Sage Advisory – Page 5

Energy’s Sharp Rebound Reflects Dramatic Sentiment Shift

ContentMigration on January 18, 2019

While a further rally in risk assets and a compression in credit spreads will require a follow-through by the Fed as a well as cooling of trade tensions, the Fed has done its part to quell market volatility to start off 2019. One sector that has had a particularly strong rebound is Energy.

Atlas Shrugged, Powell Paused

In his December press conference, Federal Reserve Chairman Jerome Powell dismissed market concerns over further interest rate hikes, roiling an already troubled equity market. The result was one of the worst months for risk assets in recent memory – the S&P 500 suffered the worst December since the Great Depression. Credit markets also experienced a massive negative turn in sentiment and price performance. Investment grade credit spreads closed the year at 153 basis points, nearly 50 basis points higher than the closing level on September 30.

Just a few weeks later, on January 4, Powell spoke on a panel with former Fed Chairs Janet Yellen and Ben Bernanke at the American Economic Association conference. His remarks reflected an about-face from his December press conference.

Notably, Powell stressed flexibility in Fed policy: “We’re always prepared to shift the stance of policy and to shift it significantly if necessary;” and, we’re: “Listening sensitively to the message that markets are sending;” and on the potential to pause its rate hike as well as balance sheet runoff, he said: “We will be prepared to adjust policy quickly and flexibly and to use all of our tools to support the economy.” The Fed then bolstered its messaging around a hiking pause this week when speeches from Fed officials Charles Evans, Loretta Meester, and Eric Rosengren echoed a similar tone.

Financial stability and markets are now squarely and explicitly in the Fed’s crosshairs, and a dour market mood turned around on a dime. Credit markets have snapped back. Investment grade corporate spreads, which peaked on January 3, the day before Powell’s speech, have compressed by 9 basis points (Chart 1). More notably, high-yield credit spreads have fallen by 92 basis points, which retraces most of December’s move (Chart 2)!

Energy Leads the Charge Higher

The Energy sector has seen a particularly strong rebound in both spreads and sentiment, bolstered by a rebound in the benchmark West Texas Intermediate Crude Oil price from a low of $42.53 on December 24, 2018 to $52.02 on January 11, 2019.

Energy sector BBB spreads compressed nearly 20 basis points following Powell’s comments, but perhaps the most notable development was the reopening of the high-yield new issue market by natural gas pipeline operator Targa Resources (NYSE: TRGP). Targa priced the first high-yield bond issuance this year, the first since December 11, 2018. Prior to this deal, the high-yield new issue market had been effectively closed for a month due to extremely poor sentiment surrounding risk assets.

It’s significant that the volatile Energy sector was the home of the first company to break the drought. So strong was the demand for this speculative new issue that Targa was able to garner $1.5 billion in bond proceeds, twice the planned initial amount. The new bonds have performed well thus far, trading 2 points higher and nearly 40 basis points tighter in spread since issuance.

It’s significant that the volatile Energy sector was the home of the first company to break the drought. The fact that an energy company had a successful issuance speaks volumes of where sentiment is headed. It also confirms the idea that expectations for global demand growth are perhaps turning more positive.

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

5 Reasons to Favor Core Fixed Income in 2019

ContentMigration on January 11, 2019

Higher Volatility. Even after factoring in some spread widening during the year, Sage believes 3% to 4% return is easily achievable for core fixed income. And with equity return expectations below average, in the 5%-to-6% range, and accompanied by greater downside risks and high volatility, fixed income is the more attractive asset class from a risk-reward perspective going into the new year.

Equity Volatility (VIX) 3-Month Average

Higher Yields. For income seekers, yields on diversified core investment grade fixed income are now 3.25%, up 60% from just three years ago, and are now well above equity dividend yields. This should add some stability to returns. For more risk-averse investors, with the curve flattening, short-duration strategies now offer attractive yield with limited interest rate risk.

Core Bond and Equity Yields

Source: Bloomberg

The End of the Fed cycle. Unlike equities, which experienced a deteriorating picture into year end, bond investors enjoyed improving returns throughout the year, with the Aggregate Index posting better returns each subsequent quarter. This is not an unusual pattern, as bond returns are typically higher into the end of a Fed cycle, as investors reap the benefits of higher yields and long rates stabilize in anticipation. The environment improves further for bond investors post-Fed cycle, with returns for the 12 months following the end of a Fed cycle almost double the longer-term average.

