Moving On Up Today s Economic Environment Presented by PFM Asset Management LLC Gray Lepley, Senior Analyst, Portfolio Strategies November 8, 2018 PFM 1
U.S. ECONOMY Today s Agenda MONETARY POLICY GEOPOLITICAL FACTORS INTEREST RATES FIXED INCOME MARKETS PFM 2
Current Economic Conditions 6% 4% 2% 0% -2% U.S. Real GDP (QoQ, SAAR) Rolling 4-Quarter Average 3.1% Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 2014 2015 2016 2017 2018 3.5% 2.5% 2.0% 1.5% 1.0% 0.5% Core CPI Core PCE Inflation Measures (YoY) Fed's Long Term Inflation Target 0.0% Sep '13 Sep '14 Sep '15 Sep '16 Sep '17 Sep '18 8% 7% 6% 5% 4% 7.2% 5.9% Unemployment Rate 5.0% 5.0% 4.2% 3.7% 160 140 120 100 80 60 Consumer Confidence 3% Sep '13 Sep '14 Sep '15 Sep '16 Sep '17 Sep '18 40 Sep '13 Sep '14 Sep '15 Sep '16 Sep '17 Sep '18 Source: Bloomberg, latest data available as of 10/30/18. SAAR is seasonally adjusted annualized rate. PFM 3
2Q and 3Q GDP Grew at Fastest Pace Since 2014 U.S. GDP Contributors and Detractors Personal Consumption Fixed Investment Private Inventories Imports Exports Government Expenditures 6% 5% 4% 5.1% 4.9% 4.2% 3.5% 3% 2% 2.3% 2.2% 1% 0% -1% -2% 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 2014 2015 2016 2017 2018 Source: Bureau of Economic Analysis, as of October 2018. 3 rd quarter contributions are based on the first GDP growth estimate. PFM 4
What We re Watching Basis Points 90 Spreads widened on a stock 85 market correction and concerns 80 about growth in Europe. 75 70 65 60 55 1-5 Year Corporate Spreads Recently, spreads have widen, amid lackluster corporate earnings, Italy s budget, and U.S. China trade tensions. 50 Oct '17 Jan '18 Apr '18 Jul '18 Oct '18 Yield 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% Flattening Yield Curve (10-Yr vs. 3-Mo) Spread 3-Month 10-Year Flattest curve since 2007: 78 bps 0.0% 0 Oct '16 Apr '17 Oct '17 Apr '18 Oct '18 350 300 250 200 150 100 50 Implied Probability 100% 80% 60% 40% 20% 0% Market Implied Fed Rate Hike Probability 4 3 2 3 1 2 2 1 1 1 Dec '18 Mar '19 Jun '19 Sep '19 Fed Meeting Dates Target Rate 3.25-3.5% 3-3.25% 2.75-3% 2.5-2.75% 2.25-2.5% 2-2.5% Economic Indicators are Strong Metrics At or Near Multi-Year Bests U.S. GDP (2018Q3) Unemployment Rate Consumer Confidence Job Openings Consumer Sentiment Avg. Hourly Earnings U.S. Manufacturing Inflation (Core PCE) Source: Bloomberg, yield spreads from ICE BofAML Indices, as of 10/29/18. Implied Fed Rate Hike Probability, as of PFM 10/30/2018. 5
The Fed: Dual Mandate or Dueling Mandate? FED PRICE STABILITY MAXIMUM EMPLOYMENT PFM 6
Strong Labor Market Persists as Unemployment Rate Hits 49-Year Low Monthly Change in Nonfarm Payrolls Unemployment Rate Nonfarm Payrolls 12-Month Moving Average 400k 8% 7.2% 300k 7% 6% 5.9% 200k 5% 5.0% 5.0% 100k 4% 4.2% 3.7% 0k Sep '13 Sep '14 Sep '15 Sep '16 Sep '17 Sep '18 3% Sep '13 Sep '14 Sep '15 Sep '16 Sep '17 Sep '18 Source: Bloomberg, as of September 2018. PFM 7
U.S. Employers Struggle to Find Qualified Workers 1.8 Ratio of Hires to Job Openings Job Openings vs. Unemployed Workers Job Openings Unemployed 1.6 Millions 16 14 1.4 12 10 1.2 8 6 1.0 4 0.8 Aug '06 Aug '08 Aug '10 Aug '12 Aug '14 Aug '16 Aug '18 2 Aug '06 Aug '08 Aug '10 Aug '12 Aug '14 Aug '16 Aug '18 Source: Bloomberg, as of 8/31/18. PFM 8
