A Fresh Look at the Numbers

Jeffrey Addis:

Welcome to our podcast. My name is Jeffrey Addis. I am the president and chief operating officer of Merganser Capital Management. Before we begin, a few important regulatory disclosures. This presentation is for informational purposes only and should not be considered as an investment advice or a recommendation of any particular issuer, security, strategy, or investment product. Now, on to our podcast.

David Fishman:

Thank you for joining us on the latest Merganser podcast. Today is Tuesday, December 1st. This is David Fishman. I’m happy to have with me our CEO, Andy Smock, and our colleague from the investment team, Jen Pasquale. Today, we wanted to provide a fresh update on the data for our community of fixed income investors. At Merganser, we look at and discuss the data on a daily basis as it comes in, but also take the time once a month to step back and reflect. So let’s jump right into it.

Jen, how about an update on GDP and CPI?

Jen Pasquale:

Sure. So GDP has had quite the ride for 2020. Of course, after a historical rebound in Q3 of an increase of 33.1%, forecasts are calling for Q4 GDP, quarter over quarter, to increase around 4%. This would bring the official year over year GDP figure for the US to a decrease of 3.6%. And if we look forward to 2021, we’re seeing the official forecast at a positive 3.8% year over year. Several economists, though, are calling for a slightly more positive outlook for the US at estimates for 2021 of around 5% GDP. This stronger outlook is supported by vaccines, implementation of these vaccines, and monetary and fiscal policy decisions.

On the inflation side of things, CPI has been the most tame that we’ve seen in about five months. It has been unchanged month over month for the past two months, and we have an annual print of 1.2%, most recently in October. There are some idiosyncratic factors that prop up inflation and we’ve seen that play through this year. For example, in the auto space with high demand in new, used, and rental vehicles contributing greatly to that overall consumer and producer price number. However, inflation is expected to remain around this 1.2% level through 2020 and into 2021.

David Fishman:

Thanks, Jen. Yeah, we know the Fed wants to engineer some inflation and policy has been rather loose. As we look back over the past 20 years of the Fed Financial Conditions Index, we see that it has generally been looser for most of the 20 years, except for a spike around the Great Financial Crisis in ’07 and ’08 and early in the Covid crisis where it barely went into tighter conditions. For now, this index is moving sideways in firmly and looser conditions.

Another variable that we look at is the Citi Economic Surprise Index, which tries to measure how the data is coming in relative to expectations. Of course, at the onset of Covid, expectations were dramatically impacted and we were missing expectations. As expectations changed, we quickly moved to beating expectations rather soundly at new record territory for the Citi Economic Surprise Index. More recently, that’s come down to a number around 76, which is still firmly beating expectations, just not as strongly as we were earlier in the Covid crisis.

Jen, where do we stand with the housing market?

Jen Pasquale:

So the housing market continues to be a bright spot here. On the construction side, we have housing starts data that show construction of one family homes rose to a 13-year high. Because of this, we have very strong US home builder confidence. However, some headwinds here are lot availability and materials that are posing challenges for builders.

On the sales side, we have new home sales increasing about 17% year to date. There’s remarkable appetite among buyers in most, if not all, regions of the US in past months. Properties have remained on the market for just 21 days compared to 32 days in the same month last year, and available inventory has declined about 20% year over year. So we will see some questions of housing affordability begin to pop up going forward. And in 2021, it’s also worth noting that we may see some more foreclosed homes hit the market as well, but overall, a bright spot.

David Fishman:

Thanks, Jen. Just like you, I’m sure all of us have been forced to look for new sources of real-time data to get a better handle on where economic activity may be headed. At Merganser, we have definitely incorporated some of these into our processes. Of course, the TSA checkpoint volume is one that’s often cited and has been trending up from very low levels as it recovers from the depths of the Covid crisis. Thanksgiving holiday was probably going to set new records.

Other fields that we look at, oil rigs have been steadily in worst territory. They are not improving. Electricity demand, interestingly enough, rolled over recently. That could be a tell on the next round of lockdowns that are being instituted across the country. Generally, the rebound that we’ve seen has softened, I would say, as we look at some of these real time data prints.

Jen, how about the consumer?

Jen Pasquale:

Yeah.

David Fishman:

Where do you see the consumer these days?

Jen Pasquale:

So consumer sentiment, we’re seeing preliminary signs of a slowdown in consumer appetite and this is shown through survey results and of course, this is before knowing the results of spending of most recent Black Friday, Cyber Monday holiday spending, which all felt really prevalent and strong. The consumer, as opposed to past recessions, is healthy and consumers have elevated savings rates. We have healthy balance sheets. We have reduced credit card debt. It’s really just a question of consumer willingness to spend, not consumer ability to spend.

And then on the business side, so business sentiment, within cap goods, we see that the core measure which is relevant to GDP has recouped most of its year to date shortfall relative to 2019. The outlook for December and into next year really depends on corporate profits and the willingness ability to spend on non-essential business projects. We also see ISM manufacturing PMI numbers remaining in expansionary territory. These PMI numbers have strong new orders and this demand is due to restocking inventory and because of that, we also see solid hiring numbers within the manufacturing and factory sectors due to this greater demand.

