Strategy
The COVID Delta variant had a significant impact on 3rd quarter economic activity. GDP is expected to have increased 2% - 3% in the quarter which is well below the 6.7% we saw in the 2nd quarter. Daily cases in the U.S. increased from 25,000 to 160,000. Airline travel decreased, borders closed, and it seemed as though we were headed back to renewed pandemic restrictions. August nonfarm payrolls were expected to increase 700,000 and the actual number was slightly more than 200,000. Inflation continued to show it wasn’t transitory as the Fed’s favorite measure showed a 4.3% annual rate versus their target of 2.00%. The CPI increased at a 5.3% annual rate versus 1.3% a year ago. Interest rates were largely unchanged for the quarter with short rates unchanged, the 5-year maturity Treasury note yield increased 12 bps, the 10-year maturity increased 7 bps, and the long bond yield was essentially unchanged. There was a sharp increase in longer-term yields late in the quarter as the 10-year Treasury note yield rose 24 bps from September 22nd to the end of the month. Is this the start of a larger move?
As we look at the 4th quarter, we see some very positive developments. The covid daily infection rates have been falling sharply and are expected to continue. The number of people having natural immunity or man-made through vaccinations is getting to a level approaching herd immunity. The CDC estimates it to be close to 83%. According to the JOLTS survey there are 11 million unfilled jobs so anyone who wants to work should find a job quite easily. A rebound in GDP is forecast for the 4th quarter to 5.1%. The market is aware the Fed wants to start to taper this year and interest rates have increased only 25 basis points. Washington is trying to pass a bipartisan infrastructure bill that would also boost economic growth but disagreements among Democrats is delaying its passage. The 4th quarter GDP looks as if it will be higher than the 3rd quarter.
Since this part of the newsletter is titled Strategy let’s look at areas of interest. We haven’t discussed CMOs in a while but have found some structures that look attractive. As an example, let’s examine a Freddie Mac backed sequential. The base case average life is 4.23 years with a 10-year cash flow window. It is priced at $102 to yield 1.47%, which is a yield spread of 66 basis points. The average life extends to 5.90 years at a slow prepayment speed. The investor receives 40% of their principal back within the first three years. If the Fed starts raising rates in the coming years, this bond will provide excellent cash flow for reinvesting. We like the 4-year part of the yield curve for investors wanting to stay short.We find yield spreads above 100 in the current tax environment to be attractive.
We find yield spreads above 100 in the current tax environment to be attractive.
On the tax-exempt front, we recently purchased a AA-rated general obligation of a city in Connecticut. It was issued in late September and matures August 1, 2035. It has a call date on August 1, 2029 at par. The bond has a 2.00% coupon, and we purchased it to yield 2.00% on a yield to maturity basis. Assuming a 21% corporate tax rate, the taxable equivalent yield is 2.53%. This equates to a yield spread over a like-maturity Treasury of 110 basis points. If it gets called in 2029, the yield spread would be 120 basis points. We find yield spreads above 100 in the current tax environment to be attractive.
Our final area of opportunity is a security we have used frequently over the years. It is a privately issued mortgage-backed security or what we call an RMBS (Residential Mortgage-Backed Security). This security was newly issued in September. It is priced two full points (64/32nds) below like-coupon agency-backed 15-year MBS. It is priced at $102.1875 to yield 1.60% at 15 CPR. The average life is 2.68 years. The yield spread is a very generous 110 basis points. The bond has 12% credit support and is AAA rated. At 24 CPR, the average life falls to 1.70 years and the yield is 1.10% (a yield spread of 85 basis points). The average loan-to-value ratio is 64% with a 783 FICO score. The credit quality metrics are outstanding making this a very attractive addition to a portfolio.
