outpace the fallen angels and that that trend should continue for 2020. A couple of different reasons through this is the Trump Corporate Tax restructuring of 2017 really put punitive measures for companies who too much leverage. It kept out interest deductability to 35% of EBITDA and what that's forced is a lot of curation on balance sheets. It's forced some of the weakest credits to actually increase credit quality through de-leveraging and we've seen that very specifically since 2017. The other thing that we can look at for this curation in lower credit is, triple B's are reducing their shareholder rewards.
Rich A. Consul: That chart on the right looks at what's called earnings payout and earnings payout basically is the cash that is a given back to shareholders in two different ways, either through corporate buy backs or through dividend issuants. And what we can see is that triple B companies who have really taken up a lot of debt over the last few years have started to significantly decrease A, share buyback activity or decrease a special dividends. The problem is we've seen a lot of companies in the A-rated bucket increase both of those activities. While we're starting to see the triple B's de-lever and focus increasingly on balance sheet improvement, A-rated credit continues to prefer to increase their corporate credit leverage. And I think we expect that to maintain this profile going into 2020. We continue to expect increased credit quality for lower rated issuers to transition from high yield into triple B and a triple B issuers to continue to deliver possibly up into A's. But we continue to believe that A credit will be a deteriorator going forward.
Rich A. Consul: As we shift to monetary policy. There's been a lot that's happened over the last year, we're going to focus on some of the key aspects of where we see the Fed signaling for 2020 as well as what we're seeing on the balance sheet side of things. As we're all aware, the Federal Reserve decreased interest rates by 75 basis points in 2019. What the Fed is currently signaling right now to the market is that they're going to maintain rates where they are through 2020. They're going to do that for a couple of different reasons. There is a lot of global uncertainties still around trade and a continued slow growth in emerging markets and international developed markets and inflation continues to be muted. And the Fed has said this in a lot of their different dialogue, in their minutes is that they're really confused on why low rates and quantitative easing has yet to spur inflation as expected.
Rich A. Consul: And that's one of the reasons why they believe that having rates on hold direct current levels through 2020 makes sense. They're really gearing their policy to sustain the expansion and hopefully move inflation back to their preferred 2% target. One of the areas that we're really concerned about though, from the Fed policy perspective is the FOMC has started to expand the balance sheet again and the Fed has been very clear that you know to saying this is not quantitative easing, but when the balance sheet increases, if it walks like a duck, quacks like a duck, it's a duck. They can talk all the way around it how they want. At the end of the day, if you increase the balance sheet through quantitative easing, it's quantitative easing.
Rich A. Consul: One of the issues is that they say that the program could end as soon as February 13th of this year. That is a real concern. You've probably seen a lot of stories out there about a lack of liquidity in the repo markets and spike up in the repo markets. The Feds restarted quantitative easing to really cure that issue in the repo markets. Then ending this program this year on February 13th without a suitable replacement could be destabilizing. And it's something that we think bears watching because the Fed is going to have to provide much better market communication. What they're going to do if repo rates were to spike back up with them backing away from the market, and let's face it, we're only weeks away from this happening. The FOMC risk factors, will the FOMC stick to their 2020 forecast of being on hold and how will the trade deals really impact inflation growth as we go through this year? Both of these are our really big unknowns, but we believe that both go hand in hand.
Rich A. Consul: We think if the trade deals are meaningful in their impact and increase global GDP from 2% up until three that it could spur on a little bit of inflation that may start getting the Fed to talk about raising rates at some point this year. And how the market reacts to them talking about raising rates will be a very key thing to watch. From a macro central bank outlook perspective, the ECB, Bank of China and the BoJ, Bank of Japan, remain in accommodative policy mode and we don't see that changing at all.
Rich A. Consul: We're going to look a little bit about the mid cycle adjustment in understanding what the Fed were looking to accomplish and what they did accomplish. And we're going to try to help understand what this mid cycle adjustment was all about and it's parallels to the late nineties. When you go back to 1998, the Fed cut rates three times due to the Asian Currency Crisis and Russian Ruble Crisis that was occurring in 97 and 98 and the Fed decreased interest rates by 75 basis points to spur on or maintain a global liquidity as well as to help sustained growth targets here in the United States.
Rich A. Consul: What did we see in 2019? Well the Fed again cut rates three times. Why did they cut rates? China currency issues and then global growth concerns. History doesn't repeat itself but it often rhymes is the old saying by Mark Twain. 2019 looked a lot like 1998. And the graph on the left hand side shows the impacts that mid cycle adjustment and what the Fed did with rates and the proceeding, succeeding 24 months. What we can see is that it only took the Fed about nine months before they got back onto a rate tightening cycle. Now on the graph on the right shows the stairstep up in rates for 2017 through 2018 and then the three cuts for 19 in the FOMC forecast for no change for 2020. We believe we're going to get back to stair stepping our way upwards.
Rich A. Consul: And the question is, is when will that occur and how will the Fed communicate that? Because if the stimulus that the Fed is providing to the market right now continues the way it is and these trade deals are meaningful, the Fed is going to have to probably start talking about increasing rates. We provided S&P returns for a 98, 99, and 2000 and what you can see is, after the Fed decreased rates by three times in 98 you got a 28% return in the stock market. Fed cuts three times in 2019, we get a 31% a return for the S&P. 1999 was another great year for stock returns. We think this year could be another good year for stock returns as well. The question is really going to be does the Fed knock it off track with either pulling back on QE or starting to talk about higher rates.
Rich A. Consul: One of the things that the Fed really did with this mid cycle adjustment and one of the things that we believe they had to absolutely do is on undivert the yield curve. And what you can see from this chart is basically you have 10 year yields in the blue and three months yields in the orange. And that period that I've highlighted there in red is the period of time, almost six months there, during the middle of 2019 where the yield curve was actually inverted. You may have seen a few of our presentations before where when the yield curve is inverted for extended periods of time, inversions of the yield curve are typically very ominous signs for the economy. And when the yield curve is inverted for over 60 days consecutive, it typically leads to a recession within three to six quarters.
Rich A. Consul: Well, with the mid cycle adjustment that the Fed was able to pull off in 2019, we believe that basically what the Fed did was reset that clock. That is a good thing but one of the things to really watch is what happens this year with the evolution of the yield curve and specifically difference between yields and three month and 10 year. Last thing we'll leave you with here is the Federal Reserve's balance sheet. You can see this chart shows Federal Reserve Balance Sheet in millions going back to 2007 to where we are today and you can see the different trenches of quantitative easing that the Fed did from 2008 all the way through to where we are now and what you can see is that the Fed basically restarted, as I define it here, not QE in September last year due to the repo issues that were starting to creep up in the funding markets.
Rich A. Consul: The Federal Reserve bank in New York plan to conduct repo operations until the 13th of February. Although the size of those term operations will be trimmed to 30 billion starting at the beginning of Feb 1. Our biggest concern is what then. The Fed has yet to communicate what their plan is once they pull back on these repo operations. If repo liquidity were to creep itself back end to being an issue, that's something to really focus in on in the coming weeks and months ahead because this could rear its head and be a real strain on global liquidity.
Rich A. Consul: Well, thank you very much for joining. Again, my name is Richard Consul. I'm a Senior Portfolio Manager on the Incore Fixed Income team and if you have any questions or concerns, feel free to reach us.