Last quarter we discussed in detail how the Fed would raise short term yields and that as the Fed walked away from bond purchases, along with technical and behavioral reasons, that there was tinder to drive broader yields higher in 2022. We have also been operating under a theme that some of the most painful sources of inflation (food, shelter, transportation, and fuel) would be “sticky.” It seemed as if the gravitational force of some of the price increases, absent wage gains keeping pace, would pull growth expectations down to earth through demand destruction. New home sales may be signaling that some of our expectations are coming to fruition. As 30-year mortgage rates have risen nearly 150 basis points, topping 5%, the pace of new home sales has declined in both January and February. The combination of recent dramatic housing price increases and the cost to finance home purchase has placed home ownership out of the reach of many Americans. It is a meaningful example of how price increases impact demand and consumer behavior. We anticipate many more examples of changed consumer habits will present themselves as the year trudges on.
In an effort to assume the mindset of the average young family in America, think about enjoying a 5.1% raise (as measured by February private-sector average hourly earnings growth on a year-over-year basis). Perhaps you are looking for a home? Through February, home prices have appreciated 20% over the past year (based on the CoreLogic Home Price Index). If that is out of reach you could rent, but rent has increased 12.6% over the past year (based on the CoreLogic Single-Family Rent Index through February). If you happen to need a car, you are in bad shape. Through February, on a year-over-year basis, used cars have appreciated 41% and new cars are a mere 12% more expensive as compared to a year ago (source: Labor Department). The cost to fill up that $11,000 2009 Volvo V70 wagon with 94,000 miles on it is roughly 38% more expensive as compared to a year ago (18.5 gallons at $3.79/gallon is $70). At the same time, food prices have broadly risen 7.9%. Through the end of March, corn prices were 22% higher and wheat prices have jumped 31% since the start of 2022 (Source: Bloomberg). Since 35% of global calories come from corn and wheat (source: CNBC) food costs and insecurities will impact families globally. It is no wonder that 48% of Americans are thinking about rising prices all the time and 81% believe a recession will happen this year (source: CNBC + Acorns Invest in You survey of nearly 4,000 people conducted on March 23-24, 2022). According to Moody’s, inflation is costing the average U.S. household an additional $296 per month, based on the January CPI as compared to a year ago. The obvious answer seems to be that employers should be paying higher wages. Unfortunately, corporate profits may diminish as their costs of production have increased 10% (source: Labor Department – Producer Price Index for Final Demand released in February 2022). Although an all-time high, consumers’ expectations, in February from the 12 months prior, are that prices will increase 7.9% over the next year (source: Conference Board), so it seems some degree of disappointment is possible for both producers and consumers. Whether we are considering people or institutions, it feels like an economic squeeze is upon us.
"Our hope is that the pain of this cycle is in direct relationship to the things we got wrong."
The main things we got wrong last quarter involved the expectation that some additional stimulus would get passed and our expectation for where the 10-year Treasury would hit was low. Another round of stimulus might have made the inflation issue worse, and we wisely said 10-year Treasury yields would exceed 2% (we started the year at 1.51% and hit a peak close of 2.49% during the quarter). We expected the Fed would raise rates in May, when they demonstrated they are far more nimble than past Fed’s, by stopping QE and hiking within the month of March. Our hope is that the pain of this cycle is in direct relationship to the things we got wrong. The Fed communicated to the market that they were going to get after the problem of inflation faster that many expected was possible. As a result, the market shock translated into sharp and eye-popping fixed income market losses. That is to suggest much of the cumulative pain may be behind us.
