Waiting for a Pivot
Strategy
The Fed has been very clear that it intends to raise rates aggressively until there are clear signs of falling inflation. There have been 300 basis points of rate increases in the last five FOMC meetings with another 125 basis points expected before the end of the year. The result of this has been a significant decline in the stock market, rising interest rates, and an expectation of a recession in 2023. Monetary policy affects economic activity with a lag which is why the recession is expected next year. One sign the Fed is moving toward their goal will be an increase in weekly jobless claims as well as an increase in the unemployment rate. Many have argued the Fed should wait to see the impact of the five rate hikes so far this year, but they don’t want a repeat of the “inflation is transitory” policy error. It’s full speed ahead for the Fed.
Given the aggressive action by the Fed, market returns suffered again in the 3rd quarter. Both equity and fixed income markets have already seen some of the worst performance ever for a 9- month period. The NASDAQ posted a -32% return, the S&P 500 declined 24%, intermediate Treasuries are 8% - 10% lower, and the U.S. Aggregate Bond Index is 15% lower thru September. It’s obvious the Fed is singular in their focus: slay the inflation dragon no matter the cost.
There is much debate about the timing of the next recession. Some think we may be already in one. While we won’t know for a while, we can look at where we are currently. GDP in the 1st quarter was negative and it was again in the 2nd quarter. Many believe this is the definition, but the National Bureau of Economic Research is the group that is charged with saying it’s so. Take the housing sector for example. It has been impacted by higher interest rates in a very big way. Mortgage rates have more than doubled, refinancings are down 90% from a year ago, and home prices have started to fall. Job openings are falling but the unemployment rate remains very low at 3.7%. Inflation is too high and the longer it remains high, the more stress on consumers. Used car inventories are increasing which should result in better pricing for car buyers. Dining out has gotten very expensive and this is one area that will see reduced demand as the economy slows. Third quarter GDP is expected to be above zero and time will tell if we had a recession in the first half of the year.
The key to getting the Fed to pivot (stop raising rates or at least slow the expected rate of tightening) is lower inflation. Most measures have been trending lower but at a very slow pace. The Fed wants the core PCE close to 2.0% but it’s at 4.7% currently. Other measures of inflation had been falling only to move higher last month sending stocks lower and interest rates higher. While investors and the Fed are hoping for a consistent and rapid decline, the odds seem a bit remote. Low unemployment means consumers have incomes to spend which increases aggregate demand. The recent decline in the money supply points to lower inflation next year. For now, we expect pressure on rates and an inflation rate that declines more slowly than we would like.
"Make sure the security can’t get called away if interest rates fall."
This is normally where we provide some ideas for investors given the current interest rate environment as well as our expectations as to what will happen. We are going to be a little vague for the purpose of highlighting the characteristics of securities most appropriate based on market conditions. First and foremost, call protection is a key element based on market conditions. Interest rates are the highest they have been since 2007. It doesn’t matter if you are interested in corporate bonds, government bonds, municipals, or mortgage-backed securities. Make sure the security can’t get called away if interest rates fall. That’s number one. Number two, credit spreads on corporate bonds have increased this year so they provide a yield that exceeds 5.0% for an intermediate maturity in many cases. Issues having at least $1.0B outstanding are generally more liquid and have a narrower bid-ask spread. Given the previous interest rate environment was very low there are mortgage-backed securities available that have coupons (and underlying rates) well below current ones. This provides the investor with significant call protection. For example, mortgage pools with 15-year mortgages have a 6% coupon but ones issued a few years ago have coupons of 1.50% and 2.00% and trade at a large discount to par. Depending on your benchmark and investment policy, we believe a smart strategy is to begin to extend duration. Yes, interest rates could move even higher but the time to start this process is now. No one can pick a top so take advantage of a rate environment not seen in 15 years. Interest rates move in cycles and this time probably won’t be any different.