Core IG Bond Returns: Long-Term vs. Post-Fed Cycle

Source: Bloomberg. Average post-cycle includes the last six Fed cycles, and long-term average is since 1985.

Equity Headwinds/Earnings Peak. Equities face greater macro headwinds relative to bonds at this point in the form of decelerating global growth and earnings, tightening liquidity from central banks, and a host of geopolitical tail risks. If earnings have indeed peaked for the cycle, the rollover process has not historically been pleasant for equity investors.

S&P 500 12-Month EPS

Source: Bloomberg

Macro Risks Point to High-Quality Core Fixed Income Outperformance. Generating returns in fixed income will not come without its challenges, however, as some of the same headwinds causing a more bearish outlook for equities are also likely to impact credit spreads and the riskier segments of the global bond market. Tightening liquidity conditions, declining earnings growth, and growing recessionary concerns is not the most supportive backdrop for credit spreads, and we expect widening pressures throughout 2019, especially among the lower-quality tiers. This suggests the best returns for 2019 are likely to come from higher-quality core fixed income. This view is also supported by our post-Fed cycle return analysis, which shows that while historically all major bond segment returns are higher post-Fed cycle, the advantage of credit over Treasury returns is diminished and core IG outperforms high-yield.

Bond Returns: Long-Term vs. Post-Fed Cycle

Source: Bloomberg

Notes from the Desk: Municipal Bonds — The Turtle That Keeps On Winning!

ContentMigration on January 8, 2019

Both classic and modern literature have countless stories of seemingly outmatched opponents finding a way to persevere and even prevail, despite the odds. One of our favorite examples, especially since we are talking about municipal bonds, is Aesop’s Fable “The Tortoise and the Hare” in which the slow and steady Turtle unexpectedly wins a race against the seemingly unbeatable Hare. Despite both literary and real-life examples of these events occurring time and time again, social influences, behavioral factors, and cognitive distortions cause many investors to keep betting, or in this case, investing in the proverbial “Hare.” Although adjectives like steady, stodgy, and plain-vanilla do not elicit a rousing response, municipal bonds continue to provide investors with positive returns, low volatility, and steady tax-free income.

Once again in 2018, the municipal market showed its merit and provided investors with positive returns, low volatility, and ample liquidity during a time when it was needed most. Despite a quarter or two of low or negative returns earlier in the year, municipal bonds finished 2018 in positive territory as most other core asset classes experienced significant challenges, as shown below:

Market Environment

Source: BarclaysLive and Bloomberg as of 12/31/18

Despite the recent tumult of the global equity and corporate credit markets, municipal bond volatility was much more muted in comparison to the U.S. equity market, further validating municipal bonds’ role as a negatively correlated asset class that financial advisors and clients rely upon during times of market turmoil.

Market Volatility Comparsion (% Chg from 11/30/18 to 12/31/2018)

* VIX Index for Equity Vol, Move Index for Muni Vol, adjusted with daily M/T ratio

Furthermore, municipal bonds not only provide attractive income on a tax-free basis, but they also accomplish this objective with significantly less risk. An often-overlooked measure of income generation efficiency is risk-adjusted income. Relative to other income-producing asset classes, municipal bonds generate higher levels of income per unit of risk, particularly versus equities, which display pre-tax yields. This is illustrated in the chart below:

Market Yield and Risk-Adjusted Income

Source: BarclaysLive and Bloomberg as of 12/31/18, Agg & HY yield tax-adjusted at 35%

Despite the inherent benefits of municipal bonds, naysayers will continue to belittle the fixed income Tortoise and praise the equity Hare. For 2019, Sage is betting on the Tortoise.

Notes from the Desk: Yield Curve Inversion — What’s Different This Time?

ContentMigration on December 7, 2018

Crossing the Rubicon – Yield Curve Inversion

In 49 BCE a provincial governor named Julius Caesar and a single legion of troops crossed a small stream in northern Italy – the Rubicon River – sparking a civil war that led to Caesar’s reign and changed the course of history for Rome. Today, the phrase “Crossing the Rubicon” serves as a metaphor for taking irrevocable steps toward an outcome. In the financial markets, no indicator of an economic recession is as synonymous with the Rubicon as the slope of the yield curve crossing into negative territory.