Interest Rate Outlook
The evolving political landscape seems as messy as ever. The debt ceiling issue arose again, with the expected date that the U.S. would default on its debt being October 18th, if the limit isn’t extended. As of now, it looks like they will punt the ceiling expansion out to December, so we can worry about defaulting again in January. As the Country becomes more divided and extreme, the game of political “chicken” gets riskier each time. This time around, we anticipate that the limit will be extended, and Republicans may use the goodwill to trim some of the size of the spending/investment plans down. Our current expectation is that the social infrastructure bill will end up around $2 trillion and the bipartisan (traditional) infrastructure bill will remain at its current $550 billion, according to whitehouse.gov. Last quarter we said that “shock and awe” spending would influence inflationary pressures and impact near-term growth expectations. The passage of $2.5 trillion in new spending probably has a similar effect to the previously hoped for $4.5 trillion. Getting progressive and moderate Democrats to get to an acceptable place of compromise may be difficult but, in the end, midterms are coming, and the politicians need to show that they “got stuff done” so something significant will be passed using the budget reconciliation in the next few months.
Housing is turning out to be the pain point we identified and expected...
Over the quarter, it seemed that the inflation picture was evolving further. Housing is turning out to be the pain point we identified and expected (due to low financing costs and significant population migration trends, along with volatile materials costs). Through the end of July, the S&P CoreLogic Case-Shiller index of property values nationwide increased 19.7% on a year-over-year basis, the largest spike in more than 30 years. The Phoenix, Arizona market was particularly hot, experiencing a surge of 32.4%. As we detailed last quarter, rents are increasing at nearly double-digit rates as well. The likelihood that a hybrid workplace model is a long-term trend in some industries suggests that the upper half of the housing market will see continued interest, especially in areas and pockets of the market that have been desirable as of late. A concern for the lower half of the market is that zoning law changes could risk making starter homes unattainable for younger people. To explain further, if cities eliminate single-family housing, investors may bid up starter homes, knock them down and build multi-family housing. Sure, you have increased housing density, but you have created incentives for prices to climb, you have made potential owners into renters, the opportunity to gain sweat equity has vanished, and one of the largest wealth accumulation vehicles will be out of reach for many young people.
Wages are the area that we feel is most uncertain. In September, enhanced unemployment benefits concluded. Although the Biden administration suggested that states could choose to use their stimulus dollars to continue the benefits, to this point, we don’t see evidence that any states are choosing to do so. Perhaps the fact that the number of unfilled job vacancies in the U.S. exceeds 9.2 million (as of mid-August, per fred.stlouisfed.org) as compared to the number of unemployed persons in the U.S. at just under 8.4 million people (as of the end of August, per bls.gov) suggests that the enhanced unemployment benefits have outlived their usefulness on a broad basis. Absent government intervention, it seems that there will be large numbers of workers seeking employment. The development to watch will be as people decide they need to find a job (against the backdrop of rising prices) will they demand wages that are an improvement on an inflation-adjusted basis, or will they be price takers as to the value of their time? In the first quarter of the year, we saw real wage growth measure approximately negative 2.5% and has settled in the second quarter to something closer to negative 1%. Rising prices of commodities, especially energy/oil costs, are applying pressure to employers and employees alike. Employers have hobbled along in a scarce and skewed labor environment for more than a year and a half and are facing multiple input and operating cost pressures. It seems that in the current wage environment, this “staring contest” favors the employers.
...it would seem that some degree of stagnation lies ahead.
We have offered the concern that the same extraordinary measures we have employed to help people, risk hurting those same people at the end of this pandemic episode. In our opinion, it would have been more compassionate to telegraph to people that stimulus and unemployment benefits were going to move toward a more normal state (if in fact, that is where we are headed). Inflation is often defined as too many dollars chasing too few goods. We have given millions of people a pay raise to stay at home; some of those same people were formerly producers of goods and services. Our solution, which was likely appropriate for a time, increased the number of dollars out in the economy, at the same time increased the consumption of goods, while restricting the ability to produce and provide goods and services. Unwind the dynamics and it would seem that some degree of stagnation lies ahead.
