What the 4th Quarter Giveth, the 1st Quarter Taketh
An investing theme we often reference is the regime switching model, where markets often vacillate between expecting prices will move among two market states. Frequently market expectations swing between an environment of growth and one of contraction. Very little time is spent with the expectation that activity will drift unconvincingly around slow growth. It can anchor investment themes with a contrarian bias, but that may be acceptable if one expects markets frequently mean-revert toward less extreme states. The bond market strength of the 4th quarter saw a regime switch in the 1st quarter of 2024. Diminishing signs of economic weakness at the end of 2023 turned to somewhat steady signs of economic strength. The market quickly moved from an expectation that the Fed would need to cut rates six times in 2024, to a current belief that fewer than three cuts will be needed. The median Fed forecast provided by the Fed’s “Dot Plot” has remained at an expectation for three cuts in 2024.
The most obvious change over the quarter was a nimbler message from Fed officials. While some still say the base case for 2024 is three rate cuts, other officials have indicated that one may be sufficient and even none could be the appropriate course of action. Perhaps most noteworthy is that Fed Chair Powell has recently said he would tolerate a rate of inflation that exceeded their target if it meant they would avoid a marked increase in the rate of unemployment (a “dovish” stance). He has gone on to say that he is in no hurry to ease (reduce the Fed Funds Rate, which is a more “hawkish” stance). They have announced a plan to taper the pace of the runoff of securities from the Fed’s balance sheet. Our call last quarter for the Fed to be sensitive of the impact that Quantitative Tightening (QT) may have on the level of reserves in the banking system, and the orderly functioning of short-term funding markets was prescient. The Fed has said that the move to slow the pace of the unwind to the QT program is partly for the purpose of moving the banking system reserves from a position that is “abundant” to one where reserves are “ample.” As mentioned last quarter, moves regarding the Fed’s balance sheet are for the purpose of supporting financial (banking system) stability and policy is for the purpose of addressing financial conditions. Altering the QT program is more opaque than announcing a rate cut, so it is a lever the Fed can pull to remove a degree of accommodation while being supportive of financial institutions.
Supporting the Fed’s more hawkish signaling is a strong job environment, a growing service sector, and a newly growing manufacturing sector. Following 16 consecutive months of contraction, at the start of April the manufacturing sector finally experienced a month of (modest) growth. With all the positivity, the discussions of a “no landing” or “soft landing” scenario is gaining popularity. The domestic stock market has appreciated nicely, and bonds have seen losses as 2024 traversed the first quarter. Year to date, most taxable bond indexes experienced losses of between 1% and 1.5%. 10-year Treasury yields increased from 3.88% at the start of the year to a yield of 4.20% as the quarter ended. Municipal bond indexes saw losses of 0.5% to 1% for the quarter. 10-year municipal yields began the year at 2.25% and ended Q1 at 2.51%.
Observations and Outlook – With All This Positivity, What Could Possibly Go Wrong (Plenty)
We will start with the “positives” in the economy. As mentioned earlier, the manufacturing sector finally joined the service sector in experiencing expansion. At the start of the quarter, real wage growth showed the largest gain since July of 2023, after many months of nearly flat real wage growth. By some measures, the household sector is less leveraged than was the case in 2008 (during the Great Financial Crisis). Since mid-2008 total household debt has grown by 36% while incomes have grown by 85% over the same period. Household debt as a percent of disposable income is currently near the lowest levels experienced over the past 40 years if you exclude the pandemic years. Now that interest costs are elevated and saving rates are at low levels, it is reasonable for this metric to deteriorate soon. Non-mortgage debt, including auto loans, student loans, and other revolving forms of credit have seen significant growth over the past decade. The interest expense on these personal lines of credit as a percent of disposable income have spiked to levels experienced just prior to the 2001 and 2008 recessions, so the most expensive and volatile sources of credit may be weighing on the consumer. Finally, the job environment continues to demonstrate surprising resiliency. In March, the unemployment rate ticked lower to 3.8%, down from 3.9% in February. People who want to work can find a job and perhaps that is enough to keep the consumer feeling good for much of 2024.
Against the backdrop of expansion in the service and manufacturing sectors and plentiful jobs, signs of inflation persist. January experienced an unexpected jump in Core CPI and the “Supercore” Services Index and elevated CPI readings have been constant through the quarter. A key subset of CPI, services prices, increased by the largest amount in two years. The main contributors to the updraft in inflation were food, car insurance, medical care, and shelter costs, which contributed to more than two-thirds of the overall increase. The combination of economic growth, persistent inflation, and a robust job environment makes the evolving and nimble Fed position appropriate.
