This month, MFI interviews Jim Palmer, CIO of Minneapolis-based U.S. Bancorp Asset Management (USBAM), which manages the First American Funds, Inc. First American, the 14th largest money fund manager, is one of the few investment advisers focusing solely on cash and investment-grade fixed income. USBAM manages 34 money funds with $58.2 billion (as of 12/31/18), according to Crane Data. We discuss the fund manager's outlook for 2019, the Fed, SMAs and a number of other topics below. Our Q&A follows. (Note: The following is reprinted from the January issue of Money Fund Intelligence, which was published on Jan. 8. Contact us at info@cranedata.com to request the full issue.)
MFI: Tell us about your team. Palmer: I am the Chief Investment Officer of U.S. Bancorp Asset Management, which is a dedicated investment-grade, fixed-income manager. We have over $83 billion in assets under management as of the end of November 2018. We focus on three primary business lines. We are the investment adviser to the First American family of money market funds. We have a book of investment-grade, fixed-income SMA portfolios. Typically, these portfolios have maturity limits of five years and under, but we do have strategies going out to 15 years. We also manage the collateral reinvestment for the securities lending program. We run both taxable and tax efficient strategies.
MFI: What are your big issues for 2019? Palmer: From an investment standpoint, I think [the biggest is] accurately predicting Fed rate changes for 2019, which we believe will be far less telegraphed than in the recent past. Obviously, making accurate predictions around what the Fed will do is crucial for money market fund and SMA absolute performance as well as for relative performance versus peers. We believe predicting the Fed will be more challenging this year for a couple of reasons. One, the Fed will be holding live press conferences at each meeting going forward, implying each meeting is live for a policy rate adjustment. Whereas [in] 2018, it was well signaled and accepted that at every other meeting we would be getting a rate hike.
I'd also say the economic and financial market outlook is far more uncertain in 2019 than in 2018, which implies we may or may not be approaching the end of the rate hike cycle and the end of quantitative tightening. [So] the next policy adjustment will be more uncertain than it has been in the past. If you looked at 2018, certainly the direction was that rates were going up. Today, there are opinions suggesting the Fed should stop or perhaps even begin cutting rates in the coming year, even while the Fed's Dot Plot looks for two 2019 rate hikes.
MFI: What about managing late cycle credit risk? Palmer: With the solid economic growth we've seen, it has been a fairly supportive environment for credit, particularly financial credit. But we are clearly coming toward the end of the credit cycle and leverage has been increasing, especially in the industrial sector. That said, we still believe the highly-rated banks and financial credits which typically make up the majority of Prime fund investments are comfortably within minimal credit risk standards based on their fundamentals and strong capital and liquidity metrics. We look for most of the credit stress to be in the triple-B type names. Issuers you would find more in SMA or short fixed-income portfolios than in the higher quality Prime money market funds. I think every investment manager is sharpening their credit work to make sure they understand the direction and risks of the overall credit markets and in their Prime fund holdings as well.
MFI: What are the major issues from a business standpoint? Palmer: The money market fund industry is almost assuredly going to face greater competition for shareholder balances from increased U.S. Treasury issuance, particularly in T-bills. With growing federal budget deficits, all that new debt will require funding, and it's going to represent a real competitive headwind for money market fund asset growth. But from a supply and demand standpoint, all that new issuance should help push money fund yields up too. One tailwind for industry growth should be higher yields making money funds a more attractive asset class. Certainly, cash yielding over 2 percent is a far more viable investment option than during the days of ZIRP. Given the market volatility we have been experiencing, the concept of holding cash seems to be gaining more steam in the broad media and marketplace as a source of adequate return for your money, especially if you are in a defensive mode.
MFI: Is cash taking market share? Palmer: Right now, it is probably a little of both [stocks and bonds]. I think money funds are a great store of value if you are looking to preserve principal. So I think cash is probably reaping the benefits of the recent market turmoil.