As the political realities avail themselves, including both the spending/investment plans, as well as the normalization of the labor environment, so too will the duration of the transitory nature of broad inflation. If people are incented to stay home and collect benefits, that should continue to drive inflationary pressures we have previously detailed. The spending/investment plans seem like they will primarily pressure commodity prices, but some of the broadly defined social infrastructure could have spill-over effects that may replicate the current situation. It seems like the bias is toward some path that will continue the pockets of inflationary pressures we have seen for several months. Absent some amount of infrastructure spending, the base effects that have resulted in the strong inflation numbers on a year-over-year basis as of late could reverse and translate into weak levels of inflation in the coming year. Sticky areas of inflation, such as housing costs, as well as backlogged areas of expenses, such as shipping and transportation costs, should place a floor on how low inflation may go. Some areas of dramatic inflation may have reached levels that suggest a degree of price reversion is in order for meaningful pockets of inflation. On a year-over-year basis, here are some eye-popping numbers: Natural gas up 110%, West Texas Intermediate Crude Oil is 91% higher, coffee (a fuel of another type) increased by 80%, aluminum spiked 64%, sugar rose by 40%, copper is 39% higher, corn up by 37% and lumber prices have increased 12%. Viewed another way, imagine if those rates of price increases persisted? Legions of people would lose ground from a purchasing power and quality of life angle if wages didn’t grow dramatically. If input costs, operating costs, and labor costs all rose meaningfully, where would that place businesses and institutions if price increases could not be passed on to customers, as has been the case during many of the whiffs of inflation we have experienced over the past decade? The possibility of a volatile path of inflation creates a lot of potential paths and the prospects for above-trend inflation to make the average person’s life better is doubtful. The main winner in an inflationary environment may be levered investments with fixed financing. If you financed an asset in a low yield environment and paid off the fixed-rate debt with inflated/devalued dollars, your returns could be amplified and at a minimum, the cost of servicing your debt should be less painful. Such a scenario would be bad for bonds, but that is not our expectation over the long term. Our expectation is that the sticky and backlogged areas of inflationary pressure will clash with other pockets of price pressures that will mean-revert toward lower prices, and although nobody really knows where it will settle, growth on the order of 1.5% to 4% seems to be a fair estimate. The low end of that estimate is based on no additional stimulus and the high end would result if all the spending passes (the $2.5 trillion mentioned earlier), plus some extension of unemployment benefit enhancements.
Perhaps the real magic came from low inflation and a focus on employment opportunities for moderately skilled labor.
Taking a slightly longer view of inflation, the Fed’s “Dot Plot” estimate of when they will need to raise short-term yields is at a 50/50 split between rising rates in 2022 versus a need to hike in 2023. It is noteworthy that this is a large change from recent guidance that suggested 2024 as the timing of the next rate hike. We believe that recent comments about the Fed’s role in addressing wealth and income inequality issues, along with past comments that may indicate that the Fed increasingly views itself as a contributor to a collection of global central banks, suggest a bias toward accommodation. Let’s face it, the world is addicted to cheap money. People feel it is only fair that they finance large purchases at 3%. Over the past seven years, the Fed noticed that as the unemployment rate fell at the same time inflation was modest, lower-skilled laborers experienced real wage growth. To replicate that environment, it may be the case that the Fed will try to let the economy run hot in the hope that unemployment trends lower. Perhaps the real magic came from low inflation and a focus on employment opportunities for moderately skilled labor.