The first week of trading in December saw the much-awaited inversion of the yield curve, with the 5-year Treasury yield trading below the 2-year yield for the first time since June 2007. Another commonly cited yield curve measure, the spread between the 10-year and 2-year, has not yet moved into negative territory, but typically follows the 5-year and 2-year spread into inversion territory.

Source: Sage, Bloomberg as of 12/6/2018

Historically, the yield curve has proved to be an accurate indicator of economic recessions. In the 1980s, early 1990s, early 2000s, and at the dawn of the Global Financial Crisis in 2006, the yield curve inverted in advance of a recession. What does the inversion signify and how does it contribute to the market outlook going into 2019?

An inverted yield curve is a symptom of tightening monetary conditions from the Federal Reserve, which serves to slow credit, asset price, and economic growth – and typically results in a recession. The degree of the slowdown depends on the fragility of the underlying economic picture. The Fed has the difficult task of keeping conditions such that the economy grows at a sustainable rate, but not so fast as to produce asset bubbles. The additional factor of the unwind of Quantitative Easing, for the first time since the 1930s, adds to the degree of difficulty of this task.

The markets are preparing for the end game of the current economic expansion. We expect a further period of higher volatility and low liquidity, absent additional public support through fiscal stimulus or markedly more accommodative policy from the Federal Reserve.

Yield Curve Inversion is a Symptom of Tight Money Policy, not a Trigger of a Potential Slowdown

Fed tightening typically involves raising short-term interest rates to the point where financial conditions become sufficiently tight to create economic headwinds and cast doubt on future growth. That doubt on future growth could manifest into a flatter yield curve and demand for longer-duration assets versus shorter-duration assets. During the most recent Fed Cycle, the flattening of the yield curve has coincided with continued Fed hikes.

Source: Sage, Bloomberg as of 12/6/2018

In fact, Fed hiking cycles typically result in flatter curves. Looking back to Fed hiking cycles starting 1976, the chart below shows that Fed hiking cycles coincide with a decreased slope of the yield curve.

Sage, Bloomberg as of 12/6/2018

A Recession is Not Imminent, but We’re Moving in the Wrong Direction

Inverted yield curves don’t mean a recession is imminent. Going back to the mid-1970s, the average time from when the yield curve moves into negative territory to the start of a recession is 19 months.

Source: Sage, Bloomberg

What’s Different This Time?

As the saying goes, “history doesn’t repeat itself, but it often rhymes,” the same goes for the business cycle. At the macro level, growth, inflation, and policy drive the evolution of the cycle, but there are often facets of those themes that are different. In the current cycle, one facet stands above all: the unwind of Quantitative Easing.

In its effort to stimulate the economy when the Fed Funds Rate dropped to zero, the Fed instituted the asset purchase program, which ballooned the Fed’s balance sheet from $900 billion to $4.5 trillion. The purchase of financial assets resulted in a “portfolio rebalance” dynamic in which lower long-term interest rates forced investors to move out into riskier and riskier asset classes to earn the same yield. Volatility fell and remained low as investors were assured that the Fed would continue to buy bonds.

The opposite dynamic is happening today. Tightening monetary policy now includes raising interest rates and shrinking the Fed balance sheet. The lack of buying has created a void in the marketplace, as investors rebalance into safer asset classes – cash becomes more attractive. Volatility has picked up, and as long as the Fed remains out of the markets, volatility is likely here to stay.

Source: Sage, Bloomberg as of 12/6/2018

Notes from the Desk: Is Corporate Leverage Offering a Warning Sign?

ContentMigration on December 6, 2018

Non-Financial Corporate Leverage is Increasing

As several market observers have written, corporate leverage continues to increase. Specifically, leverage, or the ratio of a company’s debt to cash flow, has increased noticeably among non-financial corporate bond issuers since 2010. Investment Grade issuers in this cohort have increased their Debt/EBITDA ratios from 2x to nearly 3x in this time frame, according to data from the St. Louis Federal Reserve (see below).

Source: St. Louis Federal Reserve

The reasons for this increase in corporate debt are manifold.

Some companies have increased their borrowings in order to accelerate stock buyback programs. Stock buybacks have become increasingly popular with corporate management teams as a way to manage earnings per share and appease activist equity holders, particularly at companies with tepid revenue growth.

Other companies have used the proceeds from large debt issuances to engage in M&A activity, often for the same purpose of ginning up top-line growth.

