Total time: 12:27
Michael Walton: Hi everyone, this is Michael Walton, here with Thomas Urano, who leads our portfolio management team. Thomas, I think it's important to timestamp this conversation since things are changing so fast. It's Wednesday, April 6, at around 10 in the a.m. So this quarter was definitely one for the books. But it was one of those chapters in the book you want to like rip out and light on fire?
Thomas Urano: Just don't read that book again.
Michael: Yeah, whether you're a core or even a short-term fixed income investor, you just went through one of the worst quarters in four decades. And it was really on the heels of what ended up being a historically sharp and fast increase in Treasury rates. And you know, thinking about this reminds me of the summer of 2013. So it's mid-August in Central Texas. Record Heatwave, my son is playing in an outdoor soccer tournament. It's late in the day, but it's still 110 degrees. And so we're in between games, my son comes to me and says, “I don't think I'm going to be able to keep playing.” And my response was that it doesn't get any hotter than this. Like if you can just get through this day. And this next game, you're going to be okay. And he went back out there and played and survived and didn't score any goals. By the way, I don't think he's scored any goals all season, so it wasn't any different. But he survived the day. And, you know, my comment is, I think we're in kind of a record heatwave in the bond market right now. And it won't say hot this hot for long.
And the season will eventually change. But we acknowledge this is definitely tough out there. So Thomas, just a real quick kind of post-mortem on how we got to where we are today. So on the inflation front, we're seeing inflation year over year prints in the 6% to 8% range. How did inflation become a bigger problem than really anyone, even the Fed, anticipated?
Thomas: Yeah, inflation is a difficult thing to project. The Fed expected transitory and instead we got explosive inflation. I think it was this perfect storm of ingredients that really drove it. We began with a pandemic-related supply chain issue that can reduce the amount of supplies that were available, we had record monetary and fiscal stimulus that really drove consumer demand for goods and services. And so those two combined reduce supply, excess demand drove prices higher. And then we got bonus ingredients: we have a war, we had a war that further disrupted supply chains and drove commodity prices up. And then ultimately, the Fed, the Fed just stayed accommodative and supportive way too long. Way too long. They, it turns out, they may have stayed at the party, they stayed at the party too long. If you look back at past tightening cycles, it's very normal for the rate market to adjust in the months leading up to the first rate hike. But in the last several months, we have seen what has turned out to be an entire cycle’s worth of rate volatility, really before even the first hike began.
Michael: So can you talk about a little bit about what we've seen in the in the rate market?
Thomas: Yeah, I think it's important to recognize the Fed has only engaged in a 25 basis-point rate hike so far, and what have we seen in the rates market, the rest of the Treasury curve, the magnitude of the rate adjustment has almost been the entirety of the expected rate cycle – we're seeing almost 200 basis point increases across the curves from the lows – the yield curve is flat, and inverted. At some point, all of these are very late cycle, all of these things usually happen at the end of a rate hiking cycle. I think the reason that we're seeing that is because of that perfect storm – I mentioned excessively high inflation, and the market is expecting the Fed to have to be very aggressive to get a hold of it.
Michael: Yeah, it's also on that note, it's amazing how much volatility there has been in how the market is pricing, the terminal rate or the ending point for fed funds. At one point, it was two and a quarter. And then when the war started, it got down to 175. Then it got all the way up to three, and now it's hanging around 250, 275. So there's just been a lot of volatility in the expectation of what the terminal rate is going to be. Can you talk about that?
Thomas: Yeah, I think I think that's just a function of the high level of uncertainty about the effectiveness of Fed policy, right. They're going to have to raise rates and hopefully, slow, slow consumer demand, slow the economy, and that ends up slowing inflation pressures. But the market is uncertain about just how high the fed funds has to go, you know, the terminal rate, the ending fed funds rates projected to be somewhere around 275. At this point, it could go to three, it could fall back down to two. There's just a huge amount of volatility surrounding how aggressive the Fed is going to have to be. So there has I mean, obviously rate pain caused all segments of the bond market to reprice, but corporate credit spreads have actually hung in there.
Michael: Okay, I think we were 20 wider in the IG index for the quarter. Can you talk about a little bit about what you're seeing on the spread front?
Thomas: Yeah, in all the weakness that you've seen in the bond market, rates moving, the corporate bond market, the corporate risk premium market has been exceptionally well behaved, very resilient. I think that's a function of pretty solid profits that we've seen so far. The rebound in the economy last year, so good growth, still pretty reasonable or significant consumer demand, like all the ingredients for, you know, in hindsight, well looks like a pretty good backdrop for corporate spreads. And I think that's why corporate spreads have been so strong. The one thing that people haven't mentioned or haven't really I don't think has been acknowledged, was mortgage spreads. Mortgage spreads have had a very significant repricing, right. They've cheapened to levels that we've only seen three times in the last decade. Fundamentally, mortgages are strong because home prices have gone up. But this is a very technical adjustment, and it's tied to the level of rates, the speed of the rate adjustment in Treasuries, convexity risk in mortgages. QT is a big concern for mortgage investors. But that's led to a pretty significant cheapening in the mortgage sector.