With so many things going well, what could go wrong? The geopolitical issues that have been in place continue to present massive risks to global growth. On a more peaceful note, simple central policy dispersion between the world’s central banks could cause market consternation. As Europe is expected to slip into a recession in the coming months, the ECB is expected to start cutting rates. If one of the United States’ largest trading partners is facing recession, it may create an economic drag. China is facing depressed levels of growth and a real estate crisis, along with the friendshoring trend, which may act as a weight on global growth. Friendshoring could also result in exporting inflation around the globe as trade moves away from partners with the maximum comparative advantage. In last quarter’s Insights piece, we identified slow global growth and exogenous shocks as frequent reasons given for the impetus for past Fed easing cycles. It seems like central bank policy dispersion, divergent economic growth, supply chain reshuffling, and geopolitical tinder offer many sources of economic challenge.
Looking closer to home, we have concerns about the consumer and the seemingly unstoppable job environment. Below the surface of the ISM Manufacturing and ISM Non-Manufacturing releases, which we referenced earlier, rests data that could shake the unflappable job market. For both the service and the manufacturing sectors, the “employment” component of both metrics has been in contraction for the past couple of months (longer for the manufacturing sector). The number of available jobs, the JOLTs index, is mostly in a declining trend and the ratio of job openings to unemployed people eased to a four-month low of 1.36X. The “quit rate” which measures voluntary job departures relative to the share of total employment recently remained at 2.2%, the lowest level since 2020. It indicates that US workers are less confident about their ability to find other jobs.
"At a time when the labor market is robust, the uptick in delinquencies is worrisome."
A very different take on the state of consumer debt as compared to the interpretation referenced in the previous page is that US consumers are outspending their income, and it suggests the economy is not as strong as one would think. A real possibility is that more borrowers observe the ways in which debt can turn into free money. Student loan debt is an obvious example where some non-needy people can have debt amassed for the purpose of future wage advantages expunged. Student loan debt has increased by 60%, or $600 billion, since 2013. Some people have identified the resumption of payments on student debt as a “threat to consumer spending.” One person’s threat is another’s version of personal responsibility. The combination of the ISM employment numbers, with accumulated debt, declining savings, and rising delinquency rates should cause concern. Over the past four years, personal spending growth has annualized at 6.7% while the average annualized growth in personal income has been 5.9%. Over the past 25 years, both personal income and personal spending have averaged a more balanced 4.6% rate of annual growth. Consumers have accumulated record levels of credit card debt and due to the rise in interest rates that started in 2022, interest payments on credit card debt have nearly doubled in two years. Levels of delinquency on auto loans and credit cards have risen toward levels not seen since 2010. Specifically, transition rates of new credit card balances and auto loans that are 90+ days late are at 6.4% and 2.7%, respectively. During the peak of the Great Financial Crisis, the numbers were almost 11% and 3.5%, respectively. At a time when the labor market is robust, the uptick in delinquencies is worrisome. The U.S. savings rate has fallen to 2.9%, nearing the lowest levels in 15 years. People may be expecting the government to step in to avoid the threat of reduced consumer spending that their lack of savings, accumulated debt, and outspending their earnings growth could precipitate.
Consumers aren’t the only ones that are positioning themselves for future challenges. The recent rise in rates, our insatiable appetite for deficit spending, and general lack of discipline will very likely make the cost of servicing our federal debt a part of the national conversation leading up to the election. One outcome seems certain, none of the viable candidates will balance the budget and put the country on a sustainable and fair path. The social contract between the generations appears to be in jeopardy. In previous quarters we dug deep into the consequences that frontier countries are facing because of their inescapable debt burden, along with the here and now costs of servicing the U.S. federal debt. The world is awash in debt and in a fractured global paradigm, a substantial debt burden may become a competitive disadvantage (unless you believe the following approach to debt has staying power: borrow so much that your banker doesn’t sleep at night, and you do). We continue to expect the themes of the election will be stimulus or austerity, or more probably stimulus or stimulus.
"We continue to expect that rates will be higher for longer, and the more likely scenario is that activity slows toward the end of the year."
