The second quarter of 2022 saw bond yields climb even further, as persistent signs of inflation climbed and it became clear that the Fed was behind in their efforts to contain inflationary pressures. Coupled with an excruciatingly tight labor market, May’s CPI release came in at 8.6%, a 40-year high. Moreover, the Fed seemed to have lost some credibility because according to the University of Michigan index of inflation expectations for the next five to ten years rose to 3.3% in May, far higher than the 2% the Fed has stated as a long-term average growth goal. These developments have caused the Fed to (yet again) demonstrate they are nimble. What was expected to be a parade of 25 basis point rate hikes at each meeting for much of 2022 has turned into a “front-loaded” tightening approach, with a 75 basis point hike in June and another 75 basis point hike anticipated in July, followed by hikes of a smaller magnitude in September and beyond.
In comments to the US Senate in late June, Fed Chair Powell stated that the central bank would keep raising rates to quash inflation and that a recession in the US was “certainly a possibility.” The market is anticipating that the Fed Funds Rate will peak around 3.6% in mid-2023 and that the rate may fall in 2024. In their words, the Fed has expressed resolve to tame inflation, but if the past is a guide, will the Fed have the fortitude to inflict a mild recession on the economy to elevate the pain of the current inflationary episode? We expect that the answer will be “yes.” Although this Fed has felt like it follows the market, we believe the Fed understands that if inflation is not wrung out of the economy this time around, addressing an acceleration in inflation expectations will likely be more difficult and disruptive should a dovish policy turn allow inflationary expectations to resume or accelerate.
Against the backdrop of such a lopsided job environment, a painful recession is not the first vision of the future that comes to mind.
In the face of increasing signs that we may be heading for (or are in) a recession, the strength of the jobs numbers, including the unemployment rate amid near record-low layoffs, leads many people to think we can have a full-employment recession (a recession that doesn’t “hurt” too bad). According to the Labor Department, job openings in May sat at 11.25 million. At the same time (in May) there were 5.95 million people counted as unemployed. In other words, there are 1.9 openings available for each available worker. Against the backdrop of such a lopsided job environment, a painful recession is not the first vision of the future that comes to mind.
The mix of climbing inflation measures, a strong job environment, and the new expectation for a front-loaded Fed response drove bond market yields higher over the quarter. The result has been continued suffering for bond market investors of nearly all stripes. Year to date, many taxable bond indexes have lost between 7.5% and 10.5%, with lower quality and longer duration indexes falling a whopping 15% to 22%. Municipal bond market investors were not immune and experienced losses of between 8% and 15% on a year-to-date basis, also with the worst losses focused on the lower quality, longer duration, and the “Impact” (ESG) segments of the muni market. Over the course of the quarter, 10-year Treasury yields migrated from 2.34% to 3.01%, while 10-year municipal bond yields travelled from 2.23% to 2.75% (both of which saw a brief spike higher in mid-June, before settling lower at the close of the quarter).
Observations and Outlook – Look Out Below
This job environment will very likely turn out to be a paper tiger. According to the Bureau of Labor Statistics, in April, the largest contributor to inflation was made up of services. Services can often be substituted (by doing it yourself) or they can be delayed. If the cost of dining out increases too much, or the quality of the experience declines, a person can choose to make their gourmet hamburgers at home. Most of the recent wage inflation has been focused on lower-quartile earners, largely in the service sector of the economy. If economic sentiment softens and consumers change behaviors, the recent job market “winners” could quickly become the hardest hit casualties. In the paragraphs to follow, we lay out the case for why that is our forecast.
Even though the layoff rate in May was near a historical low of 0.9% (Source: US Labor Department), industries most closely impacted by higher borrowing costs are starting to announce plans to cut staffing. Among the early sectors to feel the pinch are mortgage lenders, home builders, financial institutions, and some commodity-centered companies. A few recently released data points exhibit how the nearly two jobs per job seeker could quickly become one job (or half a job) per job seeker. Recently, job placement firm Challenger, Gray, & Christmas indicated that as of June, planned layoffs increased to 32,517, a 57% jump from the month prior, and the highest number since February of 2021. Manufacturing overtime hours have declined the past three months, the longest downward streak since 2015. Perhaps more telling of what lurks just beneath the surface of this job market is the sentiment of both workers and employers. In June, a survey of more than 1,000 workers performed by staffing company Insight Global, found that nearly 80 percent of US employees fear losing their job during a potential upcoming recession. Perhaps the “concerned employed” are wise as the same survey found that 90% of the managers surveyed said they would likely have to layoff employees during a recession. Firms like Netflix, Tesla, and Meta have announced plans to trim their workforce, and these announcements are happening before the official declaration that the U.S. (and even more likely Europe) is in a recession.
Corporate and consumer sentiment has collapsed.