Differences Between Inflation Indicators Import Prices PPI CPI PCE measures Price of goods or services purchased from abroad by U.S. residents Selling prices received by domestic producers of goods and services Prices paid by urban consumers for a market basket of goods and services Prices paid for goods and services purchased by or on behalf of persons release Monthly Before the 15 th of the month 1-month lag Monthly Before the 15 th of the month 1-month lag Monthly Before the 15 th of the month 1-month lag Monthly End of month 1-month lag composition Goods Food Energy Services Goods Food Energy Services Goods Food Energy Services Goods Food Energy Services PFM 9
Core Inflation Hits the Fed s 2% Target Inflation Measures (YoY) Expectations for Average Inflation Rate over Next 5 Years 2.5% 2.5% 2.0% 2.0% 1.5% 1.5% 1.0% 0.5% Core CPI Core PCE Fed's Long Term Inflation Target 1.0% 0.0% Sep '13 Sep '14 Sep '15 Sep '16 Sep '17 Sep '18 0.5% Sep '13 Sep '14 Sep '15 Sep '16 Sep '17 Sep '18 Source: Bloomberg, latest data available as of September 2018. Inflation expectations based on yield difference between 5-year PFM Treasury note and 5-year Treasury Inflation Protected Securities (TIPS). 10
Has the Fed Achieved Its Dual Mandate? 4% Core PCE Inflation 3% 2% 1% current Q4 17 Q4 16 Q4 15 Q4 14 Q4 13 Q4 12 Q4 11 Q4 10 Q4 09 Fed s long-term projection for unemployment rate 0% 3% 4% 5% 6% 7% 8% 9% 10% Unemployment Rate Source: Federal Reserve Bank of Chicago, as of 9/26/18. PFM 11
FOMC s September Dot Plot Projects One More Rate Hike in 2018 Fed Participants Assessments of Appropriate Monetary Policy 5% 4% Sept-18 FOMC Projections Sept-18 Median Fed Funds Futures 3% 2% 1% 0% History of Recent Fed Rate Hikes Sept 18 2.00 2.25% Jun 18 1.75 2.00% Mar 18 1.50-1.75% Dec 17 1.25-1.50% Jun 17 1.00-1.25% Mar 17 0.75-1.00% Dec 16 0.50-0.75% Dec 15 0.25-0.50% Fed expects 1 more rate hike in 2018 & maintained future projections 2018 2019 2020 2021 Longer Term Source: Federal Reserve and Bloomberg. Individual dots represent each Fed members judgement of the midpoint of the appropriate target range for the federal funds rate at each year-end. Fed funds futures as of 9/26/18. PFM 12
Divergence of Central Banks Central Bank Policy Rates 2.50% Fed Target Rate ECB Target Rate BOJ Target Rate Bank of England Target Rate 2.00% 1.50% 1.00% 0.50% 0.00% -0.50% Jan '15 Jul '15 Jan '16 Jul '16 Jan '17 Jul '17 Jan '18 Jul '18 Source: Bloomberg, as of 10/29/18. PFM 13
USMCA: the Renegotiated NAFTA Key changes to the proposed agreement include: Top 15 Trading Partners Total YTD Trade ($ billions) $0 $100 $200 $300 $400 $500 Requires a larger portion of auto parts come from a high wage factory paying a minimum of $16/hour in salaries to production workers. This provision will likely force automakers to shift suppliers from Mexico to Canada or the U.S. Requires Canada to allow more dairy imports into their country as well as ends a program in which they assist Canadian sellers of dairy products domestically and abroad. China Canada Mexico Japan Germany South Korea United Kingdom France India Italy Taiwan Brazil Netherlands Ireland Switzerland Source: Census Bureau data includes YTD figures as of August 2018. PFM 14
Geopolitical Risks Around the Globe U.S. mid-term elections Brexit, Italy s budget, and EU fragmentation Russia-NATO conflict U.S.-China trade tensions Turkey currency crisis North Korea tensions Iran sanctions U.S.- Mexico border tensions Venezuela political crisis South China Sea dispute Argentina currency crisis PFM 15
IMF Outlook For Lower Global Growth 8% World GDP Projections 6% -0.2% 4% Downward revisions from projections in April -0.2%-0.4% 2% -0.2% -0.4% -0.1% -0.1% 0% United States Euro Area Japan China Emerging Market and Developing Economies 2016 2017 2018 2019 (Actual) (Projected) Source: IMF October 2018 Update. 2016 and 2017 rates represent actual growth; 2018 and 2019 rates are projections. PFM 16
