From March of 2022 through December of 2022, the Fed raised the Fed Funds rate 4.25% (425 basis points). Much of that was a move from a very accommodative economic stance to a less accommodative posture, but as the Fed raised rates to the point where policy was restrictive for economic growth, the market started to sober up. Over the fourth quarter of 2022, some signs of inflation appeared to moderate, and naturally, the market thought that meant that the Fed could look to cease the hikes and consider easing once inflation was heading modestly lower. Some metrics, the All-Items Consumer Price Index (CPI-U) in particular, provided fodder for the belief that the Fed didn’t have inflation moving toward moderation, and that as a result the Fed would need to take yields higher than the market expected. The combination of the fear of inflation being “out of control” and the expectation for higher yields caused longer-term bond yields to peak in October. Although the yearly CPI-U inflation rate hit a peak of 9.1% in June and has declined since then, the month over month rate of 0.4% in both September and October was the basis for a bout of panic.
As we touched on last quarter, shelter inflation represents more than 30% of the headline CPI number and 40% in the Core CPI. The way shelter costs are incorporated into the number there will likely be a significant lag between the rent-centric measure used in the CPI, and the dampened price increases currently being experienced for rent, along with the price adjustments that are occurring in areas of the non-rental areas of the housing market. It may take months for the CPI to reflect the disinflationary pressures we are seeing in the “housing” market. With affordability measures, such as average price relative to household income, or monthly payment as a percent of income, approaching the levels experienced in 2007, additional downside for this market seems probable. Depending on the depth of a recession over the next couple of years and incorporating elevated mortgage rates (as compared to recent financing levels) a broad decline in home prices of between 10% and 15% would take us back toward a more normal relationship between housing costs and income.
The jobs environment also provided fuel for confusion over the quarter. The unemployment rate for September was 3.5%, and in both October and November the rate increased to 3.7% and ended the quarter in December back down to 3.5%. In other words, it seemed as if the Fed’s rate hikes were not impacting the availability of jobs, and possibly allowing the Fed to reduce the pace of tightening, but that appears to have been…transitory. As of late, growth in non-farm payrolls is progressing at a decelerating pace and average hourly earnings are also growing at a declining pace, so incrementally moving in the right direction to allow the Fed to temper the pace and magnitude of future rate hikes.
"Whatever the case, the Fed needs to act in a way that demonstrates diminished economic expectations are lasting."
During the period of uncertainty, it felt as if the resolve and bias of the Fed was amplified. As 10-year Treasury yields hit 4.24%, and 10-year AAA-rated munis saw yields of 3.46% in late October, Fed Chair Powell and the regional Fed Presidents increasingly “messaged” the markets that rates were going higher, and likely for longer than the market might prefer. They also reiterated to the public that in order to manage inflation expectations in a durable way, unpopular actions would likely be required. Perhaps it was an act of compassion, signaling to people to get their house in order, or it may have been that the warning was for the purpose of cooling economic activity. Whatever the case, the Fed needs to act in a way that demonstrates diminished economic expectations are lasting. A shallow recession (or a “growth recession”) isn’t a good bet for achieving the goal of long-term price stability. The Fed’s messaging may have worked to a degree, as the 4th quarter progressed, most bond yields fell from their late-October highs. Even with the Fed, and the reality of some economic indicators “cracking,” it wasn’t enough to spare bond market investors some of the worst pain in 40 years. Many taxable bond indexes lost between 9.5% and 13% in 2022, and many municipal indexes lost between 6% and 10% for the year. 10-year Treasuries started the year with a yield of 1.51% and ended at 3.88%. AAA-Rated 10-year municipal bond yields began 2022 with a yield of 1.05% and ended up at 2.64%. The Fed began the year thinking they would have to hike the Fed Funds Rate 0.75% (75 basis points) and ended up raising rates 4.25% (425 basis points). Even if a bond manager “outperformed” last year, there are not a lot of bragging rights that go with being the smallest loser.