Our ideas today are generally longer in nature than what we usually discuss. Interest rates have risen quickly these past 9 months and don’t get caught trying to pick the top. The yield on the 5-year maturity Treasury note was 0.80% nine months ago and stands at 4.10% today. Many of the ideas mentioned above yield 5% and even 6%. Stress call protection as you will be glad you did in a year or two. While the Fed is in a tightening mode it won’t be forever as a recession is a possibility in the next 6 – 12 months. Hopefully inflation peaks sooner rather than later which might provide a different outlook for Fed tightening and probably give all markets a boost.
Economic Observations and Interest Rate Outlook – The Fed Begins the Apology Tour
The Fed has begun their apology messaging, saying that by tightening the economy, there would be pain for displaced workers and challenges that come up with subduing economic activity. The Fed knows that to wring inflation expectations out of the economy, “below trend” growth is needed for a “sustained period of time” as said by Fed Chairman Powell. We interpret that to mean GDP growth of between 0% and 2%. Job losses are nearly a certainty to achieve below trend growth. The simple truth is that people need to feel “bad” and worried to strip inflation out of expectations. To this point the reduction in jobs available per “seeker” has dwindled from two jobs per “seeker” to 1.7 jobs per seeker, mostly through employers reducing the number of posted positions. Layoffs have started, but the pain in the job market has been minimal. To manage wage inflation and “right” the imbalance in labor markets, it would seem the Fed needs for some degree of job losses and fear of job loss to return to the labor environment to tamp-down the contribution to overall inflation that is born out of labor costs.
Although there are still mixed data points in the job market, August saw the number of available positions fall by more than a million jobs as compared to July. The 10.1 million positions were the lowest number since June of 2021. The tide may be shifting as it relates to worker confidence about the balance of power between workers and employers. As mentioned last quarter, most employers expect they would have to layoff people in an economic downturn. In a recent poll conducted by Harris Poll for Bloomberg, 58% of employees feel that companies have more leverage in the job market and 62% said current economic fluctuations are a reason they plan to stay at their current job. Our thinking is that employers have been “trading up” as they can acquire talent and upon a slowing of demand, they will shed poor performers. Keep in mind, many employers in the service industry have become used to operating with a skeleton staff during the Covid years, and customer expectations may have been shaped by diminished choice and service since March of 2020. The probability of massive layoffs experienced in past recessions, is not our outlook since few employers are operating with bloated staffing levels. Left to function in a natural state, in a mild recession and based on the current job market characteristics, wages should stagnate, rather than fall dramatically.
"As is often the case, the politicians may be fighting the wrong fight."
There have been a few job protectionism efforts that would encourage automation and relocation of some opportunities. California recently established a council that could set a $22/hour minimum wage for fast food workers in 2023. You can expect that your drive thru order will be given to a computer or a worker in a call center and the dining room will be closed. In response to losing call center jobs to Mexico, the Caribbean, the Philippines and elsewhere, California is considering a bill that requires employers to post a workplace alert 60-days prior to relocating 30% or more of their workforce. Companies that don’t post the notice may receive a fine and companies who move out of the state would have a 5-year ban on loans, grants, or tax credits. As is often the case, the politicians may be fighting the wrong fight. The issue may not be between the cost and quality of talent in California as compared to Mexico, the real competition is probably between the cost of a human solution and an artificial intelligence substitution to the call center function. The riskier it becomes to hire people over systems and substitutions, the fewer people will find themselves with job choices.
We believe that the Fed is correct to start the apology tour. It serves the double duty of possibly bringing down economic expectations for both Wall Street and Main Street, while in a compassionate way, it may cause those who are overextended the most to get their house in order, so the pain of a recession is unpleasant, but not tragic. The Fed has indicated that they don’t plan to make the mistakes of the past, by taking their foot off the economic brake pedal too soon (as was the case in the 1970’s inflation episode). Too much of the messaging by the Fed has indicated that they expect pain, some job losses, and that rates need to go higher than current levels and stay there for longer than the market expects. In our opinion, the Fed will raise rates to a point that either inflation is beaten out of market expectations, or some systemically important aspect of the global economy breaks.