Volatility Re-Enters the Market; S&P Down over Year 2,950 Year-to-Date Change High: +9.6% YTD 2,900 2,850 2,800 2,750 2,700 2,650 2017 close -0.6% YTD 2,600 2,550 Dec '17 Jan '18 Feb '18 Mar '18 Apr '18 May '18 Jun '18 Jul '18 Aug '18 Sep '18 Source: Bloomberg, as of 10/29/18. PFM 17
U.S. Yield Curve Has Flattened U.S. Treasury Yield Curve Tenor Current 9/29/18 Year-End 12/31/2017 Year-End 12/31/16 3.5% 3 month 2.30% 1.38% 0.45% 3.0% 6 month 2.46% 1.53% 0.61% 2.5% 1 year 2.63% 1.73% 0.82% 2 year 2.82% 1.88% 1.21% Yield 2.0% 1.5% 3 year 2.87% 1.97% 1.47% 5 year 2.92% 2.21% 1.95% 10 year 3.08% 2.41% 2.48% 1.0% 0.5% 0.0% 3 M 1 Y 2 Y 3 Y October 29, 2018 December 29, 2017 December 30, 2016 4 5 Y Y Maturity 10 Y Source: Bloomberg, as of 10/29/2018. PFM 18
Spread Between 10-Year and 2-Year Treasuries Tight 3.5% Spread 2-Year 10-Year Current: 28bps 350 3.0% 300 2.5% 250 2.0% 200 Yield 1.5% 150 1.0% 100 0.5% 50 0.0% 0 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Oct-18 Source: Bloomberg, as of 10/29/2018. PFM 19
Yield Curve Inversions Historically Precede Recessions Spread Between 10-Year and 2-Year Treasury Yields 3% 2% 1% 0% -1% -2% yield curve inverts worth watching Recession 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1-3% 0 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018 Source: Bloomberg, as of 10/29/2018. PFM 20
What Does the Flattening of the Yield Curve Mean? Source: LPL Research, FactSet. PFM 21
Where Are We in the Economic Cycle? Different Indicators Give Differing Views The Conference Board Leading Economic Index Continues to Rise The Conference Board Leading Economic Index (LEI) for the U.S. The Conference Board Coincident Economic Index (CEI) for the U.S. 120 110 100 90 80 70 '98 '00 '02 '04 '06 '08 '10 '12 '14 '16 '18 Supports the continuing solid growth in the economy Suggests no recession in the near-term Source (left): Wall Street Journal; Deutsche Bank (as of July 2018). Source (right): Conference Board (as of October 2018). PFM 22
Short-Term Credit Spreads Have Widened Due to Volatility Yield Spread of 6-month Commercial Paper over T-Bill Money Market Yield Curves 0.60% 3.20% 0.50% 3.00% CD/CP Average 0.40% 2.80% Treasuries 0.30% 0.20% +25 bps 2.60% 2.40% Agencies 0.10% 12-Month Low: +10 bps 2.20% 0.00% 2.00% Oct '17 Dec '17 Feb '18 Apr '18 Jun '18 Aug '18 Oct '18 1 2 3 4 5 6 7 8 9 10 11 12 Maturity in Months Source: Bloomberg, PFMAM Trading Desk, as of 10/29/18. Not a specific recommendation. 6-mo CP yield spread based on PFM A1/P1 rated CP index. 23
Short-Term Treasuries Compensate Investors for Multiple Hikes in 2019 2.70% Treasury Yield Estimated Average Overnight Repo Yield +5 bps 2.60% 2.50% +9 bps 2.40% +9 bps 2.30% +9 bps 2.20% 2.10% 2.00% 1 month 3 month 6 month 9 month 12 month Source: Bloomberg, as of October 29, 2018. Average overnight repo yield assumes an initial repo rate of 2.13% and 25 basis point (0.25%) interest rate hikes in December of 2018 and March, June, and September of 2019; it is calculated by determining the average resulting yield over each time horizon. PFM 24
Federal Agency Spreads Remain Tight 0.15% Federal Agency Yield Spreads Agency 10/29/18 Agency 12 Mos Max 0.10% 0.05% 0.00% -0.05% 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 Years to Maturity Source: Bloomberg as of 10/29/2018. PFM 25
Volatility in Corporate Securities 100 90 Yield Spread (OAS) of 1-5 Year Investment Grade Corporate Index 2017-39 basis points ( bps ) 2018Q1 +22 bps 2018Q2 +2 bps 2018Q3-10 bps 2018 Q4 Basis Points 80 70 +9 bps 60 50 Dec '16 Feb '17 Apr '17 Jun '17 Aug '17 Oct '17 Dec '17 Feb '18 Apr '18 Jun '18 Aug '18 Oct '18 Source: Bloomberg, ICE BofA Merrill Lynch Indices, as of 10/29/2018. PFM 26