Observations and Outlook – Higher for Longer (Unless Something Breaks)
Some prominent bond fund managers seem to think the Fed needs to start listening to the bond market. Specifically, longer-term bond yields have fallen from their high levels experienced in late-October and the yield curve has inverted (a situation where short-term yields are higher than the yields on longer-term bonds). Curve inversions often precede recessions, but they can give false signals. In recent history, an inversion of the 3-Month Treasury Bill and the 10-Year Treasury Note has been a good “tell” that a recession is imminent. Such an inversion may be signaling that the market’s longer-term growth expectations are more subdued relative to where Fed policy is at the time (which the 3-Month bill may pick up better than the commonly referenced 2-year Treasury). We believe it is saying something that the 112-basis point inversion of the 3-Month Treasury Bill and the 10-Year Treasury note at the time of the writing of this piece, is greater than during the depths of the Great Recession in 2007. It may be the bond managers who need to hear the Fed. They have often cited that the problem in the 1970’s and early 1980’s was that the Fed at the time became accommodative too soon, and inflation expectations became “baked” into economic expectations, requiring additional tightening to induce an inflation-breaking recession (referred to as a double-dip recession). The Fed “apology tour” referenced in last quarter’s Insights piece may not be for posterity, rather it could be because they know what is needed to bring inflation (and the cost of borrowing) down to a sustainable level. They may hold out hope that people who are living at the margin hear the message and add some reserves or adjust their spending habits, but betting against the U.S. consumer’s propensity to spend is typically a risky proposition.
The mistake that many market participants may be making is that they think part of the Fed’s job is to deliver a “comfortable ride.” It is reasonable to believe that orderly markets probably offer more stable functionality and growth, but stable may be different than pleasant. The “Fed put” (the idea that the Fed will step into sooth the financial markets upon any meaningful turbulence) may have lulled the markets into thinking the Fed’s mandate included financial market pleasure. Although the Fed has dabbled at expanding their mandate, such as identifying climate change as an economic risk, and expanding the “full employment” mandate to encourage real wage growth in economically disadvantaged communities, they have recently signaled their resolve to “stick to their knitting” and focus on full employment and price stability. Our interpretation of the recent Fed President and Chairman’s comments is that they are mission focused, wringing inflation out of the economy.
"As is often the case, markets think you have to go from somewhere to somewhere, with little weight given to the prospect of a pause."
Markets expect the Fed will be in a position to cut rates by the end of the year. According to the CME FedWatch Tool, two-thirds of traders expect that the Fed Funds Rate will be at or below the current rate range (4.25% to 4.50%). That is greatly conflicting the Fed’s outlook where no contributors to the Fed’s “Dot Plot” indicate any cuts to rates in 2023. Job growth metrics are strong, and the Current Seasonally Adjusted Unemployment Rate for December was 3.5%. Against the generally accepted definition of “full employment” being a 5% unemployment rate, there is room for the Fed to tighten further and allow the lagged impact of past tightening actions to be more fully felt in the economy, before easing should be at the tip of the tongue of the market. As is often the case, markets think you have to go from somewhere to somewhere, with little weight given to the prospect of a pause. The pause, with modest but proactive adjustments may be the best hope for a soft landing, or even the victory of a shallow recession (provided it achieves the durable price stability goal). Since central bank policy is thought to have a lag of roughly a year (per Milton Friedman’s estimate), the rate that may matter is the Fed’s policy rate minus the rate of inflation in six months to a year. As measured by Consumer Price Index (CPI), the Fed has more room to hike but as compared to the Personal Consumption Expenditures (PCE) price gauge, the current dot plot path seems promising. CPI is thought to measure out-of-pocket costs for consumers, where PCE tries to measure the cost of everything we consume (for example health care costs/consumption, which may not be paid by the consumer, they are often paid for by employers or taxpayers). As Chairman Powell recently stated, speed is less important than the destination. That may suggest that a policy pause, and subsequent minor policy adjustments are the expected path (sorry to those who prefer certainty and immediate gratification).
