Total Time: 15:35
Michael Walton: Hi everyone, this is Michael Walton here with Thomas Urano, who leads the portfolio management team at Sage. As we head into the final quarter of 2022, we want to spend some time evaluating where we are, and more importantly, our outlook going forward. I do think that things change quickly. So it's important to date and timestamp this conversation. It is Monday, October 17, at around 2pm central time. So the third quarter was a continuation of the same narrative we've been dealing with for the last 12 months – persistent inflation, a monetary policy response to meaningfully tighten conditions, and a significant retrenchment in financial assets and risk premiums across the board; duration, credit and equity. This all translated to a another really difficult quarter from a performance standpoint, capping off a historically difficult one-year period. And so Thomas before we dive in, let's talk about the latest CPI release that came out last week. It was a little hotter than people were hoping for. So can you give us an initial reaction?
Thomas Urano: Yeah, thanks, Michael. All eyes had been on CPI, but here we go again, another month of elevated CPI, core in particular came in at 0.6% for the month and 6.6% year on year. So inflation continues to run well above the Fed’s comfort zone. We did see some moderation in goods inflation; however, services inflation, it's taking its turn now, it's running high and it's keeping core CPI elevated. Big drivers in service sector: shelter, owners’ equivalent rent – that printed the highest month on month inflation since 1990. Transportation Services also drove inflation. It was led by auto insurance and auto maintenance, medical services also elevated. So bottom line, this last CPI print definitely keeps the Fed engaged and just pushes the Fed pivot hopes off for another month.
Michael: Got it. And I think you know, we'll certainly talk more about inflation, but I do want to take a step back and try to get a handle on the big picture. And so for everybody out there, the way we organize this discussion is we want to do our best to address what we would consider to be the key fixed income questions investors should be focused on. You know, number one, are we nearing the end of the rate pain? Number two, what will the magnitude be of the policy-induced economic slowdown? And number three, what are the catalysts to eventually add risk premiums to fixed income portfolios? And we'll do our best to keep this under 15 minutes. So Thomas, let's start by talking about policy and rates.
Thomas: Great. So just to recap, I think it's important to think about the policy stance in 2022. Remember, the Fed kept stimulating way too long. We had 0% interest rate policy and QE going on until just February of this year. However, coming out of February, the Fed has raised rates at the fastest pace in modern financial history, right, raising faster than the ’88, ‘89 cycle, faster than the 1994/’95 cycle. By the end of this year, the Fed will have raised policy rates by over 400 basis points in just 10 months.
Michael: So that's incredible. And where does that leave current market pricing?
Thomas: So current market pricing is looking at a policy peak of around 4.75% to 5% in the second quarter of next year. Short-term rates in the front of the curve are still a little bit below that. So this likely puts a little bit of upward pressure on the front end of the yield curve. And in the long end, we see 10-year and 30-year Treasuries, they seem to be looking through to a recessionary economy, expecting the Fed to cut rates sometime in 2024. However, I think it'd be important to caution, a number of Fed members have been speaking about holding rates steady in a recession rather than cutting rates. And if that's the case, the long end would have to reprice higher as well.
Michael: And let's talk about slowing growth and really maybe focus more on the magnitude of recession risk. And the question is, is the Fed doing enough to get inflation under control?
Thomas: Right, so we think the Fed needs to see two things happen, needs to see a slowing jobs market and a clear trend of lower inflation. Unfortunately, I think that means we're headed into a recession. And there's not much debate about that right. Employment and inflation are lagging indicators. The economy needs to be leaning into a recession or for these metrics to rollover.
Michael: And you commented earlier on the CPI release from last week, but I guess, are there any signs that inflation will soften?
Thomas: Yeah, so the ingredients for slower inflation are building, but they're just not building fast enough, right? For example, home prices, they're rolling over. Shipping costs, commodity prices, they're all well off their highs. We're seeing a number of companies that are guiding earnings outlooks lower, and recently job openings are falling. So you know these are the pieces that we need to start seeing inflation pressure come down. But we have this stubbornly sticky elements of inflation that are still here. Right recent research out of the San Francisco Fed shows that we still have a reasonable portion of inflation that is supply chain related. Geopolitical tensions are keeping energy-related aspects of inflation elevated. And despite these softening home prices, shelter inflation has a notorious lag effect to it. And that's keeping the shelter component of inflation high.
Michael: And you mentioned earlier, the Fed’s desire to see a softer job market, but employment has remained really strong. So any thoughts on the employment picture?
Thomas: Yeah, the job market is another metric that's been stubbornly resilient. So remember, it's been very difficult for employers to hire since the pandemic, right, the scarcity of labor versus the abundance of job openings has been a structural support for the job market. In addition, there has been a high cost of recruiting. You put on elevated quit rates, and it's made employers I think hesitant to really pull the plug on jobs. However, we have seen in this past month a large decline in the number of job openings. So that may be a sign that labor weakness is around the corner. This may be driving a hard landing, but ultimately that recessionary environment that the Fed is looking for.
Michael: And let's shift the conversation to credit spreads. So from a positioning standpoint, we've been cautious on spreads throughout the year lowering our spread risk, I think building up dry powder across all of our client portfolios. So what's our outlook on spreads going forward?
Thomas: Yeah, credit spreads, they're weaker on the year, right. But until recently, that weakness has been pretty orderly. I would say, however, spread vol picked up noticeably, just three or four weeks ago. So it started in late September, we started to see a lot of chop in the credit markets. And it's been very kind of volatile and choppy since then. We are also seeing some cracks in terms of market functionality. So companies continue to roadshow, they'll flirt with issuance, but they're frequently delaying those issuances. Right. So this is a sign that the market has some dysfunction to it. And it's limiting the capital availability to borrowers.