The sign that inflation is wrung out of expectations will probably be shown in the form of TIPs breakevens, the Fed 5-Year Forward Breakeven Inflation Rate, CPI, PPI, PCE, and tighter job market metrics. It may be easy to spot whether inflation expectations are acceptable, but the durability of the expectations is something that seems unknowable because consumer sentiment is volatile. We expect that before we get to that point, something important breaks.
"The housing market is poised for stagnation or decline since the affordability has plummeted."
We will name some developments that could come out of the shadows and break rapidly. Capital market access to companies may freeze. Current liquidity measures (as evidenced by the MOVE Index – a measure of Treasury market volatility) are back down to where they were at the start of the pandemic. “Junk” bond issuers, who couldn’t afford their interest costs 400 basis points ago (“zombie” companies) may become officially deceased or absorbed into stronger entities. Debt risk spreads (the yield you gain from going from a Treasury security to a corporate bond exposure) could be at risk of a dramatic widening. As a result, corporations would have to pay much more to borrow money. Deficit spending-addicted governments may find the “bond vigilantes,” on which they are increasingly dependent for funding their deficit party, have a more unfriendly benefactor than was the case when the world’s spending was funded by central bank Quantitative Easing programs. In the U.S., every 100-basis point increase in borrowing costs, results in approximately an additional $300 billion needed to service the debt, annually. That is a lot of future productivity or intelligent social spending that may not happen. Perhaps higher borrowing costs, combined with central bank Quantitative Tightening, will put Modern Monetary Theory, monetary financing, and fiscal dominance in the grave alongside the zombie companies. UK pensions “broke” recently when a jump in long-term yields rose and the pound fell, causing pension managers that use derivative securities to address margin calls on their positions, which caused them to sell securities to meet the calls, in a self-imploding cycle. The Bank of England had to step in multiple times to support the market by buying long government securities to stop the cycle. The housing market is poised for stagnation or decline since the affordability has plummeted. Mortgage rates have hit a 14-year high. In 2021 you could get a 30-year mortgage for 3%, now that number is roughly 7%, so a $2,500 monthly house payment that bought a $758,000 house in 2021 currently gets you a $476,000 home. The cost of an average home has increased by roughly $1,000, or 15% of median household income. We have a hunch that the housing market and related economic activity is in a fragile state. Corporate profits may be seeing some cracks. Higher labor costs, inflation in input costs, an extremely strong dollar, tighter monetary and fiscal policy, and the impact it may have on consumer demand seems poised to put a damper on analyst profit forecasts and stock share prices. Earnings season starts mid-October so corporate projections should provide some clarity. Finally, the consumer overall may be broken. Cost increases are hitting them from all sides and wages are not keeping up. Credit card balances are near record levels, the interest cost on that credit has increased, saving rates are down, consumer sentiment measures are generally depressed, and if the Fed has its way they have an increased risk of losing their income. Utility bills globally may grab headlines this year as heating costs may be dramatically higher. According to the National Energy Assistance Directors Association, roughly 20 million households (or one out of six) are late on their utility bills. Admittedly by some measures consumer balance sheets are said to be strong, but on average outstanding credit card balances are growing by $33.1 billion a month over the past six months as compared to the monthly average of $15.4 billion for all of 2019. Consumers are using a lot more debt and the debt is more expensive to carry. Perhaps households are just mimicking governments around the world. Although the Fed’s goals seem focused on applying pressure to consumers, there are several areas that appear to be poised to crack. What happens if several of them break at the same time? We think there is a risk that a linear decline becomes an exponential deterioration as a culmination of challenges could present the central banks with a disturbing bout of “whack-a-mole” requiring very targeted and possibly obscure policy solutions, to not give the market the impression the “Fed put” remains in place.
