Does the Fed Get Credit?

The central bank’s rate hikes battered fixed income in 2022. What does that mean for the 2023 landscape?

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We recently sat down with Dominic Nolan, CEO of Pacific Asset Management, to get his insights on recent market performance, whether the Fed should get credit if the economy experiences only a mild recession, how the central bank may navigate 2023, consumer spending, and opportunities in fixed income. We finished with a speed round of questions and a personal reflection.

Looking back on the market’s performance in December and the fourth quarter, what stood out to you?

December was a weak month for returns. S&P 500 Index was down 6%, and the Bloomberg US Aggregate Index (Agg) was flat. The fourth quarter, though, was quite good. The S&P was up to 7.5%, and the Russell 2000 Value Index up 8.5%. The standout was international. The MSCI EAFE Index was up 17%, while the S&P was up 7%. Dollar weakness was the driver here. Also, the Agg and credit were positive. I would say markets had a very strong Q4.

What about for the entirety of 2022?

People know it was a tough year from a returns standpoint as well as the experience being a grind. The S&P was down 18%. The Agg was down 13%. If you had a 60/40 mix of equities and fixed income, it would be down about 16%. That’s one of the worst years ever. It was the worst year for the S&P since 2008. It was the worst year ever for the Agg. In fact, up until 2022, the worst year for the Agg was in the ’90s when it was down 2.9%. So, 2022 was four times the worst year for the Agg. The Bloomberg US Corporate High Yield Bond Index was down 11%—the worst year since ’08.

What index had the worst performance?

The Russell 1000 Growth Index. That tech-heavy index that outperformed during the pandemic lost almost 30%.

Was there a standout asset class in fixed income last year?

Floating-rate loans. The Morningstar LSTA US Leveraged Loan Index was down just 1%, dramatically outperforming fixed-rate securities. The 10-year Treasury began the year with a yield of 1.5% and was close to 4% at year’s end. It more than doubled in yield, and that’s really the call that you wanted to make correctly this year—the duration call. Your duration call dictated most of your returns. In fact, long U.S. government bonds were down 30%, brutal.

What optimism did you see in 2022?

The S&P, the MSCI, high yield, and floating rate were up in the second half of the year, while the Agg and Russell 1000 Growth were down slightly. The bulk of the pain for 2022 was actually in the second quarter. Even though the second half didn’t feel good, that was more about volatility. Volatility whipped around markets in the second half, but the major indices had flat to positive returns. Hopefully, this is a bottoming process.

Let’s turn to 2023. How do you see inflation evolving?

I’ll give you levels that Wall Street has been forecasting for the Consumer Price Index (CPI). CPI for Q4 is expected to come in at over 7% year-over-year. Remember, peak year-over-year CPI in 2022 was in the high single digits. Expectations for year-over-year by quarter in 2023 are 5.9%, 4.0%, 3.3%, and 3.0%. That’s a substantial decline from where we sit today.

And where does that leave us with economic growth in GDP?

Forecast for GDP is not a great story. In Q4 of 2022, real GDP is expected to be up 1.1%. Street consensus for this year's quarters is 0.1%, -0.6%, 0%, and 0.9%, respectively. The market’s forecasting real GDP will be lower in the first nine months of ’23. Thus, a strong likelihood of a recession by the middle of this year, and then an expected rebound in Q4 to 0.9%.

Where do the unemployment numbers fit into this puzzle?

Unemployment sits today at about 3.7%. Forecasts are for it to steadily move up by quarter in 2023 from 3.9% to the high fours by the end of ’23. So, you’re seeing the message, right? CPI is dropping quite a bit, PCE is dropping, GDP is dropping, there’s an expected recession in middle of the year, and unemployment is expected to go up. This is the picture the market is discounting right now, which for some investors, is a buying opportunity.

Are we likely to see the Fed pause and reverse course if unemployment rises?

It’s interesting. In the Fed’s most recent FOMC meeting minutes, they still believe the labor market is tight, and that is what I think the Fed is holding onto as far its forecast for sustained inflation. But if we see the ratio of job openings to unemployed drop, I expect the Fed to pivot.

Does the Fed get credit if the economy experiences only a mild recession? And how do you expect the Fed to navigate that through 2023?