Whether it is individuals, governments, the housing market, corporations, or commercial real estate, borrowing costs have consequences. The belief that a restrictive Fed and the highest rates we have had in nearly 15 years can result in a soft landing, or no landing, seems like a fantastically remote possibility. What seems more probable is that unimaginable levels of stimulus were pumped through the economy, some of it continues to slosh around today, and that the lag in the delivery of the funds, along with debt payment suspension and forgiveness has allowed the U.S. to pull off the illusion of an economic miracle. High yield debt, leveraged loans, private debt, stocks, and commercial real estate feel like they could have room to reprice in an economic downturn. The magnitude of the commercial real estate market price adjustment, especially for office space, could be disruptive to major institutional investors and financial institutions. Recently the owners of the Chicago Board of Trade building handed the keys back to the bank. The Canada Pension Plan Investment Board just sold its interest in a pair of Vancouver towers, a business park in Southern California and a redevelopment project in Manhattan at discounted prices, with the New York property value at $1. The office real estate issue is starting to look like a problem that time won’t heal. We continue to expect that rates will be higher for longer, and the more likely scenario is that activity slows toward the end of the year. The “out of left field” risks as we look out onto the horizon include an exogenous shock or a wave election. The shock scenario will expose the cracks of economic weakness under the surface of the U.S and the wave election offers near-term euphoria, continued deficits, and higher long-term borrowing costs. The coming year represents a difficult period in which to offer an interest rate outlook. If we ignore external influences, we expect that rates will stabilize near the elevated levels experienced at the start of the 2nd quarter and that another regime switch will happen as consumer metrics soften, driving yields lower and possibly prompting symbolic action by the Fed.
Municipal Market Developments – It’s All About the Election and Taxes
In the first three months of 2024, munis “outperformed” many taxable bond indexes. Outperformed is a euphemism for saying that they didn’t lose as much value as taxable bond indexes. Although municipal bond price movements are reliable laggards as compared to Treasury bond market moves, this past year feels like it is for a different purpose. The results of the 2024 election will drive the likely continuation or conclusion of the Tax Cuts and Jobs Act (TCJA) that went in effect in 2017. In 2025, key aspects of the TCJA will start to sunset. If Republicans win the election, they will have to come up with revenue to pay for the continuation of the tax cuts. Some analysts speculate that Republicans would consider ending the traditional tax-advantaged municipal market as we know it. If Democrats win the election, it is guessed they will increase the corporate tax rate from 21% to something closer to 28%. They are also likely to allow for advance refundings of municipal bonds (a money saving opportunity for municipal issuers, akin to refinancing a mortgage) and the resumption of the Build America Bond program (a municipal financing where the government sends a subsidy to the municipality for their interest cost, rather than offering investors tax advantaged income treatment). In sum, if Democrats are the victors, the value of tax-exempt income will likely increase. The current “richness” of municipal bond market may be in advance of an expected increase in the value of tax-advantaged income, or a scarcity that could arise if the traditional municipal bond market was suspended. At current tax rates, municipal yields are “too low” to make them attractive as compared to taxable alternatives, but at higher rates they may be a fair value from a future perspective.
In line with the broader trend of municipal issuer upgrade activity outpacing downgrades, Detroit has been given its first investment grade rating (Baa2) since its bankruptcy in 2013. As part of the basis for the upgrade, Moody’s referenced that the city’s tax base has doubled over the past five years and that continued growth will come from ongoing development and continued appreciation of residential values. Detroit still has dynamics and challenges that make it a credit we would not consider to be investment-grade because they continue to lose population and the area economy is concentrated in the auto industry. Electric vehicle mandates and consumer tastes present automakers with the prospects of some difficulties and population loss is the death knell for most municipal credits.
Strategy and Summary
The recent updraft in bond yields offers another chance to average into the market, for anything that trades on a spread-to-Treasury basis. A barbell strategy seems prudent with some exposure in shorter bonds and an allocation in the five-year to ten-year area. It allows the investor to enjoy the highest short-term yields we’ve experienced in roughly 15 years, without taking on much risk, while “locking” in the relatively high rates on the longer segment of the portfolio. We expect the yield curve will steepen by short rates declining as the Fed eventually cuts rates as part of an accommodative policy shift. As the curve steepens in this fashion, although the yields on the short part of the portfolio will diminish, subdued economic expectations may drive longer-term yields lower (and prices higher).
Looking at upcoming core CPI data, we may be set for base effect comparisons in the months of June, July, and August, which could present readings that will appear as if the Fed’s actions are not able to get inflation under control. If that occurs before the consumer or the job environment takes a turn for the worse, it may offer a unique buying environment for bond investors. This year will increasingly be polluted by politics, but the surprises leading up to the eventual outcome will drive fleeting market sentiment and future regime switches. We continue to encourage a quality bias in portfolios as spread widening could erode returns in 2024 or 2025. It is worth repeating this quarter that exogenous shocks or a wave election represents the most likely “known unknown” that would significantly change our bias and market assumptions.
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