The earlier-mentioned consumer probably holds our near-term destiny in their hands. The U.S. is a consumer-driven economy and the reaction to the weight of Fed-induced higher borrowing costs will manifest themselves in changing demand patterns. Big ticket items that are often financed have seen a dramatic swing in consumption. The formerly “white hot” used car market has seen a dramatic change. According to the Manheim Used Vehicle Value Index, 2022 saw a decrease in used car values of 14.9%, the largest drop in the 26-year history of the index. Last quarter we touched on the rapid change in the housing market. In December, homebuilder sentiment fell to the lowest level in more than a decade. The result of the past increase in single-family home prices, along with greatly increased financing costs has greatly impacted home affordability. Applications to build in November fell at an annualized rate of 11.2%. Permits for single family home construction fell 7.1%. Housing seems to have more downside. Recent durable goods readings have softened some and consumer sentiment numbers are weak by historic standards (but off the recent bottom). When the substitutions and abstention of purchases moves to smaller-ticket expenses, the Fed’s work may be mostly done and the “slack” in consumer and labor demand should cool the stubbornly strong employment environment and cause wage growth to slump. According to a poll by Morning Consult, at the end of the third quarter, the share of sticker shocked shoppers who walked away without making a purchase rose from 8.7% in August to 9.9% in September. Restaurant sales per customer are struggling to keep up with “food away from home” inflation, suggesting that restaurants are not able to pass along their increased costs to consumers. It is the substitutions, “trade downs”, and cessation of purchases, for the small stuff that will telegraph that the Fed is making progress in their fight against inflation. According to the New York Fed, through the third quarter of 2022, due to increased credit card balances and mortgage balances, households increased debt at the fastest pace in 15 years. If real wage growth flatlines, or becomes negative on a real basis, it would appear the consumer will be a critical part of the Fed’s plan.
"The timing of a looming recession may be just what the junk bond market does not need."
Last quarter we detailed several areas where aspects of the economy could “break.” Although our forecast is that the consumer will falter, followed by the strength of the employment environment, it is areas of the financing and credit markets that could break in a way that causes the Fed to have to step in to rescue orderly markets. That is not to say the Fed put is alive and well. Given what must be done to Mainstreet we expect that the central bank will be fine with run-of-the-mill pain on Wall Street. Heavily financed assets, that have seen a rapidly diminished value of the collateral, is an area we would watch. This can apply to homes, autos, closed-end bond funds, junk bonds and possibly debtor nations. According to the New York Times, more than $110 billion of home mortgages have an average down payment of 6.6%, or less, and nearly half of that amount has a down payment equal to or less than 3.5%. More than $250 billion of mortgages had a down payment of 9.3% or less. Certainly many of these mortgages are for properties where some equity has built up, but if residential real estate values fell 10% to 15%, there would be a risk of a lot of underwater homeowners, stuck in their homes. Subprime auto loan defaults are up 36% year-over-year through October (which places delinquencies still at a historically low level – In the Great Recession delinquencies peaked at 15%, we hit 5.13% in October), and as mentioned earlier the collateral has experienced a dramatic drop in value. Some closed-end bonds funds that use leverage (they borrow in the short end of the market and use the funds to buy longer-term bonds) have seen their leverage work against them. As a result, some closed-end funds have slashed their dividend by nearly 50% (wait until the Fed hikes rates 75 basis points more). The timing of a looming recession may be just what the junk bond market does not need. Although maturities of junk issues are looking modest in 2023, the calendar of high-yield bonds maturing in 2024 is more substantial (and ideally the companies would arrange new financing well in advance of the maturing debt). Many junk issuers can’t pay down the debt that they issued when yields were hundreds of basis points lower. Making matters worse, the spread (the incremental yield a corporate borrower pays over a like-term Treasury to access the capital markets) is currently in the range of 400 basis points to 500 basis points. In a typical recession, junk bonds spreads more toward 800 basis points over the comparable Treasury. There is an imminent scenario where the junk bond market becomes problematic, and such an environment can precipitate a situation where investors and even banks pull back on their interest in credit exposure. Although banks are generally well-capitalized, so we don’t anticipate meaningful bank failures in the next recession, if their appetite to lend is cut off, it can contribute meaningfully to a credit crunch. Given the debt binge that world governments have been on since the Great Recession, and all the way through the pandemic experience, if credit freezes, large problems may arise. Since 2007, the G7 nations have seen their public debt as a percent of GDP move from 81% to 128% in 2022. Italy, who’s debt service costs were 3% of GDP in 2019, is expected to see debt service costs hit 7% of GDP by 2030. Bailouts may be coming back into vogue because discipline and responsibility seems to be out of fashion.