I think if we have a mild recession, the Fed should probably get a little credit. However, I see a bit of the disconnect between the Fed’s stance and what the markets are forecasting. Again, GDP has been slowing, we’re expecting to have recession, unemployment’s going up, inflation’s rolling over, and yet the Fed has messaged repeatedly that they do not expect to cut rates in 2023. In fact, they’ve said that they would rather err on the side of keeping rates higher for longer.

That’s what the Fed wants you to believe, but the markets haven’t quite been sold on that. Right now, market expectations are that in February, Fed raises rates either 25 or 50 basis points, and in March, either 25 or 50 basis points. What the Fed’s forecasting is that in the next two meetings, there will be a cumulative 75-basis-point hike. That leads to peak terminal of 5% to 5.25%. The Fed and the market agree on this.

What’s not consistent is the market right now is discounting the Fed will begin to cut rates by the November meeting. The market believes the Fed raises twice in February and March. We’re in recession by the second quarter or third quarter, and unemployment’s up. Thus, the Fed will cut in November and in December, ending the year almost back to where we started 2023 at about 4.75%. The Fed’s narrative is that they do not think a cut is in the cards for 2023 and would rather keep rates higher for longer. Regarding the balance sheet, we're off almost a half-trillion dollars. So, $400 billion’s off the balance sheet, and there’s another trillion expected to come off this year. The balance sheet continues to decline, but that’s more below the surface.

Let’s shift to the consumer. With much of the economy weakening, how did the holiday spending play out?

For a long time, the consumer has been for very resilient, and I’d still call them resilient. But holiday shopping was just okay. According to Bank of America daily credit-card spending data, spending during the holidays was up 1.2% year-over-year. That’s pretty weak. I described this as “okay” because at least it was up. What we did see, though, is a lot of holiday discounts. That wasn’t a surprise. Companies over-ordered after the shortages in ’21. As a result, they had too much inventory and had holiday discounts. What will be interesting is next week’s CPI report. That will reflect some of the discounts the retailers provided.

Consumers have been spending on experiences, not goods. That’s been a consistent behavior over the past couple of months. Heading into the last week of December, shopping, furniture, online electronics, and home improvement spending were negative year-over-year. So were clothing and department stores. What was positive fell into the experiential category, including airlines, lodging, and restaurants. But when you look through over the past three years and go to the pre-COVID levels of 2019, under performers are still airlines, entertainment, and lodging. Consumers, in my opinion, have been catching up to the experiences they were denied during the pandemic, but, compared to three years ago, there’s still massive out-performance in online retail, online electronics, home improvement, and restaurants. The big under-performer relative to three years ago remains department stores. That’s a secular story in decline.

From an investment standpoint, what does this all mean for credit? With the Fed’s actions and significantly higher yields, does the Fed get credit here?

For higher yields, yes, the Fed absolutely should get credit, especially on the short side. But when we look through to fixed income right now and where it sets up, it’s pretty similar to last month’s levels. The Agg is 4.5% from a yield standpoint with a price of $89. Investment-grade credit currently has a 5.3% yield, and the price is still in the high 80s. For high-yield bonds, the current yield is 8.7%, and price is $87. And floating rate is yielding 9.94% with a price of $92. Those prices haven’t changed much over the past month. Yields have been moving on the margin, but the reason you’re getting attractive returns right now is coupon clipping. High-yield bonds have outperformed equities over the past six months. We’ll see if this continues.

I do want to note some empirical data. U.S. high yield has had negative returns in seven of the past 30 years. Each of those times, the index was positive the following year, and, in six out of seven of those instances, the index was up double digits. Now, the math: with the yield at 8.7%, if the price increases by two dollars—so if high yield bonds end up priced around $90 by the end of ’23—plus your coupon, you’re in double digits. But you should factor in that you’re also staring down a recession and a tight Fed.

I would also point out that defaults are expected to rise. Looking at Moody’s, 2022 defaults are coming in around 2%. Forecasts are for defaults to rise to 4% to 5% by the third quarter of ’23. That tells me what the credit markets are pricing in. We’ll see if that’s an optimistic scenario, but you have a base case of 5% defaults. Even though those are the expectations, you’re probably going to see a lot of sensational headlines about defaults going up, but markets have priced that in.