MFI: What about Prime/Govt spreads? Palmer: Currently, the spread between Prime funds and Treasury and Government funds is around 20 basis points. I think that is probably a reasonable range going forward. I suspect any uptick in T-bill yields from the amount of forecasted Treasury issuance will offset any marginal increase you might see in bank spreads for shorter term bank paper. So I don't see much movement. I suspect the difference between Treasury and repo funds and Government and repo funds will basically be negligible going forward.
Right now, Treasury funds are actually out-yielding Government funds despite the perceived difference in credit quality. In the current environment, the yield advantage is probably driven by the different composition of floating-rate securities.... However, the difference between repo rates on Treasury versus agency collateral has shrunk to a basis point or two at best. Also, there is a greater amount of Treasury-backed repo in Government funds, which blurs the difference between the two funds.
MFI: Can you talk more about the Fed? Palmer: Sure. Looking back a few months, we expected, as most market observers did, that the Fed would raise rates in December. We have also been consistently taking the 'under' versus the Fed's Dot Plot which had been suggesting three 2019 rate hikes. We were in the 'one or two' camp and will probably remain there, with a bias leaning toward one 2019 rate hike right now. On the balance sheet, the Fed certainly seems adamant about shrinking its securities holdings. [But] I do think Chairman Powell's comments that quantitative tightening may be more on autopilot was really just a verbal gaffe, which is already being dialed back by Fed officials. In the end, I think the Fed will re-evaluate the pace of quantitative tightening and perhaps take measures to reduce the maximum monthly balance sheet reduction, if for no other reason than to let investors know they are observing and aware of current market conditions and are not restricted by their models.
MFI: Tell us about your SMA portfolios. Palmer: USBAM's SMA assets under management at the end of November 2018 were about a third of our money fund assets, so it is a significant but smaller portion of our overall business. The SMA assets are longer-term portfolios, which vary anywhere from enhanced cash to portfolios with durations out to four years. Many SMA portfolios invest in triple-B credits as well, though we do not manage any high-yield strategies. The dynamics for SMA portfolios are a little different than money market funds. We think repatriation and the tax code changes impacted the SMA business more so than money market funds. The late 2017 tax code changes caused companies to become more conservative and more liquid with their cash.... So, I think companies were prudently being more conservative, especially when you consider the opportunity cost for holding cash was much lower as the Fed raised rates. Then late in the year you saw volatility in the marketplace which made cash an even more attractive opportunity.
MFI: Do investors use SMAs in tandem with money funds? Palmer: Absolutely, combining money market funds and SMA portfolios is a core strategy for many large companies. These companies first invest a significant portion of their operating cash in highly liquid instruments such as money market funds and bank deposits to meet their day-to-day business needs. SMA portfolios play a role when these companies have large excess cash balances which may not be needed for an extended period, probably measured in years.
MFI: Talk about communications. Palmer: Our investors have access to our investment team to discuss markets and our strategies, but we also produce a fair amount of market commentary. We have just started posting weekly blogs on our USBAM website, which will help distribute our views not only on current market dynamics, but also on basic market fundamentals, investment terms and a little history as well. I write commentaries on a quarterly and monthly basis, which go a bit more into detail on the strategic thinking driving our portfolio decisions. Our credit analysts also produce commentaries on topical issues. There is no question as to the importance of investment advisers producing relevant content and education. We certainly have increased the amount of value-added content we produce for our clients and shareholders.
MFI: What about investment philosophy? Palmer: We seek to add excess returns utilizing yield-curve positioning, duration management, sector allocation and security selection. We consider ourselves to be an unbiased manager among these strategies as each may represent greater relative value in any given market cycle. Core to all our investment strategies is portfolio and sector diversification along with a strong focus on fundamental credit research. Those fundamentals are crucial in all markets, but are particularly important in periods of increased market volatility and as we approach the late stages of a credit cycle.