"The people that were helped by the stimulus may have been harmed more than any other group."
Smart people have surmised that it may be possible that sticky wage inflation and other stubborn sources of inflation might mean the Fed would have to accept an inflation rate that exceeds 2%, perhaps something on the order of 3.5%. Something between 3% and 3.5% would be in line with long-term averages. As of December, more than 50% of CPI components were seeing annualized rates of inflation in excess of 4%. Our response is that due to the hardwired expectation of nearly free financing, a large percent of the population will “do without” until reality moves in line with their expectations. If your $2,500 monthly house payment budget used to buy you a $750,000 house and now you would have to settle for a $475,000 shack, you will simply keep renting until the market comes back to you. At a higher level, it may be easier for low-wage earners to maintain a standard of living if the rate of inflation is low (hopefully, they would have a better chance of experiencing real wage growth). During this inflationary episode, many workers saw wage gains that looked positive, but that were negative on an inflation-adjusted basis. We expect that is the primary motivator for the Fed. The people that were helped by the stimulus may have been harmed more than any other group. The pain of a recession, which is often felt by those at the bottom of the economic ladder, may eventually benefit them over the long run (and we don’t say that flippantly). The crux of our basis for why elevated inflation is unlikely, is that in September, following a largely ignored policy meeting, the Fed revised down significantly the US potential output. Of note, the Fed’s assumptions change due to disappointing productivity gains and slow improvement in labor force participation. We have mentioned the Output Gap in the past (the theoretical maximum output for an economy). Typically, the economy runs below the maximum output (a negative gap). Occasionally, the economy can run above the theoretical maximum output (a positive output gap), but typically this only happens for short periods of time, and it almost always portends a recession. It may be the case that running the economy hot causes malinvestment or production costs for goods and services that are unprofitable. Do you pay a pizza delivery person $50/hr., or do you offer customers $3 per pizza as a discount to deliver it to themselves (turn a fixed cost into a variable cost)? The next revolution in productivity may come from the customers themselves, paying at the individual level for sources of utility that are specific to them, along with capital investments in automation and applications for artificial intelligence. From a Fed policy perspective, the reduction in the potential output means the economy was running even more overheated over the past two years than previously thought. For context, at the end of 2022 the positive output gap on a real basis was 0.66% and prior to the Great Recession it peaked out in 2006 at 1.13%. The average output gap for the past 20 years was roughly -2%. It might suggest that some output gap shrinkage is required to lower inflation expectations and stabilize the economy. Short rates will rise farther, and longer-term bond yields have farther to fall as an economic slowdown, and all the new uncertainties that go with that, become the reality.