David Fishman:

Thanks for that, Jen. I’m going to move over to the labor market. Of course, in this environment where our friends, our family, our neighbors may be experiencing unemployment, the individual stories are crushing here, but as a whole, the month of October was the sixth positive month in a row of job creation, but has been trending down ever since. The absolute levels of employment are at about 2015 levels, despite the population that has grown by about 8 million people over that time.

Claims have recovered but remain rather high. They seem to be leveling off around a million, which is still a rather remarkable figure in any economic environment. The labor force participation rate has bounced back but still remains rather low and, of course, will reflect those people that are actually looking for work. That will be a challenge going forward with people’s children still working from home. It will be really important to see how many are able to go back to look for work when things get back to normal. That will be a big spur for economic activity.

In the meantime, the participation rate is the lowest since 1977 and regular unemployment benefits have been declining, but the pandemic-related assistance remains rather high. Of course, we’ve all heard how long-term unemployment can be harder to overcome and the longer this goes on, the longer it will be for some of these stories and tragic individual stories, that is, for those people to overcome these hardships.

Andy, you want to talk about the Fed and what the Fed has been up to?

Andy Smock:

Thanks, Dave. Thinking of the Fed, there’s another meeting coming up December 14th and 15th. As we sifted through the minutes of the last meeting, there’s a couple interesting things and definitely the 14th, 15th, while there’s going to be no rechange, there’s a lot of language and positioning that we need to be mindful of.

First is their buying of securities. They’ve been buying 80 billion treasuries a month, 40 billion mortgages a month. They’re going to try to use that money as effectively as they can to help the economy. So if you think back to 2008, 2009, there was Operation Twist where they adapted their buying to the long end of the curve to try to shape it with the steepness of the curve right now. That could be something they look at. I don’t think that’s a huge problem as it is, but they have that ammunition. It’s a lot of money they have available to buy in different parts of the curve to affect decision-making. The Fed funds rate is anchoring the front end of the curve, but tenure’s really what drives mortgage rates and a lot of other lending.

The other thing that is interesting and ties back to something Jen said earlier when she was talking about GDP and inflation, there’s three conditions they laid out to raise rates. This really addresses the question of how long are rates going to be low. The Fed is saying that labor market needs to be healed. It’s an interesting choice of words and it’s a little bit of a pivot. It’s not full employment. Even as it was pre-pandemic, full employment, the understanding of that, was changing where maybe it’s not just the unemployment rate, but maybe there’s some kind of secret pockets of folks that are underemployed or pockets of the economy that are less served so that they want to see the labor market heal and there’s a lot of flexibility as to what that means.

They want inflation to be at 2% and they’ve long said they want it to be symmetrical, meaning they’re willing to tolerate periods overheating and we’re not close to 2%. We haven’t been there for a long time. There are certainly pressures in the economy that could get us to 2% temporarily. But then, there’s the third condition, which is inflation is projected to run at above 2%, so temporary moves above 2% isn’t going to do it. They want us to be at 2%. They want to see that it’s going to be sustained there. It has been a very long time since we’ve seen that and if we stick to those same conditions, or if the Fed does, it means we’re going to be at a low rate environment for a very long time, measured in years, in my opinion. And looking globally that we still look like we have yields that are quite a bit above the rest of the world as the reserve currency and the most liquid and deepest market in treasuries, there’s a lot of value there.

As it relates to other fixed income mispricings or relative value, there’s a lot of rich securities right now. The Fed buying has facilitated companies like Carnival coming to market and issuing debt and getting gobbled up. The Fed doesn’t need to buy it directly. They just push folks into seeking things with yield and also, making sure that yields are low enough overall since price of treasuries that it’s an attractive level for companies like Carnival and they can buy time until this is all over.

The Fed buying has a lot of first order and second order implications, but most of them lead right now to securities and investment grade in and high yield being pretty expensive. There are pockets of value, but every month, that spreads tighten and however many basis points makes it less attractive than it previously was.

I’ll hand back to you, Dave.

David Fishman:

Thanks for that. Let’s take a step back and talk broadly about rates. Two-year has been firmly anchored, given the Fed. The 10-year has been slowly creeping up and that spread the 2’s-10’s curve is approaching 80 basis points, a level we haven’t seen in a number of years.

All right, well thanks, everybody. We didn’t talk very much about politics or Covid. Of course, those have been driving markets a lot over the past seven, eight months now. The market always climbed a wall of worry. We’ve gotten past the election. We will get past Covid eventually. It seems to me that vaccines will usher in a new economic expansionary cycle. The question is just how long until that begins. There’s a lot of pent-up demand to restart an economic surge that is stalling as the virus surges, given the consumer’s collective behavior ahead of the vaccine, and as vaccine news is priced into the market remains a K-shaped recovery with lots of winners and losers. As fixed income investors, we need to be on the lookout for inflation and all the saved stimulus improvement in consumer balance sheets, supply destruction. A dovish Yellen now at Treasury hand in hand with the Fed’s preference to allow for overheating are all factors that increase the possibility of inflation that we haven’t seen in a long, long time. And these will all bear watching.

Jeffrey Addis:

This commentary contained or incorporated by reference certain forward-looking statements, which are based on various assumptions, some of which are beyond our control. Opinions and estimates offered constitute our judgment and are subject to change without notice as our statements of financial market trends, which are based on current market conditions. No part of this presentation may be reproduced in any form or referred to in any other publication without the express written permission of Merganser Capital Management.

For more information, please visit our website at www.merganser.com. Thank you.