Total time: 9:14

00:01

Michael Walton: Hello everyone, this is Michael Walton here with Thomas Urano, who leads the portfolio management team at Sage. Back for another quarter of talking fixed income markets. So Thomas, central bank policy was a primary driver of capital markets last year and it's still influencing markets as we start 2023. So understanding that economic growth, inflation, monetary policy and the bond market are all intertwined, let's dissect these variables and get to our view of the bond market. So we'll start off with growth. And my question is how do we see growth in the first half of the year? And the number one question we're getting is are we looking down the barrel of a recession?

00:48

Thomas Urano: Yeah, so recession risk is the hot topic of the day. You know, it's our view that Q1 may surprise people. There's still some upside and some optimism out there. A couple things we could look at: employment, which has remained surprisingly resilient; pretty consistent job growth with low unemployment claims. Looking at the Atlanta Fed’s GDP Now forecast, it's still showing positive growth projected for Q1. But one of the takeaways is that forward guidance that we've seen coming out of earnings season so far has pointed to some trouble on the horizon, which kind of lower forward expectations and downgraded earnings expectations. So the short answer is we may limp into mid-year avoiding a recession. But the risks are certainly rising.

01:31

Michael Walton: And assuming growth muddles through the first half, what recession signals are we at Sage watching for?

01:39

Thomas Urano: Right so let's say we don't actually get through the first part of this year, and things continue to weaken. Like what are we paying attention to? Soft business indicators like PMI and ISM surveys, they're all pointing to a contraction in both manufacturing and services sectors. That's a clear sign that there's been some weakness. We saw a very sharp drop in new orders. That also tells us that business investment and inventory spending are all collapsing. The consumer, which has been on a spending spree in the second half of last year, it's been supporting the economy, but signs are pointing to some consumption headwinds. For example, credit card balances have skyrocketed. Savings rates have collapsed. Consumer delinquencies are starting to rise. Notably coming out of earnings season, one of the things we've noticed or seen from the banking sector is that they're recognizing rising credit risk. So we've seen banks start increasing loan loss reserves. So that's another sign of anticipation of weakness in the consumer side, rising defaults, rising charge offs. The housing market, it's also been on a sustained decline for the better part of last year. And this is leaving a number of homeowners who purchased their houses since the housing peak are underwater on those purchases made now. So there's definitely some headwinds for the consumer here. So lastly, thinking about all that, how's that come together? Earnings coming out, you know, on the softer side this year, so far at the end of Q4. And again, companies are downgrading their forward outlooks, and we expect earnings to remain pretty soft.

03:16

Michael Walton: Yeah, so definitely some things to be concerned about. And let's take the optimistic side of the view. If growth stays positive, does the Fed continue raising rates until we see a recession?

03:30

Thomas Urano: That's a good question. We think the Fed has clearly messaged that they're going to this “high and hold” strategy, right. That's where we're going to target a near-5% policy rate. That's something like maybe two more 25-basis-point hikes coming at us. And then they're going to hold there for some time. We think to take the Fed at face value, they can achieve this elevated policy rate, we expect them to wrap up these hikes after they're getting there. And assuming inflation continues to moderate, we think the Fed would probably go on pause as they approach 5%.

04:03

Michael Walton: We've covered growth in great detail, which is everything you said is a really great segue into inflation. So we have seen inflation moderate over the last several months. The question we're getting, is Sage thinking about inflation? How do we expect it to unfold as we move throughout 2023?

04:27

Thomas Urano: Yeah, so inflation has been moderating of late. And there's a couple of things to reflect on here. So looking at inflation on a year-on-year trailing basis, it still includes early ‘22, which involved the late stages of recovery, the beginning of the Russian Ukraine conflict, both of which had really large impacts on pricing for energy, goods and services, right. But if we look at more recent reads on inflation, for instance, the rolling three-month inflation rate, it's only 1.8%. Right. So if inflation continues to trundle along like it has over the last three, four, or five months, that's kind of moderating pace. If this holds, year-on-year inflation should be back towards the Fed’s target range by the second half of ‘23.

05:09

Michael Walton: So this leads us to policy. So if inflation continues to soften, and growth slows or goes negative, where does that leave the Fed?

05:19

Thomas Urano: Yep, so like I said, we still think the Fed has one or two more hikes in them, 25 bps apiece, and then I think they go to this wait-and-see approach, then what they're trying to do is make sure that inflation continues to moderate, right. But it is important to remember the Fed does have a dual mandate of price stability and full employment. And that's going to be a challenge to navigate. If the labor market falls apart, it may signal the Fed has gone too far.

05:42

Michael Walton: I understand the market expects the Fed to reverse policy, as we look at market pricing and Fed expectations. And for that reversal to happen in the near future, what's our take on that?

05:56

Thomas Urano: Correct. So the futures market is pricing the Fed to cut rates beginning in Q4 of this year, pretty aggressively. At least the futures market has priced the Fed to take policy rates back to 3% by year-end 2024. Right, so that's a full 200 basis points of rate cuts, the market may be a little bit ahead of itself here expecting a very aggressive Fed stimulus, assuming we kind of get recession on the table in the second half of this year. One of the things we're worried about the way the market’s priced is that this last period of inflation that we've been through, it's likely altered the Fed’s reaction function to a recession, meaning the Fed’s response to weakening growth may be less aggressive than what we've seen over the last 15 years.

06:43

Michael Walton: We’ve covered growth, inflation, policy, let's get a little bit more specific on the bond market and our outlook. To summarize, our macro picture, weakening growth with recession risk on the table, keeps inflation on a moderating trend, the Fed will have succeeded in bringing inflation back under control, but will be less aggressive with monetary stimulus in the coming business cycle. So what does all of this mean for bond investors?

07:12

Thomas Urano: Yeah, so for the bond market, we think income is back in fixed income. And since 2008, since the 2008 financial crisis, careers have been made trying to source fixed income alternatives in a 0% interest rate world. Investors have sacrificed liquidity and marketability in order to generate these mid-single-digit yields in alternative fixed income investments. But now, on the heels of all this inflation fighting policy, the landscape has changed, right? The bond market yields are at levels that you haven't seen in over a decade, you have to go back to 2010, and then pre-2008, in order to see yields offered to the market where they are today. Basically 5% income with public market liquidity, that's something that's going to be hard to ignore.

08:00

Michael Walton: Yeah, 5% income on your core bond portfolio makes everything work better. So Thomas, thank you so much for your time. For everybody who tuned in, we appreciate you listening. Of course, your friends at Sage are here anytime you'd like to visit. Thanks so much.

08:14

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