The themes we introduced last quarter that were prescient involved an inverted yield curve, quantitative tightening, sources of inflation persisting at a pace faster than wage growth, devalued human capital, a retail muni investor sell-off, and that 10-year high-quality municipal bond yields would hit 2.20% (they started the year at 1.05% and hit a peak of 2.26% before closing the quarter at 2.23%). We know that having experience match our forecast does not ease the concern that can be caused by experiencing unrealized market value losses. The fact that the basis for our estimates was what led to the losses may offer clients comfort that we are knowledgeable about the markets in which we serve, and we monitor and analyze market data to make informed position shifts. According to Bloomberg, in a graph released by Bloomberg on March 28th, a Bloomberg Treasury Index just experienced a loss of roughly 5% on a year over year basis, which going back to 1990, has only happened 4 times. The study suggests that losses of this magnitude represent a 2.5 standard deviation event (meaning very rare). As believers in mean-reversion, the expectation that experience tends to return to long-term “normal” relationships, we forecast that over the next year or two, bonds will broadly experience above average returns from this point. By some measures, you have lived through one of the worst bond markets since the mid-1970’s. We think there will be reward for being on the other side of this event.
Observations and Outlook – Curve Inversions and Quantitative Tightening (QT)
You may have heard that a yield curve inversion just occurred. We must admit the financial news coverage addressing whether the inversion was a fraction of a basis point, or a commanding handful of basis points has been gripping. Some will say that it is a poor indicator of recessions and others believe with the intensity of 1,000 suns that a recession is now a foregone conclusion. We have heard people discuss the 2-year Treasury as compared to the 10-year Treasury, the 3-month Treasury Bill as compared to the 10-year Treasury and a number of mixes ranging from 3-month Treasuries to 30-year Treasuries. An unscientific examination of the relationship between curve inversions and subsequent recessions is that a relationship of sorts must exist. Sure, the 2-year Treasury versus 10-year Treasury inversion has offered false signals (but not many) and the 3-month Treasury as compared to the 10-year Treasury inversion has been a near perfect indicator of subsequent recessions in modern history (until it doesn’t). The real reflection is whether cause or correlation is the relationship between inversions and recessions. The unsatisfactory answer is that at times it may be causal and other times it may be correlation.
Since the inversion is the talk of the market right now, we will indulge with some additional “curve talk.” First, the Fed has quickly addressed the inversion. In a recent appearance before the Senate Banking Committee, Fed Chair Powell recently said he isn’t convinced an inverted yield curve suggests a recession is coming (Source: Thinkadvisor.com). In a speech to the Economic Club of New York, Kansas City Fed President Esther George said, “My concern about an inverted yield curve does not reflect its intensely debated value as a predictor of recession”. Her view is “an inverted curve has implications for financial stability with incentives for reach-for-yield behavior.” We can see how an inverted curve places pressure on the banking system (that simplistically borrows short term and lends longer term), but given it is a widely watched indicator of upcoming recessions, we would expect that a curve inversion could precipitate “risk-off” behavior. Interestingly, Fed policy makers consider the spread between the current 3-month Treasury bill and the forward market for the 3-month Treasury bill in 18 months to be a superior indicator of looming recessions. Oddly enough, that indicator gave the same false indication as the 2-year Treasury versus the 10-year Treasury inversion did in 1998, and it gave the same correct indications prior to the 1991, 2002, 2008 and 2020 recessions.
Our suggestion is to be aware of curve inversions and study the past behavior of various asset classes around the time of inversions and recessions but understand that central banks around the works have manipulated markets since at least 2008. In 2008, the Federal Reserve had as “little” as $500 billion of securities on its balance sheet, as of March 31st that number has ballooned to more than $8.5 trillion (source: Yardeni Research at yardini.com). The same balance sheet that soothed markets during the Great Recession and the Covid pandemic through the Quantitative Easing efforts (buying securities to support prices or prop up market liquidity) may very well be the source of yield curve manipulation, through QT (allowing securities to mature from their portfolio, or outright selling). Indications have suggested that the pace and amount of the QT will be ramping up rapidly to a number that is more aggressive than the last QT effort. In Fed meeting notes, released during the writing of this piece, they have indicated that the pace of roll-off will approach $95 billion per month. This has been a nimble Fed and if a need to adjust the yield curve presents itself, while making progress on the dual mandate of full employment and price stability, asset sales are a possibility, we expect outright asset sales could quickly sober up markets and dampen the faint animal spirits in the market. In truth, this doesn’t seem like an animal spirits-driven inflationary episode, it feels like a hesitant bottleneck laden economy with zombie companies and consumers being propped up by cheap borrowing and a deluge of stimulus cash. While curve shape is certainly worth noting, curve consequences are the indicator we will be watching.