Away from the employment environment, there are many influences that are building which can push the economy into a stall. Corporate and consumer sentiment has collapsed. The “sticky” sources of painful inflation we have been calling for all year, especially in the context of a possibly more challenging corporate growth and related negative real wage gains, has brought a sense of “falling behind” on the psyche of the economy. The June University of Michigan Conference Board survey of consumer sentiment fell to a record low, and their gauge of expected business conditions is at one of the lowest readings of that metric going back to 1978. A Dartmouth College economics professor and former Bank of England policy maker co-authored a 2021 paper that showed declines of 10 percentage points or more in either of the University of Michigan Conference Board surveys are predictors of recessions going back to the 1980s. The headline number is down by 30 percentage points this year. Near the end of the quarter, Goldman Sachs economists put the probability of a recession in the next year at 30%. A Bloomberg Economics model placed the probability at 38%. We think the number that may matter the most in the near term is the Atlanta Fed’s GDPNow gauge, which is a volatile yet accurate predictor of GDP growth during a current quarter. Currently GDPNow sees the second quarter running at a contraction of 2.1%. As a quarter gets closer to a close, the accuracy increases, according to Nicholas Colas of DataTrek Research. Since the Atlanta Fed first started running the model in 2011, its average error has been just 0.3%. In concert with the first quarter of 2022 contraction of 1.6%, the current GDPNow measure suggests that we are currently in a recession (typically defined as two consecutive quarters of GDP contraction).
Sentiment is down, workers are not confident about the employment environment; it appears that we are in a recession, but the headwinds don’t stop there. Although elevated fuel costs are weighing down both consumers and corporations alike, some current operating challenges may start to impact corporate profitability (which we expect has a strong chance of pulling the “E” down in the widely observed P/E Ratio followed by stock investors). Specifically, the strong US Dollar is being mentioned by companies including Costco, Microsoft, Salesforce, and Hewlett-Packard as a reason for reduced profitability. For companies with overseas sales, a strong dollar reduces the value of their foreign revenue and at the same time it makes their products less competitive as prices rise in local currency terms (in the foreign currency, more money is required to buy US goods). Beyond currency dynamics, other areas of difficulty for corporate profits include rising wage costs, volatile yet generally higher input costs and nagging supply chain hiccups. When the demand picture sours, look for abrupt production, cost containment, and investment changes on the part of corporations.
Last quarter, we discussed the prospects for upcoming challenges for “zombie companies” but look for turmoil in most sectors that are exposed to rising borrowing costs as a risk. It appears that the housing market is set for a meaningful pause in activity. According to Redfin, in June nearly 60,000 home sales fell through, which was roughly 15% of the transactions for the month. The primary factors impacting affordability and transaction trends has to do with the fact that mortgage rates are nearly double what they were at the start of the year, and according to an S&P CoreLogic Case-Shiller housing price index, prices are up approximately 20% as compared to last year. Sales of new homes fell in April by the most in nine years, decreasing by 16.6%. A lot of economic activity is generated by the buying and building of homes, so marginally this will act as a weight on domestic GDP growth.
It seems retail is poised to be a sector that could add to the economic drag...
Retailers are also feeling the pinch of higher fuel prices, elevated staffing costs, and changing consumer behavior. In May, both Walmart and Target guided earnings estimates lower. Walmart said that rising food prices were forcing consumers to spend more on essentials than expected. Walmart’s inventories of $61.2 billion at the end of the first quarter were about a third higher than a year prior and as of April 30, Target was carrying $15.1 billion of inventory, about 43% more than a year earlier. It seems retail is poised to be a sector that could add to the economic drag from both the perspective of profitability and contribution to the job market.
Ignoring the geopolitical risks waiting in the shadows, our wildcard event is what we call the dire “feel good” scenario. In this scenario, Q2 GDP growth comes in negative, officially placing the US economy in a recession. Mid-term elections are coming up, and a natural solution to our recession would be another round of stimulus programs to help working families shoulder the burden of higher food and fuel costs during this challenging time. Unfortunately, it was supply bottlenecks, extreme central bank accommodation and stimulus dollars (both superfluous corporate and individual payments) that heavily contributed to getting us to inflation not seen in 40 years. If the Fed were to be using its nearly $9 trillion balance sheet at cross-purposes with a Congress and White House that is likely willing to throw trillions of dollars of stimulus at voters, the unintended consequences could be immense. The recently broadened goals of the Fed seemed to be a danger to their ability to fulfill their dual mandate of price stability and full employment, but if the Fed were to be acting counter to the actions of Congress, we think there would be calls for the end of the Fed in its current state. At a minimum the efficacy of the Fed would be undermined, but it would also face a credibility crisis. We mentioned a potential scenario of recession and stimulus benefits (both for the politicians and the recipients/voters) last quarter and it seems like in small ways it may already be playing out. Starting in October in California, a relief package totaling $9.5 billion will involve sending checks of between $200 and $1,050 to approximately 17 million families. States including Colorado, Maine, Indiana, and Delaware are implementing similar programs to help people cope with high prices. At the margin, such efforts are counter to the Fed’s goals. This whole inflation issue is a vicious cycle, especially if pain is required to stop the inflation. It very well may be the case that solutions born out of compassion are the very acts that risk an inflation mindset persisting and exacting more pain on working families. Although the pain of recessions tends to not be equal, it seems as though the only way to get through this episode more unified is if the sacrifices are as wide-spread as possible (and our hope for that mindset among the “problem-solvers” is probably misplaced).