Michael: Which has benefited our portfolios because we've had a significant underweight to mortgages.
Thomas: That's correct. We've been underweight mortgages through the entire timeframe here mainly is because we've been worried about the exact things I just mentioned. However, just in the last two weeks, on the heels of all this weakness, we've begun to load mortgages back into the portfolio.
Michael: That's great. Yeah. So that kind of brings us to looking at like our client and consultant partners. They want to get a sense for where we're headed. And so looking ahead, you know, on the inflation front, you talked about the perfect storm and looking out 12 or 18 months, the question is, you know, is the Fed going to be able to get inflation under control?
Thomas: Yeah, that's a great question. I mean, this is always about best guess estimates. And you know, the Fed is going to deal in probabilities, because their policy is always lagging, a look at the weight of evidence that suggests that inflation is going to come under control. I think there's three things to really consider: number one, geopolitical tensions need to ease, right. I don't know how fast this Ukraine war situation resolves itself. But it certainly had a function of driving raw material costs higher. And that's really helped drive inflation or keep it elevated. Number two, supply chain issues need to resolve. So we've seen some easing and supply chain constraints, but it's not done yet. So there's still some work to be done to really improve availability of goods. And then lastly, we need to slow consumer demand. Right. And I think that's really where the Fed is focused. If they can raise rates, slow the economy and ultimately slow demand, then we can get inflation under control.
Michael: Yeah. And on the demand front, I mean, to put out the inflation fire, you're going to have to you've mentioned slowing demand, and I guess all of those things combined, you know, what's the impact on growth? And maybe the effect of that on markets, right?
Thomas: So in order to get demand to slow, you have to slow the economy. The tricky part is, can the Fed engineer a soft landing – the mythical soft landing that everyone hopes for – without driving the economy into recession? Right. And that's going to be a real challenge. And I think the market is considering whether or not the Fed can actually engineer that. But recession risk is going to be high.
Michael: A recession’s likely, what does this mean from a positioning standpoint? For us, specifically, in regard to our onboarding risk and risk premiums?
Thomas: Yeah, so recession risk is certainly going to be a negative headwind for the corporate sector. I mentioned earlier, corporate spreads have been very well behaved, that sector has done very well in the face of all this repricing in the rates market. But I think if we get to a point where recession risk becomes elevated, and growth slows significantly, corporate spreads are going to weaken, right. And for us, we've been unloading credit premiums into all of this strength. And as I mentioned, picking back up some mortgage premium on all the weakness. So it's kind of worked in our favor here. But I think you have to prepare the portfolio for potential risk of an economic slowdown.
Michael: So we're building dry powder on that side of things as it relates to credit risk. Where do rates go from here?
Thomas: Yeah, that's a great question. So rates have largely discounted the bulk of the projected move, unless the Fed says we're going to have to take policy rates up to 3.5% or 4%. You know, there's more pressure. But if the market is correct, and a 275-ish policy rate from the Fed is going to be enough to slow down the economy, then the bulk of the rate move is done. And typically what you see in these late at the end of a hiking cycle is that rates peak out near the end, and then start falling as the economy slows and recession risk starts picking up.
Michael: So does that mean, at some point, there's going to be an opportunity to extend duration?
Thomas: So as we've already seen most of this repricing, then you can adjust the overall portfolio exposures, you can add some duration risk in the face of a slowdown. I'm not saying now's the time, but as we progress through the balance of this year, if we start seeing signs of the economy starting to slow, or potentially falter or slip into recession risk, there will be an opportunity to extend duration and put more rate exposure in the portfolio.
Michael: That's great. Yeah, Thomas, appreciate your comments and your time. And as we wrap up, I'll just make a few comments. You know, one, we know this has been difficult and we've got record summer heat in the bond market. And I do want to leave everyone with just a few words of encouragement. One, obviously, as investors we all want yields to be higher, and we got there faster and kind of a more direct route than we would have liked. But you can get IG 10-year corporate bonds at 4% now. So like just the mechanics of diversified fixed income portfolios benefit from these higher yields as bonds mature, and we think that'll help smooth out returns and provide positive returns going forward. Secondly, you know, Thomas, your point, the Fed’s successful in slowing the engine down, there's a high likelihood that rates are going to drift lower, so you're going to get some price recovery, where you've, at least on the rate front. And then you know, you mentioned this earlier, I think it's really important, we built lots of dry powder. And so, as market dislocations occur, we're going to have the ability to onboard risk premiums and drive returns and yields higher going forward. But listen, we appreciate everyone taking the time to listen. I hope you know this, but don't ever hesitate to reach out to anyone at Sage should you like to discuss further. Thank you so much.
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