Regardless of the ultimate use of funds, the simplest reason why corporations have increased borrowing is also the most likely: because they can. Companies are more comfortable than ever with higher leverage and lower credit ratings because the market has not yet punished them for it. Over decade ago, only 25% of investment grade issuers carried a credit rating below “A.” Now, nearly 50% of the Bloomberg Barclay’s Corporate index is rated “BBB.” In addition, the extra spread demanded by investors for investing in BBB-rated credit vs. A-rated credit has hovered in the 40-to-70 basis point range for most of the time period following the 2008-2009 financial crisis. Many CFOs figure that paying an additional 0.50% of coupon yield for lower ratings and another turn or two of leverage is worth the gamble — if it allows them keep equity prices high, since equity returns are often correlated with management compensation.

Source: Barclay’s Capital

Strong Equity Performance Has Helped

This conflict of interest between management teams and bondholders also drives another self-fulfilling prophecy: borrowing money to help improve equity returns at the expense of credit quality leads to higher equity returns, which leads to more complacency amongst bondholders. Bondholders often look at “equity cushion” as a mitigating factor against increased leverage. They reason that if equity investors are willing to pour money into the capital structure at a level junior in priority to unsecured bondholders, then bondholders should feel relatively more comfortable with the risk of lending to the entity. The strong equity market returns of the past nine years has made the increase in leverage seem less significant to the capital structures of most companies than it actually has been.

Source: St. Louis Federal Reserve

Some Industries Have Bucked the Trend

The Banking sector is a good example of an industry that has not followed this trend of increasing leverage. After the last financial crisis, banks were forced to adopt capital buffer requirements, which have effectively lowered leverage, while the rest of the corporate bond universe has been going in the opposite direction.

A bank’s tier 1 risk-based capital ratio is a measure of liquidity and financial health. Tier 1 capital is a bank’s equity capital and core reserves. The ratio is calculated by dividing tier 1 capital by total risk-weighted assets. While major banks are required by Basel III regulations to hold a ratio of 6% or greater, on average most large banks have ratios in the 13% range, more than double what is required by law.

Source: Bloomberg

The energy and REIT sectors have also been de-leveraging in recent quarters. REITs have been decreasing leveraging due to lower returns in the real estate industry and in anticipation of bargains in the near future.

Energy companies have benefitted from an improving price environment for oil and natural gas, as well as increased operational efficiency, which has allowed them to use free cash flow to pay down debt organically.

What Should Investors Do?

As the end of the current bullish business cycle appears to be near, bondholders should proceed with caution. The recent sell-off in risk assets has presented some opportunities and exposed risks in the corporate bond market.

At Sage, we believe that now is the time to “sharpen the pencil” and go to work analyzing credits more closely, as dispersion in returns is likely to increase dramatically. As the large global Quantitative Easing program being orchestrated by Central Banks begins to wind down, companies that have weak financial fundamentals will see increased scrutiny from analysts and in some cases, will have trouble accessing capital markets to refinance debt. Given this possible outcome, we’ve developed a credit playbook for selecting the winners from the losers:

Look for companies that have avoided the urge to lever up in order to engage in shareholder-friendly activities, such as stock buybacks, dividends, and frivolous M&A.
Look for companies that have the capacity to service their own debt organically through stable or growing free cash flow.
Avoid companies with complicated corporate structures or that have engaged in dubious M&A activity to mask declining top-line revenues at the expense of bondholders.
Look for opportunities within sectors where fundamentals are still intact, leverage is lower, and liquidity is strong.

Recent Market Volatility

ContentMigration on October 11, 2018

In another sign that markets continue to move into a late-cycle, higher-volatility regime, equity markets fell significantly yesterday. U.S. equities registered a 3% to 4% loss led by high-momentum technology names, yet other asset classes, such as bonds, did not react in an outsized way. High-yield spreads widened by 9 basis points and investment grade corporate spreads ticked higher by 1 basis point, well within normal levels. Given the sharp and isolated nature of the equity sell-off, we think that this move is reflective of a positioning-led capitulation and equity prices should stabilize.