Yield Environment as of October 29, 2018 Maturity Treasury Federal Agency AA Corporate A Corporate 3-Month 2.31% 2.29% 2.45% 2.43% 6-Month 2.46% 2.42% 2.66% 2.71% 1-Year 2.63% 2.63% 2.83% 2.98% 2-Year 2.82% 2.87% 3.12% 3.26% 3-Year 2.87% 2.96% 3.24% 3.41% 5-Year 2.92% 3.07% 3.45% 3.60% Source: Bloomberg BVAL yield curves for Treasury and Corporate. TradeWeb for Federal Agency yields. 3 and 6 month corporate yields from commercial paper; A-1+ for AA and A-1 for A. Yields are for indicative purposes only; actual yields may vary by issue. PFM 27
Q3 Sector Returns Favor Spread Products 2018 Q3 1-5 Year Sector Returns 2018 Q3 Treasury Returns 0.7% 0.6% 0.5% 0.4% 0.3% 0.25% 0.66% 0.55% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% 0.49% 0.19% -0.16% -0.37% -0.79% 0.2% 0.1% 0.04% 0.10% -2.0% -2.5% 0.0% -3.0% -2.81% U.S. Treasury Agency Corporate (A-AAA) Agency MBS ABS (AAA) 0-1 Years 1-3 Years 3-5 Years 5-7 Years 7-10 Years 10+ Years Source: ICE BofAML Indices. MBS and ABS indices are 0-5 year, based on weighted average life. As of 9/30/18. PFM 28
Sector Returns over Time 2.00% 5-Year Return 1.75% 3-Year Return 1-Year Return 1.50% 1.51% 1.22% 1.47% 1.00% 0.73% 0.93% 0.73% 0.97% 0.50% 0.00% 0.17% 0.35% 0.44% 0.03% 0.06% -0.50% -0.58% -1.00% -0.82% U.S. Treasury Agency Corp (A-AAA) Agency MBS ABS (AAA) U.S. Treasury Agency Corp (A-AAA) 1-5 Year Treasuries Agency MBS ABS (AAA) U.S. Treasury Agency Corp (A-AAA) Agency MBS ABS (AAA) Source: ICE BofA Merrill Lynch Indices. MBS index is 0-5 year, based on weighted average life. As of 9/30/2018. Returns greater than 1-year are annualized. PFM 29
Return Benefits of Diversification Example 1-5 Year Portfolio Sector Allocation Portfolio Return 5-Year Returns 2017 Returns 15% 30% 25% 10% 10% 10% 6 1.20% 1.35% 15% 40% 25% 10% 10% 5 1.17% 1.29% 25% 40% 25% 10% 4 1.09% 1.19% 40% 50% 10% 3 0.86% 0.82% 50% 50% 2 0.83% 0.75% 100% 1 0.73% 0.65% Treasury Agency Corp A-AAA Mortgage-Backed Securities Supranationals Asset-Backed Securities Example portfolio returns are based on the ICE BofA Merrill Lynch 1-5 Year indices for all sectors except for Supranational which uses the 1-5 Year index and are annualized for trailing periods longer than one year. Source: ICE BofA Merrill Lynch PFM Indices, as of 9/30/18. 30
Total Return During Tightening Periods 12% 1-5 Year Treasury Index Total Return 18 Month Moving Average S&P LGIP 7 Day 10% 8% 6% 4% Fed tightening 2% 0% -2% Sep '95 Sep '97 Sep '99 Sep '01 Sep '03 Sep '05 Sep '07 Sep '09 Sep '11 Sep '13 Sep '15 Sep '17 Source: Bloomberg, as of 9/30/18. PFM 31
Total Return vs. Yield During Tightening Periods 1.4% 1-5 Year Treasury Index Total Return 18-month MA 5 Year Treasury Index Yield 1.2% 1.0% 0.8% 0.6% 0.4% Fed tightening 0.2% 0.0% -0.2% -0.4% Sep '95 Sep '97 Sep '99 Sep '01 Sep '03 Sep '05 Sep '07 Sep '09 Sep '11 Sep '13 Sep '15 Sep '17 Source: Bloomberg, as of 8/31/18. Includes the 1-5 Year Treasury Index Total Return 18-month MA and the 5 Year Treasury Index Yield. PFM 32
Long-Term Benefit of Longer Duration Investment Strategies Millions $35 $30 Fed tightening $25 $20 $15 $10 Sep '95 Sep '97 Sep '99 Sep '01 Sep '03 Sep '05 Sep '07 Sep '09 Sep '11 Sep '13 Sep '15 Sep '17 1-3 Year Treasury Index Total Return 18 Month Moving Average 1-5 Year Treasury Index Total Return 18 Month Moving Average 1-10 Year Treasury Index Total Return 18 Month Moving Average S&P LGIP 7 Day Source: Bloomberg, as of 9/30/18. PFM 33
Questions? PFM 34
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