In this month's LDI market commentary:
• October’s Treasury market action
• Credit outlook for insurance companies
Bond Market Activity
Yields took a jigsaw path in October. Economic indicators continued to validate some modest improvements in U.S. GDP growth. Progress on tax reform and speculation about a potentially hawkish new Fed Chairman drove yields higher. As chances of tax reform waned a bit and as the most hawkish Fed Chair candidates looked less likely, yields settled down and finished slightly up for the month. Equities finished at record levels.
Ten-year Treasury yields rose 4 basis points to 2.38% while 30-year Treasuries rose a modest 2 bps to 2.88%. Investment-grade credit spreads tightened 6 bps with widespread strength most visible in energy, financials and autos.
New issuance exceeded expectations at $113 billion as Northrop Grumman, Goldman Sachs and Waste Management all had $6 billion to $8 billion deals. Expectations for November are $85 billion to $95 billion. Year-to-date issuance is up 3% from 2016.
Sector Outlook — Insurance
The U.S. insurance industry is holding record levels of capital post-crisis with a higher focus on liquidity. A low interest-rate environment has created earnings volatility for life insurers on their legacy business blocks, but improving leverage has helped stabilize credit quality. Investment portfolio yields continue to decline as 10-year Treasuries remain below 3%. For property & casualty insurers, 2017 has been a record catastrophe year, with industry losses approaching $100 billion. The storm season was manageable, however, for large-cap primary insurers with limited ratings actions and capital raises required. 2018 could spur modest pricing increases needed to replenish losses.
Event risk through M&A remains muted due to heightened equity valuations and regulatory uncertainty. Consolidation should be limited to bolt-on transactions and non-core asset disposals. Given the fundamental backdrop, our outlook remains cautious near term as valuations are skewed to the downside.
Structural Issues — Labor Market Influence
As the unemployment rate declines towards its lowest level since the internet boom, there is widespread concern that this decline must push inflation and interest rates higher. In past economic cycles, tight labor markets have usually led to higher wages, higher prices and higher bond yields. Yet as Stanford economist John Cochrane outlined in a recent blog post, this economic argument is not as airtight as it seems. So far in 2017, as wage growth has shown signs of life, consumer price inflation has remained tame.
If labor is in short supply, economic theory tells us that the price of labor should rise relative to other prices. But does this mean that nominal wages must rise? And does that mean consumer prices should rise in turn? On the contrary, if labor markets continue to tighten, there are quite a few possible scenarios, including:
1. Wages rise, prices rise and there is a wage-price spiral. This happened in the 1970s.
2. Wages rise, prices rise and the Fed hikes rates aggressively to prevent a wage-price spiral, possibly triggering a recession. This outcome is the typical historical pattern.
3. Wages rise but firms have little pricing power, so inflation stays low.
4. Wages don’t rise but firms are willing to hire lower-productivity workers for the same wage, so the effective price of labor rises.
5. The rate of inflation for the non-wage components of labor compensation rises, such as a rise in the cost of employer-provided health insurance.
An investor who thinks that growth will remain solid and labor markets will keep tightening would be wise to prepare for the first two scenarios: higher inflation, higher interest rates and a yield curve that may be either steeper (in scenario #1) or flatter (in scenario #2).
Some combination of the other scenarios is also possible, and it’s worth noting that all of the other scenarios involve some pressure on profit margins and hence, potentially, on equity prices. The results are likely to vary by company. And it is much less clear what happens to interest rates in the other scenarios.
(Portfolio managers Wesley Phoa and Andy Barth, as well as analyst Mandeep Saini, contributed to this report.)