"As input and operating costs put pressure on margins, some of these companies will likely fail or be acquired."
There will likely be consequences to the removal of cheap short-term borrowing costs, challenges with a flatter yield curve and economic headwinds caused by the recent increase in longer-term borrowing rates. Rising short-term borrowing will likely drag on consumers and high-yield corporate borrowers. Prior to the start of Fed rate hikes, at the end of 2021, consumer debt service payments for financial obligations as a percent of disposable income rose at the fastest pace since 1980. Zombie companies are allowed to remain undead due to modest risk spreads and artificially low short rates (compliments of the Fed). As input and operating costs put pressure on margins, some of these companies will likely fail or be acquired. As mentioned earlier, a flat curve creates challenges for traditional financial institutions as they source funds in the short part of the yield curve and lend or buy investments farther along the curve. The misery of these groups, along with the interplay among them, may determine if an elusive “soft landing” can be engineered by the Fed, or if a recession falls upon us.
A key barometer of where this is all headed should be the unemployment rate, along with analysis of where wage growth persists, and the areas of the labor market where job openings remain, along with where they evaporate. Chair Powell has indicated the employment environment is too tight. If inflation collides with widely felt economic uncertainty, the unemployment rate could climb. An indicator of recessions, developed by Federal Reserve economist Claudia Sahm, The Sahm Recession Indicator, says that if the three-month moving average of national unemployment rises by .5% or more, relative to its low during the previous year, a recession is underway. Note it is not a predictive indicator, rather, it tends to identify early in a recession that you are in a recession. If the unemployment rate increases by 2% (two percentage points) it is expected a deep recession is upon you. As rising costs take their toll on people, we can’t see how consumers won’t reduce dinners out, cancel trips and reduce transportation expenses. The consumer discretionary area, the hospitality and service industries could be poised for job losses once again.
Last quarter we introduced concerns about the lack of collaboration between employers and employees about how to run a profitable and competitive corporation that is made up of satisfied and motivated people. The recent unionization developments at Starbucks and Amazon seem to be a natural reaction to the devalued human capital issue (and in our opinion both sides of the equation own this problem). We have a lot of workers with low to moderate skill sets and seemingly the relationship between employees and employers has become increasingly adversarial, or at a minimum, apathetic. Overconfidence is a common behavioral flaw in economic decision-making. Our hope is that neither side overplays their hand but realizes that both the employee and the employer benefit from a relationship of mutual respect and concern. If the labor environment becomes increasingly hostile, quality or utility of goods and services could decline, and customers may change tastes. Then, both the employer and employee lose. The Fed’s tightening plans very likely mean that the labor market of the near future will not look like the market of the recent past.
We anticipate that 10-year Treasury yields will flirt with something close to 3% in the second quarter, before heading lower as the year ends. We believe the muni market has experienced most of the pain it will experience in 2022, so we may see 10-year high quality muni bond yields top out at 2.45% and move to 2% or lower, later in the year. The Fed raises rates to slow the economy down. They have been clear in their resolve to wring the inflation feedback loop out of the economy, and the employment environment is so tight, they can introduce more discomfort than previously thought to achieve their goals. We continue to expect the volatility and yield updrafts of the second quarter will represent the bond market buying opportunity of the year.
Muni Market Developments – Can it Get Any Worse?