Sharply higher rates and growing trade concerns have given way to capitulation in equities. Given the strong macro backdrop, we also do not think this is the “big one.” Underlying growth conditions still point to a low probability of a recession. The U.S. economy is projected to grow at an above 4% pace in 3Q, and the world’s major economies remain in a modest economic expansion. The worst performers during this drawdown have been the high-momentum and growth market segments, areas of the market that have seen a massive uptake in long positioning in recent years. The downward move is being exacerbated by the fact that the U.S. equity market is currently in a buyback blackout period similar to the February episode. U.S. companies typically have a five-week “quiet period,” which limits companies’ ability to buy back stock. We estimate that 90% of the U.S. equity market is under the blackout, and as the calendar moves closer to earnings season in November, this source of demand will come back to support equities. Markets have swung to oversold territory over just a couple days, and in the past, this has consistently led to positive gains over the following month.

Other factors point to an isolated correction vs. a broad reversal. High-beta markets, such as small caps and emerging markets outperformed U.S. large-cap equities, which suggests this is not a broad-based risk-off scenario and is likely to continue. Additionally, credit markets have not corroborated equity sentiment, with high yield and investment grade stable throughout recent equity market volatility.

The sharp rate move from August yield levels has been driven by the strong U.S. growth outlook, a more hawkish Fed, and the initiation of tapering in the Eurozone. We still hold our year-end yield range on the 10yr of 3.00%-3.25% for the following reasons:

1) This recent move has not been driven by higher inflation (YOY core CPI has dropped in the last two releases), which we believe would have to happen to see a sustained higher-yield environment.

2) Given the Fed’s terminal rate of around 3%, still muted inflation, and the market pricing in four additional rate hikes, we don’t see a meaningful rate move higher.

While markets are likely to remain volatile given higher rates, trade tensions, and other macro concerns, we do not see recent market action as a signal to a broader change in the current cycle. We still believe the keys for fixed income allocations going forward will be active duration and curve management, along with a heightened emphasis on issuer selection and relative value within credit allocations. For equity allocations, we added international exposure toward the end of the third quarter, based on overdone negative sentiment, improving data for non-U.S. regions, and attractive valuations. We also tactically moved back to an overweight position in EM equities, based on significant underperformance and a more supportive policy stimulus outlook from China. Despite the recent increase in yields, we still see limited risk of a real hawkish surprise from the Fed. And with the increased policy support from China, we believe this sets the table for upside in EM markets. That said, we have kept our overweight in the region small and resisted adding to it as the stabilization in sentiment has been slow.

There are a few risks to our view that warrant caution. First, the ECB’s balance sheet tapering began this month; we will be watching whether financial condition tightening in the Eurozone spills over to global markets in a significant way. Second, China’s response to escalating trade tensions have been to bolster its economy with both monetary and fiscal stimulus programs. To the extent that that continues, we believe investor confidence should return to EM, but there is still some uncertainty as to how China will conduct its economic policies. Lastly, the U.S. earnings season begins in November with expectations for continued high earnings growth. A downside surprise to earnings could shake investor confidence in the U.S. economic expansion. These scenarios are not our base case, but they could present a risk to our baseline views.

A Better Balance of Risk: ESG Investing for Insurance Companies

ContentMigration on September 21, 2018

Insurance has always been a balance of risk – a balance of pure insurance risk (or underwriting risk) versus investment risk. The balance that is ultimately struck determines the unique personality of each insurance company. What is common among these disparate personalities is a desire to achieve specified results with the least amount of risk possible. From the investment side of the equation, this means protecting the growth of capital and surplus while maximizing risk-adjusted returns. Cue ESG!

At Sage, we view the incorporation of ESG principles as a logical and effective means of risk mitigation for insurance company portfolios, one that is a natural extension of the insurance experience. This experience refers to Enterprise Risk Management (ERM), an essential part of an insurance company’s ongoing operations. ESG applications serve to reveal risks that were once embedded in the investment portfolio, resulting in a more robust ERM framework. We now have further affirmation of this view. Survey trends continue to suggest a growing interest in and incorporation of ESG considerations into the investment process as a means for further enhancing risk mitigation efforts while at the same time not sacrificing returns.

A recent FundFire article surveyed the 2018 Global Insurance Report by BlackRock, which has over $7.8 trillion in assets under management. The findings in the report indicate that environmental, social, and governance issues are very significant to the insurance industry globally. That report states that:

83% of insurers suggest having an ESG policy is either extremely important or very important
59% of North American insurers have already adopted an ESG investment policy
70% of insurers lack ESG internal modeling capabilities

Through our own engagement with clients and the insurance industry at large, we are now seeing more frequent inquiries into how to better incorporate specific values, advocacies, or concerns that reflect the unique personality of the insurance company in question.

