The 10-year Treasury yield fell along with growth expectations as legislative progress has been slow to arrive. Actions on reduced regulation or tax cuts may provide the main boost for growth from the White House this year.
Despite reduced optimism, the economy continues to perform smoothly, with Gross Domestic Product (GDP) likely bouncing back in second quarter from a weak first quarter. Steady results in employment, housing and continued strong lift in consumer confidence led to strong business sentiment.
Stocks hit new highs again, despite lower growth optimism and decidedly weaker inflation. All asset classes have done pretty well in an environment that doesn’t require the Federal Reserve (Fed) to act too hastily in raising interest rates – continuing the balance that’s persisted for quite some time of slow growth, low inflation and accommodative monetary policy.
One of the biggest surprises this year has been the record low stock volatility – both realized and implied. The market’s risk measure, CBOE VIX® (VIX), has recorded some of its lowest readings ever. Against the more unconventional political backdrop in Washington, and what could be a season of substantially more policy uncertainty, this appears to be at odds with investor expectations. Another surprise is that oil entered a bear market, down $11.36 from $57.40 at its high this year, which put pressure on oil stocks, bonds and peripheral energy exposures.
The Fed raised rates 25 basis points in June, following a similar rise in March and last December. The changes were largely expected and had little impact on the markets.
The administration’s growth agenda should get a test soon with a key vote on healthcare reform. This could set the stage for whether tax reform has the potential to pass later this year or next, and consequently should impact investors’ views of growth expectations.
Bond returns were positive for the second quarter. The big story in bonds this year has been that long-term rates have fallen as growth expectations and inflation have disappointed. This along with the Fed raising the Fed Funds Rate has contributed to a significant flattening in the bond yield curve (the difference between long and short yields). The difference between 30-year and 2-year bonds was 145 basis points at the end of the quarter, the flattest yield curve spread between these two rates since September 1, 2016.
Slow and steady economic growth and low inflation are good ingredients for non-government (corporate and other) bond performance versus Treasuries. Investment grade and high yield corporate bonds outperformed Treasuries in the quarter as did all other fixed income sectors except for agency mortgage backed securities.
However, spreads now are pretty narrow when considering historical experience. Despite the favorable mix of economic growth and inflation, the value in non-Treasuries is low. The economy and credit cycle are now entering the ninth year of recovery and expansion. Corporate credit growth has risen faster than GDP growth for some time. As a result, we believe it’s prudent to be cautious about risk positions.