Municipal Market Developments – What Goes Down May Come Up
As bond managers it is a pleasure to turn the page on 2022, the worst bond market in 40 years. As inflation was determined to not be transitory, rates shot up, bond prices fell rapidly, and fear (real fear that we could hear in people’s voices) spread throughout the market. Following the shutdown of the economy, we federalized all the uncertainty and added some extra stimulus for good measure. One can’t really know where acceptable policy ended and irresponsible “fuel on the fire” giveaways began (but the third to the last round of stimulus programs, including the inflation reduction act, is probably as good a guess as any). Municipal bond investors pulled as much as $100 billion out of municipal bond funds, with the final total at yearend being estimated at $90 billion. Some of the money didn’t leave the market altogether, there was a migration out of funds and into low-cost ETFs and custom separately managed accounts. On the whole, most municipal bond indexes saw losses for the year of between 6% and 10%, but municipal “impact” funds lost 12% and long duration funds fell by more than 13%. It was a hideous year for the historically calm backwater that is the municipal bond market.
As a largely retail investor-owned asset class, the municipal market is susceptible to herd behavior, with investors coming into and out of the asset class during short periods of time. That was not the case in 2022. The year soon began with municipal bond fund outflows and with rare exception, they persisted for much of the year. It led to a vicious cycle. Yields rose, investors sold bonds, liquidity dried up, causing more losses, precipitating more sales, eventually extending bond and portfolio durations (as bonds went from being priced to the call date to being priced to the maturity date), causing more losses, followed by more sales. It was terrible for investors, and away from putting money to work at higher yields than we’ve seen for years for those investors with additional investment dollars for munis, it was a year of effort with few victories.
"The result could be reduced supply of new municipal bonds, which would tend to be another source of price support."
As a comparison to the roughly 8% losses experienced in 2022, the last time the municipal market saw worse performance was in 1981, when municipal bonds lost more than 10%. 1981 was also a year of rapid Federal Reserve interest rate increases. Following the terrible performance in 1981, munis experienced gains of more than 40% in 1982. Sadly, we don’t expect that kind of return in 2023, mostly because we expect the economic slowdown will occur later in the year and the returns experienced as the calendar turns again, may not capture the gains we may experience as we move toward the depths of the recession. In 2023, our best guess is that muni bond investors will earn a return that is equal to current coupon income on par bonds, plus roughly 1.5% to 3% for capital appreciation as yields fall, for a total return of approximately 4% to 5.5% (a bit higher than other forecasts we have seen lately). The main risk to that forecast is the “fear of credit exposure” scenario that was mentioned earlier. We would see a credit concern event as a buying opportunity for munis, as the credit quality of most municipalities is strong, and they are typically not exposed to the competitive pressures of a market or significant changes in usage/revenue patterns. Also of note, more from a market stability standpoint, with the slightly divided government, no major changes to tax policy are likely, so the probability of any change to the tax advantaged status of municipalities will not be a risk we would expect anytime soon. That near-term certainty is helpful to muni market bond prices. Just as higher borrowing costs are impacting large purchases for individuals, higher financing costs may make fewer projects make sense for municipalities. The result could be reduced supply of new municipal bonds, which would tend to be another source of price support. The key for strong performance in 2023, along the lines of our forecast is a reversal of the outflows from the municipal bond funds.
