The President recently nominated Federal Reserve Governor Jay Powell to replace Federal Reserve Chair Janet Yellen when her term expires this coming February. Powell is viewed as a relatively non-controversial pick that will continue the current gradual rate and balance sheet normalization. However, Powell differs from his trained economist predecessors in that he is a lawyer with real world experience at Dillon, Read & Co. and The Carlyle Group. Powell has developed a reputation in Washington as a consensus builder who prefers to operate behind the scenes. President Barack Obama felt comfortable enough with Powell to nominate him to the Federal Reserve Board of Governors in 2012, and re-nominate him in 2014. In his time at the Federal Reserve (Fed), Powell never cast any dissenting votes, opting instead to voice any concerns he had at the decision making table. Assuming Yellen resigns her seat as a Governor, the President will have the opportunity for a major makeover of the Federal Reserve Board of Governors, with four open seats awaiting appointments.
Powell inherits an accelerating economy, one that has grown at a 3% pace in each of the last two quarters and with many forecasts for the current quarter in the same range. Employment continues to improve, touching 4.1% in October, the lowest level since March of 2000. This strength in the employment arena logically has resulted in consumer confidence also reaching heights not seen since 2000. Home prices have also recovered to a level just under the 2006 peak, as measured by the S&P Corelogic Case-Shiller 20-City Composite. The pickup in economic activity is not isolated to the U.S. There appears to be a global pickup in activity that can be seen in strong stock market performance across a broad swath of the developed and emerging economies. It would seem the domestic and global economies have reached escape velocity…the point at which we no longer need the extraordinary monetary stimulus from ultra-low and negative rates and unprecedented central balance sheet expansion.
Much has been made of the ongoing flattening of the yield curve (i.e., the decreasing spread between the short end and long end of the yield curve) as the Fed has raised overnight rates 100 basis points (bps) over the last two years. Some have looked to past “flattenings” which occurred in Fed tightening cycles as precursors to a slowing economy or even recession and have concluded that the current flattening will lead to the same outcome. We think this ignores the impact of foreign capital flows into the U.S. driven by negative yields on government and corporate debt in the Eurozone and Japan. Short-term real yields remain negative, making them still very accommodative. We expect another 25 bps hike in December and three or four additional hikes in 2018 as the Fed responds to a tightening labor market and a pickup in inflation, as well as stronger than expected growth.
The good news is that yields on the short end have risen nicely on a percentage basis. Two-year treasury yields are now about 30% higher than at the beginning of September and about double what they were a year ago! Still low by historical standards, but an improvement. We expect insurance company investment income to begin to improve after nearly a decade of declines.
With an outlook toward higher yields, we continue to position fixed income portfolios with durations shorter than their benchmark indices in order to protect principal. Virtually all sectors (corporates, mortgage-backed securities, taxable municipal bonds and tax-exempt municipal bonds) are near their tights with respect to spreads versus Treasuries, as global investors continue to flock to the meager yield available in the U.S. markets. This argues for up-in-quality holdings and shorter duration to protect against the inevitable reversion to the mean in spreads. The current tax proposal in the House of Representatives could make tax-exempt municipal bonds fairly unattractive versus taxable sector alternatives. This may change as the final plan is negotiated, but we will be cautious on the taxable sector weighting until we get full clarity.
After a decade of unprecedented global central bank intervention which saw not only zero percent yields but negative yields in many parts of the world, the simultaneous global upturn we are currently witnessing signals a beginning to the end of the era in monetary policy. As it did at the beginning of the financial crisis, the Fed is leading the way out with balance sheet reduction and gradually rising interest rates. The European Central Bank (ECB) will follow later next year. Market volatility should increase as we emerge from central bank manipulation. As this happens, investors who have increased portfolio risk over the past decade in search of return may find themselves heading for the exits in the riskier, less liquid corners of the marketplace at the same time as everyone else. Now is the time to examine your asset allocations and risk budgets before markets force you to.
Bonds are subject to certain risks including interest-rate risk, credit risk and inflation risk. As interest rates rise, the prices of bonds fall. Long-term bonds are more exposed to interest-rate risk than short-term bonds. Although the information in this report has been obtained from sources that the firm believes to be reliable, we do not guarantee its accuracy, and any such information may be incomplete or condensed. All opinions included in the report constitute the authors’ judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Madison Scottsdale is the Insurance Asset Management Division of Madison Investment Advisors, LLC © November 17, 2017.