Given our ESG modeling capabilities and experience, potential solutions range from a separate ESG mandate; to a partial ESG “overlay” onto the general account; to a more holistic approach with a full integration of ESG principles into the investment process. At all three levels, Sage is able to effectively deliver an ESG solution.

We invite you to contact us for a deeper discussion or to even submit a portfolio for review to determine an effective implementation of ESG principles. You can also view our website for a thorough understanding of our insurance-specific capabilities and ESG-specific solutions – and how the marriage of the two can deliver a superior risk-managed approach to investing for insurance companies.

Facebook’s Fall: Why Considering ESG is Important in the Investing Process

ContentMigration on August 3, 2018

Long before Facebook revealed that 87 million users’ data may have been breached (April 2018), and even before it was revealed that Ted Cruz’s presidential campaign retrieved Facebook users’ data without their permission (December 2015), Facebook had a Sustainalytics Controversy Score of 3 (on a 1-5 scale) because of data privacy issues. While Facebook’s stock has had some jolts and recoveries, which is typical in the days surrounding company “incidents,” it was, until very recently, up by triple digits since mid-2014. Until the stock fell 19% last week, it might have been difficult to make a case against investing in Facebook given the stock’s ascent. To be sure, those who made bets against Facebook have seen a pay-off.

Facebook’s Stock Price

Source: Yahoo Finance

For as long as it’s been controversial, the company has been screened out of Sage’s Environmental, Social, and Governance (ESG) security selection process because of its controversy score alone; we don’t invest in companies with a controversy score higher than 3 (Facebook’s current Controversy Score is 4). The consideration of Controversy Scores is just one factor Sage considers when analyzing securities through our ESG Framework. We also analyze each E, S, and G factor, as well as impact and impact intensity. We believe companies that have high standards for ESG – in Facebook’s case, there’s a lack of Social integrity – build sustainable business models and create sound investment opportunities. That being said, Facebook could be an opportunity worth looking at if it’s valuation becomes attractive, and it has a positive controversy outlook. As of now, it has neither.

Sage ESG Investment Approach

Source: Sage Advisory

Facebook Controversy Outlook

Source: Sustainalytics

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

3 Questions for the Second Half

ContentMigration on July 20, 2018

What follows the volatile market environment we saw in the first half of 2018?

If the volatility during the first half of 2018 was caused by fears of reflation and higher rates negatively impacting equities, then the theme unfolding for the second half is looking like the opposite – a shock to growth due to trade issues or a slowdown abroad. In the first half, synchronous global growth gave way to U.S. growth leadership. After coming into the year with high expectations for private sector growth and corporate earnings, the U.S. economy has met or surpassed expectations while economies abroad have struggled to keep pace. European economic growth has not met the ECB’s expectations, and with inflation anchored in the region, the European Central Bank has responded by delaying any rate hikes until late 2019. Emerging market economies, while much stronger than they were in 2013, have shown vulnerability to tighter financial conditions caused by tighter Fed policy, rising short-term rates, and a stronger U.S. Dollar. These negative shocks have been exacerbated by political issues, such as those in Latin America, or trade issues in China. The big question in the second half will be the market’s reaction to continued shrinking of central bank balance sheets. By our estimation, aggregate QE purchases by the Fed, the European Central Bank, and the Bank of Japan will turn negative going into 2019. Will the volatility suppression dynamic of central bank purchases reverse along with the end of QE?

Source: Sage, Bloomberg

Is a trade war going to hinder growth?

As we’ve written in the past, a trade war caused by increasing tariffs raises prices for the private sector and acts as a tax on the economy, thereby lowering growth in the process. World trade activity has been decreasing since the global financial crisis; while this is not the first episode of restrictive trade policies in recent years, what makes the current episode significant is how it is occurring: between the world’s two largest economies on the most public stage — news headlines. While the tariffs don’t promote economic growth, they aren’t enough to turn the current economic expansion into a retraction. Our main concern are the indirect effects of tariffs – there could be a second order of effects in the form of negative “animal spirits” in the financial markets or an escalation that moves beyond trade.

Is it time to get defensive?