Some sectors of the municipal market may grab headlines and cause concern. Hospitals, continuing care facilities, and nursing homes are facing a difficult operating environment. Many are plagued with staffing shortages and a difficult payor mix (translation, patients covered by personal or employer-sponsored health insurance). According to the Center for Healthcare Quality and Payment Reform, roughly 30% of rural hospitals, totaling more than 600 facilities, are at risk of closing in the near future. We’ve discussed the challenges of transportation authority and toll road bonds and we would expect that situation gets worse in a recession. As the tide rolls out, the poorly managed municipal entities, especially those with mounting underfunded pension liabilities may be exposed, ideally before the situation is fatal. Chester Pennsylvania, the Commonwealth’s oldest city, filed for Chapter 9 Bankruptcy last month due to unsustainable municipal debt, a pension shortfall of more than $100 million, and a population where 30% of the residents live below the poverty line. Without a loan from the Commonwealth, they won’t have funds to pay vendors by the second week of January and the police retirement will run out of money within months. The city has debt of $500 million and assets of $50 million (that debt is $15,151 for every man, woman, and child in the city). There is a reason why we do credit analysis for all our credit exposures, partly to stay far away from a situation this dire. The sad reality is that unqualified, short-sighted, or selfish prior generations and their public officials enjoyed services and assets that they didn’t adequately pay for and now they have created a place that may become uninhabitable for the foreseeable future. We expect that headlines such as this, along with concerns about decreased revenue collection that can occur during recessions may cause bouts of indigestion. A large majority of municipal entities are well-run and of an essential nature to their constituents. Between that fact, and our in-house credit surveillance efforts, clients should take comfort in the creditworthiness of their holdings, should the economy take a turn for the worse. Thanks, in part to stimulus dollars, along with recently robust tax collections, municipal rainy-day funds are at historically high levels and in 2022, municipal entities saw credit rating upgrades at 10 times the rate of downgrades. Municipals broadly appear ready to weather a storm.
Strategy and Summary
Our strategy for bonds at the asset class level is straight-forward and possibly more satisfying than the strategy that is specific to municipals. As it relates to Treasuries and bonds that trade on a spread to Treasuries basis, we encourage a barbell strategy (some exposure short and some long), with an emphasis on quality, and limited optionality/callability. Our internal analysis suggests in the second half of a Fed tightening cycle, high-quality and longer duration often outperforms other fixed-income areas. We believe with strong conviction that the Fed is well over halfway through this tightening cycle. The reason for the addition of short exposure this time around has to do with the outsized degree of yield curve inversion, in concert with the expectation that the Fed will take short rates roughly 75 basis points to as much as 125 basis points higher. If we get to the point where 1-year and 2-year Treasuries offer yields of 5% to 6%, that is a lot of return for very little risk (especially if you think the Fed has the tools to beat inflation, and you subscribe to the prospects of a policy pause).
"...our best hope for a compelling trade opportunity would center on an emerging fear of credit exposure."
The strategy for munis incorporates the fact that the muni bond yield curve is generally not inverted, beyond the 2-year area. Last year in anticipation of short muni yields rising, we sold shorter muni bonds and extended to take advantage of the steepness of the muni yield curve and the historically high yields in the part of the curve beyond 10 years. Market liquidity and general quirkiness made that effort somewhat successful, but we were able to find acceptable bids on less than half the bonds we attempted to sell. As buyers have returned to the muni market, there may be an opportunity to attempt to sell some of the bonds that did not sell last year, but the yields on the long end of the municipal curve have fallen significantly from the levels we saw in late-October. To that end, the municipal strategy is somewhat “wait and see.” Wait to see if credit fears take longer muni yields higher, either for those with cash, or wait and see if the muni yield curve shape becomes such that selling some of the remaining short pieces and extending ahead of a recession becomes a possibility. We threaded the needle last year with a prudent yet bold maneuver, although to a dissatisfying degree. This year our best hope for a compelling trade opportunity would center on an emerging fear of credit exposure.
The Fed must deflate the recent inflationary episode. They have recently sharpened their messaging to say what they have to do may be unpopular and that their focus is once again on their dual mandate of full employment and price stability. The main consternation of the market will likely be the fear of the unknown. Chairman Powell has said the speed of this journey is not a goal he expects, and speed may actually produce a result that is counter to their real goal, but the destination (full employment and average inflation of 2%) is the prize. That journey means millions of unfilled jobs will vanish, millions of people may lose their current job, and GDP will probably shrink in the near future. It will not be a comfortable ride, but rather it may be a trip that is required to achieve more lasting future comfort for many people. We expect the Fed will use the word “pause” in their post-meeting statements this year (and they may throw in a “data dependent” for good measure). So now we wait and see.
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