Market response to events in Iran: a pause, not a panic    

Brian Nick

The last week’s market highlights:

Quote of the week:

“Be at war with your vices, at peace with your neighbors, and let every new year find you a better man.” – Benjamin Franklin
Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s 2020 Outlook :
  • U.S. economy: No recession in sight. 
  • Global economy: A clearer path for growth.     
  • Policy watch: Fed looking to stand pat as Brexit and trade risks abate. 
  • Fixed income: Low yields, tight spreads.   
  • Equities: Cyclicals and eurozone stocks set to lead 
  • Asset allocation: No big bets with valuations rich in most spots.

Putting 2019—a banner year—in perspective 

In terms of asset class performance, 2019 will be tough to top. Returns were strong across the board:
  • The S&P 500 Index surged 31.5%, marking its best year since 2013.
  • Non U.S. stocks were also profitable. Europe’s STOXX 600 Index advanced 28% in local currency terms (25.3% in U.S. dollars), while the MSCI Emerging Markets Index rose 18.1% and 18.4%, respectively.
  • Fixed income joined the rally, with U.S. Treasuries (+6.9%), investment-grade corporate bonds (+14.5%), high-yield corporates (+14.3%) and emerging-market debt (EMD, +13.1% in dollar terms) all pumping up portfolios.3
Although we don’t enjoy pouring cold water on such excellent results, it’s important to remember that much of 2019’s broad rally was due to markets’ “exhaling” as the global economy avoided recession. Investors had to play catch-up after a less-than-stellar 2018 that saw U.S. and overseas equities, corporate bonds and EMD all post full-year losses.4 The fourth quarter of 2018, in particular, was a low ebb for U.S. and global growth as the U.S. government partly shut down and the weight of U.S./Chinese tariffs began to take a toll.
Heading into 2020, the U.S. economy appears to be in good shape, even as the manufacturing sector showed further signs of struggling in December. GDP forecasters have lifted their outlooks. For example, the AtlantaFed GDPNow model currently expects annualized fourth-quarter GDP growth of 2.3%, up from just 0.3% in November. Among the recent economic highlights: 
  • Consumers, the economy’s engine, continue to open their wallets. The Saturday before Christmas was the biggest U.S. shopping day ever, with sales topping $34 billion, according to the Wall Street Journal.

  • The housing market has kicked into a higher gear. Homebuilder confidence jumped in December to a 20-year high, according to the NAHB/Wells Fargo index.

  • The labor market is still a source of strength. Initial jobless claims (222,000) stayed near a multi-decade bottom for the week ended December 28.5 
Taking a broader look at the job market, the labor force participation rate has edged up over the last six months or so, while the number of available workers remained extremely low by historical standards. At the same time, the number of job openings continued to top 7 million in October, per the JOLTS report.6
We expect this labor supply/demand mismatch to lift wage growth, and there are signs this may be happening: In November, personal income topped forecasts, and average hourly earnings for nonsupervisory workers grew at their second-fastest year-over-year rate in more than a decade.7 December’s jobs report, due out Friday, will provide an update on employee earnings growth.
But what’s good for workers’ paychecks may not be good for stocks if wage pressures threaten company bottom lines and the Fed allows the economy to “run hot.” Although the core PCE Index, the Fed’s preferred inflation barometer, has remained below its 2% target since September 2018, a significant pickup in inflation still poses a risk to equity returns.8 

A 2019 repo recap (Spoiler alert: All’s quiet in short-term markets) 

During the last few months of 2019, “repos” featured prominently in financial headlines. But what exactly is a repo and why should investors care? A repo (short for repurchase agreement) is essentially a loan in which one party lends cash to another, who offers U.S. Treasuries or other high-quality assets as collateral and agrees to repurchase those securities at an agreed-upon date for a slightly higher price.
Repos are considered the “grease” of the global financial system since they provide cash that banks, broker dealers and other institutional investors need to run their daily operations. The market for repos typically operates like a well-oiled machine, with more than $2 trillion trading hands every day.9 But beginning in mid-September, this relatively sedate corner of the market showed signs of malfunctioning.
Because repos are backed by high-quality collateral, their interest rates are typically lower than the effective fed funds rate, the interest banks charge each other on unsecured, overnight loans. On September 16, however, the Tri-Party General Collateral Rate (TGCR), a common repo benchmark, closed at 2.42%—17 basis points higher than the 2.25% fed  funds rate. And the following day, the TGCR closed at 5.25%, a whopping 300 basis points higher.10  
Market participants attributed these unusual rate spikes to a perceived lack of liquidity. Strong demand for cash met sparse supply. On the demand side, companies needed funding to pay quarterly income taxes, and banks paid for their U.S. Treasury purchases following a Treasury auction. Regarding supply, the level of reserves held by banks at the Federal Reserve has shrunk considerably since the Fed ended quantitative easing in 2014.
This demand/supply imbalance triggered anxious memories of the 2008 financial crisis, when strains in the repo market were among the first signs of trouble. Back then, counterparty risk was the primary concern. Because lenders doubted the ability of borrowers to repay the loans given questions about both liquidity and solvency of major financial institutions at the time, they demanded sharply higher overnight rates.
So the Fed sprang into action on September 17, injecting $53 billion into the overnight repo market—the first time since the crisis that the central bank had taken such drastic steps to keep short-term interest rates from rising. That move has been followed by more than 100 daily loans, mostly in the $30 billion-$80 billion range.
But the Fed didn’t stop there. To ensure an adequate supply of reserves, in October it began buying $60 billion of short-dated U.S. Treasuries a month. These purchases are slated to continue until at least the second quarter of 2020. 
The Fed’s aggressive support successfully contained repo rates for the remainder of 2019 and into January. Investors paid particular attention to interest-rate action in late December, when banks often abstain from lending ahead of important regulatory calculations taken before the start of the new year. In the past, these tighter conditions have triggered sharply higher TGCR rates—but not this time. Each day during the week between Christmas and New Year’s, the TGCR closed in line with or below the effective fed funds rate, a clear sign of market calm.
Minutes from the Fed’s December meeting, released on January 3, indicated that officials expect to dial back the frequency of their repo interventions once banks have built up reserves sufficiently. (The Fed didn’t disclose how long it plans to keep buying Treasuries.)
Also discussed was the possibility of setting up a “standing facility,” which would allow banks to borrow on an as-needed basis. This arrangement would replace the daily loans that the Fed has been providing for nearly four months. 
  1. S&P 500, STOXX 600 data from Haver, Morningstar
  2. Treasury data from treasury.gov
  3. Fixed income data from Bloomberg, Morningstar
  4. 2018 data from Bloomberg, Morningstar
  5. Haver
  6. Employment data from Haver
  7. Bloomberg, BEA, People’s Pundit
  8. Haver
  9. SIFMA
  10. TGCR, repo data from Bloomberg, NY Fed
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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