Muni Market Developments – Thank You Sir, May I Have Another
The municipal bond sector misbehaved in the second quarter. Whereas we expected the muni bond fund outflows would reverse (and for about a week in May they did) generally over the course of the quarter money continued to flow out of muni bond funds, so the resulting liquidity was poor and performance suffered. Outflows have totaled more than $80 billion. The magnitude and duration of the outflows was very unusual, and in our opinion, it was responsible for municipal bond yields getting so high relative to most bond market sectors that foreign buyers (who don’t benefit from the tax exemption) jumped into the market. Many closed-end municipal bond funds and the lower quality and longer duration sectors of the municipal market experienced losses of around 15% to 16%. Broader municipal bond indexes have seen losses of between 7% and 11% for the year. The good news is that outflows appear to be decelerating, and as the third quarter of 2022 gets underway, municipal bond yields have been falling relative to Treasury yields. If signs of recession come to the surface, look for municipal yields to continue to decline. Absent a recession, even if the relationship between municipal bond yields and like-maturity Treasuries reverts to a more normal state, municipal bond investors should see values improve. It has been the worst start of a year in the municipal bond space since at least 1981, and we feel bad for those who are uncomfortable with the temporary losses.
Unlike the zombie companies (the roughly 20% of US publicly traded companies that aren’t earning enough to cover their interest expenses, let alone turn a profit) municipals are poised to weather an economic hurricane well (broadly speaking). Clearly, California is doing so well that they can get checks out to families and voters in October. State tax revenue is 25% above its pre-pandemic peak. State rainy day funds are at record highs, and credit rating upgrades are exceeding downgrades by a three-to-one margin. Most governments are in good financial shape. Municipal governments are generally perpetual entities, overseeing monopoly assets that are essential to the daily lives of constituents. Investors in municipal bonds have effectively made loans to very creditworthy entities. The recession scenario will likely enhance muni bond market values, while the same can’t be said for many other sectors in the bond market.
The good news is that many states have well-stocked rainy-day funds...
That is not to say that states are immune to recessions and revenue/spending volatility. According to the Urban-Brookings Tax Policy Center, state revenue growth is forecasted to grow by 4.4% in fiscal year 2022 and shrink to 0.1% in fiscal year 2023. Governors in 30 states are proposing net decreases in taxes and fees in 2023, while only three are anticipating increases. Of note, the largest expected drag in 2023 is an 8.6% year-over-year decline in corporate income tax collections. Won’t they be surprised if the recession occurs in fiscal year 2022. The good news is that many states have well-stocked rainy-day funds and they are anticipating a slowing of revenue growth, so massive budget surprises seem less likely.
Strategy and Summary
Fits and starts of inflation will be our reality until the 80% of workers who fear losing their job in a recession start convincingly changing their consumption behaviors. We find ourselves getting trapped in the regime-switching mindset we have discussed many times in the past (the idea/market behavior that says you are always moving from position A to position B, or vice versa). Our expectation is that a recession is in the cards, but the same nimble Fed that ended Quantitative Easing and then tightened and announced Quantitative Tightening (QT) in a matter of weeks has the ability to cease aspects of the tightening programs if market liquidity, risk spreads, capital market access, or elements of the Fed’s dual mandate dictate. Following the mid-term elections, a form of gridlock will be the political operating environment for the next couple of years, so broadly needed spending plans may succeed, but more partisan goals will be slow to progress.
The world continues to be awash with significant monetary supply.
As the Fed continues to raise short-term rates, the yield curve should be flat, and depending on the degree of fear about the recession, we may see significant inversions. The world continues to be awash with significant monetary supply. That leads us to expect that term premium (the yield compensation for holding longer-maturity bonds) and general interest rates will have a longer-term bias toward being modest. Productivity also seems to have a generational pull toward being not supportive of rapid growth. Against that backdrop, we believe meaningful dislocations from long-term relationships are buying opportunities. The recent municipal market liquidity crunch, dramatically wider than average spreads (for quality borrowers), or certain odd sector relationship deviations may present opportunities to buy quality issuers of sectors during the “throw the baby out with the bathwater” moments.
As expected, QT has impacted market liquidity, so bouts of volatility will persist. Europe is moving toward recession and the US seems to be moving in lock step. The regime-switching mindset probably means that bond market investors will continue to be knocked around by market moves, but as the probability of recession and the magnitude are thought to be understood by the market, we expect a downward trend in the less manipulated segments of the bond market will ensue. 10-year Treasury yields should continue to flutter around 3.0% before drifting lower at the end of the year. Municipal investors may see 10-year yields circle back toward 2.50%. Longer-term, we think there is more force that will likely push yields closer to 2%.
Fiscal spending seems to be shrinking and gridlock will make that the base case. Business and consumer sentiment is in collapse. Major industries are facing numerous headwinds and turning an eye toward cost savings. The Fed’s fear of not breaking inflation is palpable. How does this not translate into a recession and eventually lower bond yields? The idea of a full-employment, pain-free end of the inflation situation in which we find ourselves is fiction. The story we are about to read belongs more on coarse newsprint with the annoying ink that stains your fingers.
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