Although the Fed made one of the largest policy blunders in decades, their task is about as easy and rewarding as a blind-folded two-person potato sack race through a crowded cow pasture. There are no real winners. Perhaps “savers” are the winners as the Fed’s tightening policy rewards savings with higher interest rates. In past editions of Insights, we have discussed at length the deflationary headwinds facing developed economies. Slow growth and increasing cost influences may support the stagflationary theme we have feared. Global instability and a possibility of a reordering of global powers and global trading blocks seem to solidify trends that could escalate the instability. The hodgepodge of influences including deglobalization, relocation of strategic industries, protectionism, a need for supply-boosting policies, and clean energy goals all to some degree replace trade based on comparative advantage and existing low-cost activities/resources with more expensive replacements (clean energy advocates, we are not saying what is “good” or “right” just what is the cheapest source of energy – in isolation of broader and more indirect “costs”). For more than a decade, some small reversal of the low inflation and cheap goods trend of the past 30 years may occur (when “Chinafication” of the manufacturing sector meant that many goods were produced in China and the Asian continent and sub-continent).
"Perhaps the bond vigilantes will put fiscal responsibility back into vogue."
Short term, the largest risk to cooling inflation down may involve the uncertainty caused by the lag in Fed policy moves and actual influence on economic activity, imbedded lags in economic indicators, OPEC, suspended disbelief, and well-intended political policy that marginally mitigates the Fed’s goals. Some of these inflation indicators are real and others may be unhelpful head fakes. The impact of Fed rate hikes and quantitative tightening have a marginal and gradual impact on the economy. Not everyone is making large purchases that are financed at the same time. Some indicators are constructed to reduce the noise created by volatility of the indicator. The widely watched Consumer Price Index (CPI) is largely influenced by rent prices. The headline number is approximately 30% determined by rent prices, where the Core CPI (excluding food and energy) is roughly 40% influenced by rent prices. Since rents are not often reset, typically at the end of the term of the lease, this component of CPI may put upward pressure on the CPI through 2023 and possibly into 2024. As long as the job market and average hourly earnings holds up, rent inflation should create the risk for stronger inflation numbers than are consistent with the Fed’s goals. That is not to say the Fed won’t consider more responsive measures of “shelter inflation” but CPI is a widely watched gague of inflation. This mechanical reality of CPI could generate inconvenient messaging issues. As a result of a shift in global alliances, or possibly just some foreign policy missteps, OPEC is cutting production which should also put upward pressure on gas prices, a challenging development for many households. As evidenced by the declining savings rates and increased use of credit, consumers seem to have an amazing ability to suspend disbelief that the bad scenario is upon them and that they will temporarily be worse off than they may have been in the recent past. It is what makes betting against the will of the U.S. consumer to spend, generally a bad bet. Finally, it seems the most meaningful inflationary risk involves politics. As the pandemic has largely subsided, politicians have attempted to spend nearly $4 trillion (includes: $900 billion in the Stimulus and Relief Bill of December 2020, $1.9 trillion from the American Rescue Plan in March of 2021, $740 billion in the Inflation Reduction Act in August of 2022 and the $400 billion student loan debt forgiveness jubilee announced in September of 2022). Very little of that spending was related to address the pandemic or revive still ailing aspects of the economy. It was political spending to win over voters. Too bad that capacity to spend wasn’t saved for another rainy day but it wasn’t and now the tab to pay for the excessive spending is coming due (and the needless nearly 10% addition to the Federal debt gets to be paid for by taxpayers, most likely eternally). Perhaps the bond vigilantes will put fiscal responsibility back into vogue. In a way, our wildcard event mentioned last quarter, the dire “feel good” scenario somewhat came to be the case. In this scenario, Q2 GDP growth came in negative (and it did), placing the US economy in a recession (which is debatable, but we are not in an officially declared recession) and with mid-term elections coming up a solution to our recession would be another round of stimulus programs. In practice the impetus for the most recent spending efforts appears to be the goal of getting things done before a risk of gridlock makes big spending packages more challenging. The desensitization to unimaginable levels of spending makes it quite possible that the vigilantes are not the villains people think they are, rather they may be the hero to future generations.