Our call for an updraft of interest rates doesn’t have to do with run-away inflation, but rather, for some more mundane and mechanical market issues. As the Fed begins to reduce asset purchases, bond desks may choose to reduce risk exposures, which may force yields higher than would be the market effect if the impact of the reduction of the Fed’s purchases were considered in isolation. Around the time of the start of the taper, bond trading desks may need to reprice risk tolerance as the ability to sluff off risk to a captive buyer (the Fed) subsides. Bid/ask spreads may widen, meaning market liquidity may diminish and the cost to sell a bond may rise. Some corners of the bond market may experience greater impact as compared to the broader bond market. The more technical influence that could work to drive bond yields higher has to do with negative convexity hedging on the part of mortgage-backed security servicers and some holders. Convexity hedging involves selling Treasuries to compensate for the impact that rising rates have on the duration of mortgage-backed securities (as people prepay mortgages at a slower pace in a rising rate environment, it extends the interest rate risk of a mortgage-backed security). Morgan Stanley analysts estimate at current yield levels, each basis point of increase in the 10-year Treasury yield translates into approximately $4.7 billion of selling pressure as a result of convexity hedging. Mechanically, it is a feedback loop that could result in a short-lived updraft in yields in three to six months. As rates rise, they must hedge; the selling pressure causes rates to rise further, resulting in more hedging.
Our outlook is for annoying and painful pockets of inflation, but broadly acceptable levels of inflation, spikes in yields due to mechanical issues that collectively settle lower based on the weight those influences have on the bulk of the population as they suffer through negative real wage growth. Longer-term, there will be a troubling push-pull battle between the disinflationary influences of technology, the cost of moving forward with green energy initiatives (new technologies are expensive), and the largest challenge of them all, the diminished value of human capital. It feels that the pandemic has expedited the trend toward making humans devalued, at least from a commercial and aspirational aspect. Some schools are doing away with “F’s” or are making grade assessments a pass/fail, people are understandably gaming emergency unemployment benefits (and their fellow citizens in the process) and the resulting work ethic of people who have the perspective that employers are lucky to have employees show up, is underwhelming. It is difficult to imagine a productivity boom and future excellence emerge from such an environment. The future looks like it will involve pockets of well-paid vocations, such as the trades, technology jobs and professional services, against a backdrop of a lot of jobs that people just will not be willing to pay much to fill because automation and other substitutes for a particular service are readily available. It is possible that the pandemic afforded us a window into our future, with a population of producers and a contingent of kept consumers.
Policy errors, like those used in the 1970’s, could be the treatment that makes the patient sicker.
It feels like there is a real risk that a stagflationary economic environment could result from the sticky sources of inflation met with negative real wage growth. Policy errors, like those used in the 1970’s, could be the treatment that makes the patient sicker. Compassionate people can help their fellow citizen in ways that do more harm than good, although a well-communicated bridge to normalcy may be the healthy path back to a sustainable economic and labor environment. Traditional infrastructure investment has been needed for some time. The cyber-attacks on our infrastructure suggest that basic utilities, communication infrastructure and other basic government deliverables need to be “hardened” to potential disruptions. The double positive of investment/spending in this area comes from continued reliable delivery of basic services while stimulating productive job activity. Reasonable people can debate the size and scope of social safety net needs. We expect that trillions will be spent on both areas, which may perpetuate the current state of consumption, resource utilization, and modest real wage improvement. Inflation may not be as transitory as the Fed originally thought, but the weight of price increases should guide inflation to a more reasonable level over the next year or two.
The opportunities that are ahead seem as if they will be the result of mechanical issues that may occur around the time the Fed begins to taper their asset purchases. We suggest buying the updrafts. Treasuries have seen a significant move since we started writing this piece, but we expect that 10-year Treasury yields will exceed 1.70% at a point in 2021 and in 2022 we could see yields exceed 2.0% that may be coupled with spread widening in corporate bonds. 15-year municipal bonds are seeing yields of 2%. Long term, that may prove to be a good level but based on municipal bond fund outflows that could follow losses that muni bond investors may experience in the coming quarters, we could see yields jump up to 2.50%. Tax rates for some people and businesses will likely trend higher, and the “Trump tax cuts” may roll off between 2025 and 2027, so a tax-free 2.5% will likely be worth more in the future.
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