Following the Fed’s announcement, please see below for market views from the Global Fixed Income, Currency & Commodities Team (GFICC):
The Federal Open Market Committee (FOMC) cut the Fed Funds rate target range by 25 bps to 1.50% ‐ 1.75%. At the press conference, Chair Powell communicated a desire to see the expansion sustained but felt monetary policy was in a good place. The Chair also indicated that the 75 bps of cuts to date were sufficient to offset the uncertainties caused by trade and allow the Fed to be data dependent going forward. The unscheduled meeting on October 4th where the Committee convened to address stresses in funding markets was also briefly discussed. Chair Powell re-iterated the decision to continue buying Treasury bills through Q2 2020 to ensure abundant reserves.
The October FOMC statement maintained most of the language used in September. However, the committee removed the phrase to “act as appropriate to sustain the expansion” indicating they have provided sufficient insurance against trade uncertainty to date. While the Committee still expects a strong labor market and 2% inflation as the most likely outcomes, the statement maintained mentions of global developments and uncertainties in conjunction with muted inflation pressures as reasons to closely monitor the data.
There were two dissenters at the meeting, Esther George and Eric Rosengren both preferring to keep interest rates unchanged.
We can break the statement into two parts:
Chair’s Press Conference
Chair Powell spent much of his time explaining the Committee’s reaction going forward now that a number of insurance cuts have been executed. The Chair indicated that incoming data would need to result in a “material reassessment” in the outlook in order to serve as a sufficient catalyst for the next move in the policy rate. The early part of the discussion centered on trade developments and other uncertainties which the Chair characterized as having improved. While the tone was predominantly hawkish and focused on the positive outlook for labor markets and consumers, the Chair did suggest that the policy cuts done so far this year would remain in place for a considerable time.
In general, Chair Powell continued to show little immediate concern for the US economic outlook and indicated the consumer is still very strong. On the inflation side, Chair Powell continued to highlight the risk that inflation expectations could remain low and become anchored below the target rates. However, he suggested this would be addressed in the new policy framework but did would not elaborate on the details and suggested the framework would not be available until middle of 2020.
Chair Powell repeatedly emphasized monetary policy was in an appropriate place but emphasized the large role that trade uncertainty has played in the decisions of the Committee.
Additionally, the Chair discussed the recent volatility in repo funding markets and the Fed’s response. The Chair appeared willing to re-evaluate the liquidity issues within the banking system but without jeopardizing financial stability.
Pension and Insurance clients may look to total return or income focused strategies to meet their investment objectives. In assessing both type of strategies, it is important to understand traditional metrics of risk may not be appropriate for income focused strategies.
The investment approach of total return strategies focus primarily on top-down investment views (asset allocation, duration, curve) followed by bottom-up analysis (sector, issuer, security); while income focused strategies focus on bottom-up analysis, namely the fundamental strength of each individual company. Traditional measures of risk management include Tracking Error (TE) and Value at Risk (VaR) both consider the deviation of returns of a total return strategy versus those of the benchmark. It’s plain to see that these traditional measures are unsuited to a benchmark agnostic income focused approach where the emphasis is on ratings stability.
For Income focused portfolios, a rigorous assessment of the fundamentals is important to ensure the long standing quality of these portfolios. A low level of turnover is borne out of the buy and sell discipline which is clearly articulated for income focused strategies. The manager carefully considers the analyst’s fundamental credit opinion on whether a sale is required (or a purchase should be made). The decision is driven by the level of visibility the analyst has on the future cashflow predictability of the bond and its ability to meet liability cashflows. Unlike total return strategies, income focused strategies must consider the importance of investment income, realizing gains and losses as well as reinvestment risk. Insurance clients specifically will also have accounting considerations such as IFRS9 which introduced the concept of expected credit losses (ECL). IFRS9 is an impairment model based on the deterioration of underlying credit quality of an issuer, and can lead to great earnings volatility for an insurance company.
Income focused strategies exhibit less turnover but are also deemed benchmark agnostic with the objectives more closely aligned to client specific cashflows or liabilities. Initial portfolio construction, selecting the appropriate assets to meet these cashflows, is a crucial stage of the income focused investment process. Once the assets and liabilities are aligned, maintenance of these assets is key to ensure the scheduled cashflows are met. It is for this reason, risk management should focus on fundamental credit quality and ratings stability when assessing the risks inherent in the strategy.
Analysis of ratings evolution and complementary metrics
When the current economic expansion nears its end, the credit quality of our income focused strategies will be tested. As part of our risk management around these strategies we look to the evolution of ratings migration during previous downturns to determine how strategies will be impacted at the end of the cycle. In a recent blog, we assessed how a future economic downturn would compare to previous downturns using National Bureau of Economic Research defined recessions from 1981 to 2009. We concluded the next recession would be most analogous to the one which occurred in 2001, which was the longest period of growth in U.S. history up to that point. Despite the bursting of the ‘dot-com bubble’, GDP declined by just 0.3% from peak to trough and unemployment increased to 6.3%. Based on ratings migration over the following two years, this scenario assumes that 15% of A rated companies will be downgraded to BBB or below, while 17% of BBB rated companies will be downgraded to below investment grade.
It is important to understand the spread impact due to rating migration as our risk management team will assign a spread move per rating bracket to determine the overall portfolio impact. The spread widening is tiered by bucket and our broad based assumption is that A rated spreads would widen 30% on a downgrade to BBB while BBB rated spreads would widen 70% on a downgrade to high yield (<BBB).
As described above, the main characteristic of an income focused strategy is the maintenance of credit quality, which ultimately leads to ratings stability and low turnover. We look to restrict turnover to approximately 5%; this is a function of diversification into new issuers, credit migration through the cycle and/or a change in client guidelines or assumptions. Turnover may in fact fluctuate somewhat at different stages of the credit cycle. The global economy is currently experiencing its longest economic expansion and credit conditions are favorable leading to upward ratings migration and low defaults. However, we believe we are now nearing the end of this cycle and expect ratings migration to deteriorate going forward. As such, we will continue to monitor the implicit correlation of credits in the portfolio in order to assess to what degree the portfolio is diversified.
How to measure performance?
The upgrade/downgrade ratio is a key metric to measure the ratings migration of the portfolio over time. Investors incorporate the impact of expected ratings migration into the returns they expect to achieve from the strategy.
Book yield attribution is a key metric to consider since income focused strategies’ main objective is to generate sustainable income. As yield levels develop over time and bonds mature, it is important to monitor the evolution of portfolio income as well as the risk taken to achieve it. Book yield may be gained through purchases and lost through sales and maturities.
An income focused strategy is designed to have low turnover as described above. A low turnover strategy is achieved through rigorous initial portfolio construction. Turnover statistics are arguably an additional factor to consider when assessing the performance of income focused strategies since traditional measure of performance versus benchmarks fail to consider turnover levels.