Since the Fed is just now entering “restrictive territory” with the Fed Funds Rate, we are likely near peak volatility over the next few quarters. Additional hikes in November and December, totaling roughly another 125 basis points should start to weigh heavily on the economy. The November hike, and more probably the December hike may invert the 3-month Treasury yield as compared to the 10-year Treasury. Historically, this is a strong predictor of a recession. Even if it fails as an indicator, the truth of the matter is that we have switched from low yields and an accommodative Fed to some of the highest yields in 14 years with a tightening Fed. We had been encouraging spending and now we are enticing saving over consumption, but many consumers haven’t figured that out yet. Slowly but surely, they will see what the monthly payment in the new car is, and they will unceremoniously choose to fix the old car, and possibly feel good about the fact that they are earning something on unspent money. Alternatively, they may look at the cost of going out to dinner, and perhaps just paid the increased interest expense on their credit card balance and decide to make dinner at home. Multiply this marginal change in economic decision-making times 100 million and the weight of the Fed policy is both gradual and possibly multiplicative. Now, imagine if governments start to think this way with the help of the bond vigilantes. In the next six months, chances are, more people will start to feel “bad” about things. The Fed needs people to feel bad and expect to feel that way for the foreseeable future to “win” the battle with inflation.
"Rates must find a place where a more natural equilibrium exists."
Some of the largest bond-buying balance sheets in the world are stepping away from US Treasuries. It means a new bond-buying world order must be established. Rates must find a place where a more natural equilibrium exists. That sounds scary to bondholders, but the uncertainty may make “risk-free” U.S. Treasuries not too far from these levels attractive to the free market, especially if we believe inflation will be brought under control and future economic activity is more subdued. Low risk yields of 4% and 5% start to be enticing, and it starts to make bonds attractive in many portfolio management applications. Empirically, valuation matters in all asset classes as it relates to forward returns. Again, bond yields are as high as they have been in 14 years (meaning prices are “low”). We expect it gets a bit worse before it gets better, but after suffering the worst losses in roughly 40 years, betting against bonds over the next handful of years seems like a bad wager. For illustration, if the stock market was at the lowest P/E ratio in 40 years and you had an investment horizon of more than 10 years, wouldn’t you start to buy into that market? To repeat, we think in the near-term people will fear credit, current market liquidity is poor, and some genuine sources of sticky inflation will probably drive yields and risk spreads higher. Adapting to opportunity in a bond portfolio typically involves averaging in and averaging out of certain portfolio or security characteristics.
At the start of 2022, the Fed thought they would raise rates by approximately 75 basis points in 2022. With their massive budget, huge balance sheet, market influence, and their army of PHDs and analysts, they were wrong by 400%, and at the end of the year, they could have missed it by nearly 600%. We thought at times during 2022 that the 10-year Treasury yield would hit 2.50% and flirt with 3.0%. We currently sit close to 4.0%. All of this may be a good example of decision anchoring, basing your forecast on past estimates. To break away from our anchors, we need to understand that in 1980, the Fed Funds Rate topped out at 20%. That is the unimaginable level of pain, inefficiency, and economic destruction the Fed is trying to avoid. This Fed is committed to avoiding as much of that misery as is possible. They are going to slow this economy down and when things break, we expect that the fixes will be technical in nature and possibly not widely advertised or understood. The reason being, they cannot perpetuate the expectation of the “Fed put” as they are trying to make the economy feel bad, and the sad truth is they must squeeze hope out of the market psyche. 10-year Treasuries may see yields hit closer to 5% and when recession is solidified, we think yields could be lower in a year from where we currently sit. 10-year munis may see a spike to 4.50% and then recover as cross-over buyers and long-term investors see that yield meets their long-term needs and the nuance is established that not all “credit” risk is the same. When the Fed achieves its driving goal of making everyone feel bad, bond investors should start feeling better.
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