Michael: And the spread volatility hasn't been isolated to corporate issuers, mortgage spreads have had a tough time as well. So can you give us some thoughts on the MBS?
Thomas: So the mortgage sector also has been weaker for the better part of the year here. Mortgages have suffered from fears of quantitative tightening where market participants were expecting the Fed to unwind its balance sheet in the mortgage space, and that was resulting in selling and weakening pressure in the mortgage sector. However, it's starting to look interesting at these levels. Valuations have repriced to spread levels that we haven't seen since the 2008 Financial Crisis. On top of that, you had the fact that dollar prices are now trading at very, very steep discounts. And that leaves mortgages in this a kind of unusual position where you have a very healthy income level. And you can combine that with some decent performance upside when spreads ultimately normalize.
Michael: And so, you know, talking about having dry powder in the portfolio is what will be our catalyst to onboard risk premiums.
Thomas: So, you know, I'd like to think of it in the mortgage space, in the credit space and the mortgage rate space, we think spreads can do well, ultimately when rate volatility subsides, right. And that's just a function of when the Fed signals it's done. But as rate volatility subsides, mortgage spreads will generally normalize. And like I said, you'll have some nice upside in that sector. Investment grade credit premiums, that's a little more nuanced, right, we would expect to see an initial rally in credit spreads on the back of the Fed policy tightening wrapping up; however, you’ve got to remember where that puts us economically, right. Credit, I think is going to face another stage of uncertainty and risk going even wider on fears of the depth and duration of a Fed-induced recession.
Michael: Got it. And there has been quite a bit more discussion of late around bond market liquidity. So what are we seeing?
Thomas: Yeah, so market liquidity has been pretty thin. And this is kind of consistent with fourth quarter seasonality effects. However, there are a number of other liquidity indicators that are running at extreme lows. So the depth of book in the Treasury market: how much volume can you trade in Treasuries on any given trade? It's near decade lows, right? It's very low bid ask. Spreads are trading wide, also indicative of liquidity premiums in the market. And then just the ultimate measure of volatility? Bond market volatility indexes, they're trading near decade highs, right. So where does that leave the market? It leaves the market susceptible to these exaggerated swings, right, and investors, I think you should be prepared to witness these outsized daily moves both up and down. And that's likely to occur through the balance of Q4.
Michael: And let's switch gears. Now what's kind of going on with the UK and the pension plans over there? We've had gilt yields be extremely volatile, which has created some problems for UK pension plans. And I think the question that we're getting is, is this an issue that could bleed into the US, particularly for LDI strategies?
Thomas: Yeah, so kind of at first blush, I think the situation in UK is kind of unique to circumstances that are in the UK, primarily, we have fiscal actors and monetary authorities who are there, they're going back to directly opposing policies, right. The UK, British government was pushing for an unfunded stimulus package in order to stimulate growth and provide tax cuts, while the Bank of England was doing the exact opposite. They're trying to fight inflation by tightening monetary policy and slowing growth. So these two policy approaches are completely at odds with each other. And it's kind of unique to the circumstances in the UK at the moment. But ultimately, what happened is the UK bond market revolted to this whole notion of stimulus and unfunded tax cuts. And we saw 30-year gilt yields jump 150 basis points in just a matter of days.
Michael: And how did that spike in yields cause problems or flow through to the UK pension plans?
Thomas: So UK pension plans, generally, a number of them have used interest rate derivatives to immunize liability risk, right. And I think it's important to remember, in rate derivatives, you get embedded leverage, and that embedded leverage creates excess capital that then gets invested in other market segments, right. But ultimately, when you see these large moves in gilt yields, these rate derivative exposures, they ended up going underwater, right, and counterparties turned around and started issuing margin calls in order to raise capital for these positions. So several UK pension plans became forced sellers to raise margin capital, which created this whole negative feedback loop, ultimately, drag in Bank of England to step in and support the market. And we got some stability. And since then, the prime minister has reversed course on stimulus. So UK rates appear to be stabilizing.
Michael: Yeah, and to your point, I mean, it definitely seems like an issue that is sort of unique to the environment in the UK. But it is a reminder of what a fragile market environment we're in, but it's also this notion that it's really important to know what you own. Whether you're using derivatives and leverage, particularly in a collective fund, and you get into a really volatile environment, you could wind up on the bad side of things fairly easy. And so Thomas, let's wrap things up. And I'll make a statement. You know, one, I think investors have been very resilient and patient given how historically bad this last year has been. But it's fair to say that that patience is being tested. So can you spend a few minutes as we wrap up framing the reasons to be optimistic about the outlook for fixed income going forward?
Thomas: Right. So I think when you look at the bond market historically, it typically does well in a recession, and following a tightening cycle, right? Why is that? Yields are moving higher, and they end up giving a higher income cushion to fixed income investors. Recession fears usually drive a flight to quality that ends up being supportive of the bond market. And then lastly, risk premiums are usually overcompensating investors following rate hikes and recessions. That fear of risk generally leads to higher levels of risk premiums. So our key takeaway is, Q4 this year, likely high volatility, right, there's still a lot of uncertainty on how high the Fed goes; there can be still upward lift in rates. So, it would behoove investors to be cognizant of the degree of volatility and upside risk and yields through the balance of Q4. But as we get into the beginning of next year, if we see the economy rolling over, right, that could lead to a scenario where the bond market looks attractive again. And remember, environments that we've been through this year, they usually set up fixed income markets with a pretty favorable outlook going forward.
Michael: Yeah, it's very well said. So Thomas, thank you very much for your comments and everybody who’s listening, just as a wrap up here. One, just know that we're always here to have a conversation. We put this together to make it convenient for you to hear from us, but please don't hesitate to reach out anytime you want to have a discussion. And thank you very much for your time. Appreciate it.
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