The story of the first quarter of 2022 was the “catching up” of the muni market to the Treasury market move, which precipitated a liquidity crunch caused by investors selling their municipal bond fund holdings. The selling pressure made municipal bond yields hit levels that exceeded like-term Treasuries. Since the start of January 2022, a total of $25.4 billion fled municipal bond funds. The Blackrock municipal bond ETF saw its largest one-day outflow of assets since the fund opened in 2007. It was the worst quarter for municipal bond returns since 1994, with many municipal bond indexes losing between 5% and 9% (Source: Bloomberg). The good news is that over the past week, even though municipal bond funds have continued to see some outflows, assets are flowing into municipal bond ETFs. It may be a signal that the liquidity crunch is behind us. We have seen large institutions buy effectively entire bond deals (an aggressive “strip” order where they get the whole bond deal, or they want none of the issue), so some institutional investors have identified this as a municipal market that should be bought with force. We are inclined to agree, based on the 2.5 standard deviation event (losses) experienced by the broader bond market, as well as the fact that the liquidity crunch has made municipal yields nearly equal to like-term Treasuries (that relationship has been closer to 80% for much of the past four years, except for the first year of the pandemic).
During the Great Recession, essential service issuers experienced revenue shortfalls, tightened liquidity and increased service demands, but default activity was very rare. Most default experience tends to be focused in the areas of nursing homes/assisted living facilities, development related issues, hospitality exposures and conduit financing on behalf of corporate entities. The historical default numbers for high-quality essential municipal bonds are compelling as compared to corporate bonds of a similar quality. In many cases, municipal issuers are perpetual entity publicly owned monopoly assets. That simply makes them unique. As cost pressures could drive mergers and acquisition activity in the corporate bond market, resulting at times in large credit quality changes (as the A-rated bond you owned gets acquired by a BBB-rated issuer), it is a reminder that munis are poised to mitigate such risks. Finally, the luxury of owning individual bonds at a time like this can’t be ignored. Not to minimize the pain of recent unrealized market value losses, but absent an issuer default, from this point until maturity, if you hold the bond, you will earn your semi-annual coupon income, as well as the likely price appreciation from the holdings’ current market value and the par amount. Not many investments allow you to generate yield while offering you the ability to have a highly probable holding period return following an event like we just experienced.
Summary
Past performance is not a guarantee of future results. It feels like that that warning is so ubiquitous that financial service clients know it as well as the advisors who must share that insight on a regular basis. It is so prevalent that it almost discourages practitioners from synthesizing information gleaned from past market events to inform current strategy and communicate our expectations. Here are some nuggets we’ve uncovered. April tends to be a strong month for stock market performance, but the second quarter of the year of a midterm election seems to be the most dangerous of all the quarters of a Presidential term. Following a curve inversion, but before a recession, historically both stocks and bonds experience above average returns. As measured from the start of a 2-year Treasury versus 10-year Treasury inversion through the following 12 months, long government bonds and high-quality corporate issuers and sectors tend to do materially better than more volatile sectors of the corporate bond market, lower-rated issuers and short Treasuries (all based on averages experienced during the past five inversions). Our synthesis of this information is that you can choose to trade this market (whistle through the graveyard until the shoe drops) or you can get your house in order for a failed soft landing that will likely turn to an uncomfortable recession.
In the context of the Fed slamming on the breaks with Fed Funds hikes and QT, along with the global sources of fiscal stimulus tapering off dramatically, it certainly seems that Q2 of 2022 will be a bumpy ride as people realize the “party” will have to be over for inflation to be snuffed out. To be safe, we will say that “risk assets” will see meaningful volatility, but it seems that broadly bonds will see more discomfort and stocks should see additional losses. As stagflationary pain turns to expectations for a recession, more than that, fear of a looming recession, stocks will find a bottom and high-quality bonds should see price gains. As mentioned earlier, high-yield, and risky corporate sectors may not take the same ride.
As mentioned earlier, we could see 10-year Treasury yields approach 3.0% before drifting lower at the end of the year. Municipal investors may see 10-year yields touch 2.50%, but we think there is more force that will likely push yields closer to 2% than the risk of materially exceeding 3%. Against the backdrop of the Fed’s actions, the risk of the second quarter repeating the market value losses of the first quarter seems extremely low.
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