Investment Insights: Excerpts from our Q2 2017 report

Wade Balliet
Posted by Wade Balliet
Investment Strategy

The following are excerpts from the 2nd Quarter 2017 Strategy Letter, produced by the Global Investment Management team. For the full report, click here.

Photo of the US Treasury building, with historic male statue in front.The end is nigh

Fed officials have finally signaled the beginning of the end for their $4.5 trillion bond portfolio that was amassed during the times of quantitative easing. Yellen and her cohorts have indicated they will likely announce their decision to start shrinking the central bank’s balance sheet in September. Markets had initially anticipated the move to come closer toward the end of the year to allow the securities to roll off the balance sheet and mature over the next few years with little change to the fed funds rate.

The new strategy will provide a few advantages, mainly time. Under the new plan, Fed officials should be able to evaluate the market’s reaction to the reductions before the more than likely third and final rate hike in December. Additionally, this will provide time to further review if the recent drop in inflation is indeed transitory or a more worrisome indication of a growth slowdown. With the new timeline, the program also initiates well ahead of the expiry of Chair Yellen’s term in February next year. Even though President Trump has expressed disapproval of Yellen, she may end up keeping her job. A Bloomberg poll from June showed a sample of leading economists believed Yellen would most likely be reappointed; however, other candidates are still in the running.

Political turmoil and the fiscal injection

U.S. politics remains exceedingly uncertain as turmoil grips the White House and Congress struggles to pass practical legislation. Markets are still anxiously awaiting President Trump’s promised tax reform and fiscal spending, which have the potential to lift U.S. economic growth out of the low trend we have seen over the past years. However, some are losing faith that these policy changes will get through a gridlocked Congress which is still working to pass an acceptable replacement to the Affordable Care Act. Procedurally, it is unlikely that policymakers will be able to move on to taxes or spending matters until healthcare reform is dealt with. Moreover, the federal budget and the debt ceiling also need to be addressed – and we may be headed for our seemingly annual government shutdown at the end of the government’s fiscal year in September. To help members of Congress tackle their long to-do list, Senate Majority Leader Mitch McConnell recently announced the Senate will delay the typical month-long August recess by two weeks – the last time the recess was delayed was in 1994. Even with the additional time, it is unclear if legislators will be able to meet their deadline.

Where we are

The Global Investment Management team and the Bank of the West Economics team believe the Fed’s unwinding program to be a sizable risk, despite the fact that it is a necessary step for the central bank. We believe yields will climb during the remainder of the year and the 10-year Treasury may end the year above 2.5%, or even approaching 3%, toward the end of 2017 contingent on how bond markets respond to the unwinding. Our strategies remain slightly underweight to duration in an effort to hedge out some of the rise in rates, while holding larger allocations to investment grade credit. Muted inflation and wage growth may keep the Fed cautious even as unemployment overshoots their target. As such, we will be keeping an eye on announcements and our rate sensitivity particularly over the next 6 to 12 months as events unfold in Washington.

Click here to read more of the quarterly “Investment Insights” report.

Investing involves risk, including the possible loss of principal and fluctuation in value. Economic and market forecasts reflect subjective judgments and assumptions, and unexpected events may occur. Therefore, there can be no assurance that developments will transpire as forecasted. Nothing in this newsletter should be interpreted to state or imply that past results are an indication of future performance.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

International securities involve additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets.

Diversification and asset allocation does not ensure a profit or guarantee against loss.

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