While we are in the late stages of the current economic expansion, we don’t yet think a recession is imminent. Real interest rates remain at historically low levels relative to economic growth, which we believe provides a solid foundation for economic activity to withstand any trade-driven shocks. However, we do think it’s important to remain diversified across stocks and high-quality fixed income. With the end of QE, the period of a low-volatility bull market is over. Higher-quality bonds should serve as shock absorbers in times of stress. Within fixed income, we favor mitigating risk by allocating to shorter-maturity corporate bonds (CSJ, FLOT), as well as agency MBS (MBB), as they provide a better risk-return profile when compared to longer-maturity spread sectors.

On the equity side, we see the U.S. economy continuing to lead in the second half, which should result in the continuation of U.S. equity outperformance versus international equities. Specifically, U.S. mid- and small-cap equities have done well, and we believe they will continue to do so. Cyclically-oriented segments of the market, such as tech (XLK), energy (XLE), and consumer discretionary (XLY), should continue to outperform. One segment to underweight is emerging markets, which continues to be plagued by political concerns, a strong dollar, and tightening global monetary policy.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.

How to Invest with an Economy at Full Capacity

ContentMigration on June 14, 2018

According to the most recent jobs report, unemployment is the lowest it’s been in 18 years. At 3.8%, the unemployment rate is significantly lower than the Fed’s long-run projection of 4.4%. All signs point to an economy running at full capacity. But what does that really mean for investors?

Imagine running a wildly successful widget factory. Your customer base can’t get enough of your widgets – they’re sold out everywhere. Your factory is operating at full tilt, and you’re having to pay employees overtime to meet your production targets. While widget production increases, the factory is not running as efficiently – your employees are overworked, and the wear and tear on your equipment is higher than normal. Your factory is running above its production capacity or potential output.

Like the factory, an economy’s potential growth is also commonly used to refer to an economy’s productive capacity. Potential growth is measured by the amount of goods and services the economy can produce (known as GDP) while operating at its most efficient capacity. What complicates potential growth are fluctuating periods of higher and lower growth, commonly known as the business cycle. To measure whether there’s too much, too little, or just enough growth, it’s important to know how close these growth fluctuations are to the economy’s potential growth.

What is the economy capable of producing and what is it actually producing?

The output gap is the difference between what an economy is producing and what it’s capable of producing. A positive output gap means the economy is growing above its potential growth rate; typically, demand is high and companies are forced to operate far above what is most efficient. A negative output gap signifies the opposite – demand is weak so companies operate with spare capacity. In a perfect world, economic growth equals the potential growth rate, but the cyclical nature of a market economy doesn’t allow that, which necessitates mechanisms such as a central bank to dampen output gaps throughout a business cycle.

Two things drive the potential growth of an economy – 1) the labor force, and 2) the productivity level of that labor. Since productivity moves at a glacial pace, the labor market is more important to economists on a day-to-day basis. Full employment is synonymous with an economy operating at full capacity.

How does capacity affect inflation?

When an economy is operating at capacity, there is no pressure on prices one way or another. A negative output gap results in lower prices, or disinflation; while a positive gap should result in inflation, as prices rise to reflect increased demand relative to tighter supply.

This theory and background are important because after years of operating with a negative output gap, the U.S. economy is increasingly showing signs of full capacity, as evidenced by May’s employment data. The numbers reflected the continued tightening of the labor market in the U.S. as the unemployment rate ticked lower to 3.8%. Compare that figure to the Fed’s projection of long-run unemployment at 4.4%, and the U.S. is squarely operating above capacity.

What does it mean for investors?

The game changes for investors during a backdrop of an economy at full capacity. Most importantly, with an economy at full employment, central bank policy transforms from one that aims to generate economic activity to one that attempts to slow economic activity due to a positive output gap. In the U.S., this takes the form of a higher Federal Funds Rate and a shrinking of the Fed balance sheet. Without the Fed in play, investors can expect a period of higher market volatility. Relative value between regions, sectors, styles, and individual securities rise in importance as the global equity markets’ beta is less likely to provide favorable risk-adjusted returns as it had during the previous few years. Also, a tight labor market and peaking demand should result in inflation. For investors, this means a focus on commodities and inflation-linked asset classes, such as energy sector equities and bonds, as well as TIPS.

Sage Advisory Services, Ltd. Co. is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. For additional information on Sage and its investment management services, please view our web site at www.sageadvisory.com, or refer to our Form ADV, which is available upon request by calling 512.327.5530.