The U.S. Federal Reserve raised the discount rate 25 basis points as expected. But, was it warranted? Markets have certainly been going gangbusters, but the economy has been muddling along, and it appears that fourth quarter growth is likely to be more tepid than the third quarter’s >3% results.
The recent equity market reaction to President-elect Trump’s upset victory seems out-sized based on the underlying fundamentals of corporate America. Corporate investment is still lagging, and capacity utilization was estimated at 75% in November. That is the same level that we were at during the market correction in 2001. Regrettably, real wage growth has been stagnate for nearly two decades further tempering demand for goods and services.
Pension America, at least those that mark liabilities to market, should be happy that U.S. long rates have risen substantially. The 10-yeat Treasury’s yield is at 2.55% today, up 25 bps from the beginning of the year, but a whopping 1.23% from the low of 1.32% established on 7/6/16. Asset performance in the fourth quarter should be strong and liability growth should be negative. The combination should help plans see meaningful improvement in their funded status.
But, if equity markets are ahead of themselves from a fundamental perspective, while bonds have sold off more rapidly than the economics dictate, plan sponsors may be sitting on a potential negative scenario. The fact that most plans have little exposure to US bonds, which are highly correlated to plan liabilities, exacerbates this situation.
We believe that DB plans should de-risk when possible, even plans that are not well-funded. We’ve written about this on many occasions. Our preferred implementation is through a cash-matching strategy, as opposed to a duration matched program. With Treasury bond rates up, an implementation using Treasury STRIPS is cheaper today.
Interestingly, high yield bond rates have actually continued to fall making an implementation using high yield a little more expensive. Although, there is still a huge advantage creating a cash-matched strategy using high yield and lower quality investment grade (BBB and A) bonds, but the advantage has been narrowed.
If a cash-matching strategy is not in the cards at this time we’d recommend that you review your current asset allocation versus your policy normal levels, especially in small cap value, which had an extraordinary result in November. Capturing profits is a good thing.