Wednesday May 3

Stocks today finished lower as investors digested the FOMC statement. The S&P 500 fell 0.1% to 2,387 and the Dow Jones was little changed at 20,956. The KBW Bank index rose 1% on higher rate hike expectations in the aftermath of the FOMC statement and the DJ Utility Average fell 0.6%. The ADP employment report showed that 177,000 payrolls were added last month which was slightly higher than consensus of 170,000. The PMI Services index was 53.1 which was higher than the expectations of 52.3. The ISM non-manufacturing index also exceeded expectations coming in at 57.5 versus 55.8 expected. Investors today focused on a FOMC statement that was slightly more hawkish than expected. Among other important parts of the FOMC statement the Fed said that fundamentals were solid and that inflation was close to the 2% target. As earnings season continues analysts point out that this is one of the best quarters in the last five years for earnings growth. The two year Treasury yield rose 2bp to 1.30%. The ten year Treasury yield rose 3bp to 2.32%. Accordingly 2yr vs 10yr bear steepened to 1.02%. USD was stronger on the day against peers. USD rose 0.3% against EUR to $1.0896. USD rose 0.6% against JPY to Y112.68. USD rose 0.5% against GBP to $1.2874. Oil prices rebounded from a sharp selloff yesterday only slightly, and gold prices were lower 1.1%. WTI rose 0.2% to $47.74. Brent rose 0.6% to $50.74.

Along with all the well publicized issues plaguing oil companies such as persistent oversupply, low demand, and plummeting prices, oil producers can add rising interest rates to their list of concerns. Companies in the energy sector typically rely on financing a significant amount of their capital spending from issuing debt. In 2016 exploration and production companies spent $15bn more than their free cash flows. Prior to the plummet in oil prices that began in 2014 oil companies typically spent between $2 and $3 for every $1 they earned in operating cash flow. That means they were heavily reliant on debt markets. In many ways record low interest rates facilitated and drove the investment in shale production that led to the present situation. For many producers higher interest rates could eliminate the operational efficiencies they have achieved over the last few years as they have tried to be resilient to the global supply glut. Companies are tightening their belt and focusing on “cash flow neutrality” which means spending less than free cash flows. ConocoPhillips is one company that has achieved that and other companies have been looking to have their cash flows be greater than capital expenditures. The companies that are financially prudent will be able to participate in the consolidation in industry that some analysts are predicting. Companies that produce excess cash, reduced debt burdens, maintain investment grade ratings will be able to buy smaller producers as falling prices becomes uneconomic for small producers.

A hedge fund manager named Eric Yip of Adler Hill Management is making a bearish bet on malls using the CMBX index. Many investors are bearish on the future outlook of malls as ecommerce as a percentage of all commerce has risen from around 4% in 2011 to more than 8% at the end of 2016. Mr. Yip analyzed regional malls all over the company and after speaking with store owners, workers, and consumers he identified certain malls that were poorly maintained, outdated, and had a high concentration of mom-and-pop shops. He identified these types of malls as particularly weak, along with malls that had Sears, JC Penney, and Macy’s as tenants. Sears year to date has closed 150 locations so malls that are dependent on those anchor stores to make lease payments. From this process he formed a bearish view on the outlook for retail stores in certain locations, and sought to short malls using credit derivatives. The CMBX 6 index is an index of CDS which tracks 25 CMBS that were issued in 2012. Of the 1,500 loans in the pool 40 are from malls, and Yip identified more than half of those 40 as having a negative outlook. BAML identified 15% of the debt underlying the index as coming from weaker malls, which although low is still a higher concentration than comparable securities. As loans underlying the index default and/ or the index declines generally Yip is positioned to profit. Investors such as Alliance Bernstein and PIMCO are on the other side of the trade and they think the bearish narrative is being over exaggerated. Of Adler Hill Management’s $200mm fund the WSJ reports that bets against CMBX 6 make up more than half of that total.

The Fed statement today said that they see the recent lull in economic data as temporary and they haven’t derailed plans to raise interest rates this year. At the meeting today the Fed held policy rates in the 0.75% to 1% range and said that slow growth at the start of the year was “transitory.” The markets are currently pricing in a 94% chance of higher rates in June compared to 70% this morning before the statement. The Fed said economic risks are balanced and came across as positive on the slight resurgence in global growth. It appears now that the Fed is on a more determined path to normalize monetary policy. In recent years the Fed’s plans may have been derailed by a poor string of data however now that the economy seemingly has some momentum behind it, it will take more for the Fed to abandon plans to raise interest rates. Data recently showed that the economy grew at a 0.7% rate in the first quarter and that PCE inflation fell to 1.8% last month. The outcome of the French election also may have contributed to the Fed’s decision to hold course. It is also worth noting that the statement didn’t have any mention of unwinding the balance sheet so investors will have to wait until the minutes are released in May to get more clues on what the FOMC’s mindset is there. The somewhat hawkish statement sent bond yields and the US dollar higher.

Wednesday May 3

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