Add all that together and that’s why I remain very constructive on credit and the relative value. I think even if you just clipped coupons over the next year, you will still be in the high single digits on the fixed-income side. I feel strongly about it. The real risk to me—the sustained risk—is that the Fed will keep conditions tighter than they need to be because the Fed is anchored to a 2% inflation number that, I believe, is lower than what it should be for our economy. But that most likely won’t play out until 2024 and beyond.

Specifically on investment grade, any thoughts on shorter or longer duration, and how that compares to high yield and floating rate?

I’m often asked by advisors, “What’s the right allocation breakdown?” I think client risk tolerance is the key element to address because with the curve being flat, there’s a couple ways to play this. If you have a client who is very concerned about volatility, 5% and 6% yields on the short end of the curve may solve for the fixed-income allocation. Plus, you also have high single-digit yields with floating rate. So, you can be short duration and clip a very strong coupon. The downside of going that route, though, is if you have rates drop, then you’d be better off holding more intermediate-term bonds for total return and maybe even some high yield bonds.

Risk tolerance should dictate your duration, but make no mistake, you can be short duration and clip an attractive coupon, but you will not have the best opportunity for total return should rates drop. From a risk/reward standpoint, personally, I still prefer loans over high yield right now. I think today’s high-yield spreads are not as wide as they probably should be given an expected recession, where the seniority of loans, the lower duration of loans, the avoidance and the Fed aggressiveness makes, to me, the relative value of loans attractive.

Let’s switch to the lightning round. I’ll give you a word, short phrase, or question, and you tell me the first thing that comes to your mind. Are you ready?

Let’s go.

Job openings.


Commodity prices.

Rolling over. Caveat’s China. If China opens, you could have stability or even an increase.

ISM manufacturing index for December at 48.4, which represents contraction.

Historically, the best time to invest is when the ISM bottoms. Now the problem is, is 48.4 the bottom? My point is, you buy when the ISM is heading toward 50. I think the ISM numbers will be an interesting measure to watch as far as the economy coming out of the trough of a recession. It’s an underestimated indicator that investors should watch over the next three to six months.

The U.S. economy versus the global economy.

Long term, it’s still U.S. The global economy might have a little reversion to the mean, especially if we have dollar weakness.

The China COVID surge.

I think it was unavoidable. Zero-COVID was not a wise policy decision in my opinion. Hopefully, they’re peaking in the very near future.

The state of cryptocurrency.

Right now, it’s drowning. We’ll see if they’ll get a life preserver, but that’s going to take longer than people think to come back.

Southwest Airlines.

I think Southwest’s meltdown during the holidays will stick in the mindset of consumers longer than they think.

ChatGPT, the recently released app that makes “chatting” with AI software more natural.

Played around with that over the holiday break. Pretty amazing technology. It’s going to be fascinating and dangerous.

Can we close out with a personal reflection?

It is New Year’s resolution time. A lot of people don’t choose to do one, but I have two. One is health oriented. The other is around gratitude; I want to write one letter a week to someone in my life expressing my thanks to him or her.

But how do I stick to this? I read a book during the pandemic called “Atomic Habits: An Easy and Proven Way to Build Good Habits and Break Bad One.” The book’s message is don’t focus on the goal, focus on the habit. In other words, don’t focus on the goal of losing weight, focus on being a person who doesn’t eat late at night or who doesn’t miss workouts. Essentially, the thesis is small behaviors create little habits that will create great habits. So, whatever your goal is, make it obvious, make it attractive, make it easy, and make it satisfying. For example, if you want to exercise in the morning, put the shoes next to your bed. Make it easy, make it obvious. Wake up, put on those exercise shoes. And make the goal for the first week just walking out of the house. And then you build on that habit. Next, get up, put on your shoes, head out the door and go for a walk. And all of a sudden, those habits will compound. I’m going to try and give that a shot. I’ll tell you next year how that went.

For Financial Professionals Only — Not For Public Distribution

Credit Perspectives conference calls are for financial professional use only and not for use with the public. Any performance data quoted represents past performance, which does not guarantee future results. This commentaries for informational purposes only does not represent a recommendation of any kind and reflects the views of Pacific Asset Management as of January 7, 2023, which are subject to change as markets and other conditions warrant any forward looking statements are not guaranteed. Investors should carefully consider an investment goal, risk charges and expenses before investing Pacific funds, prospectuses contain this and other information about the fund and are available pacificfunds.com. The prospectus should be read carefully before investing.

Past performance does not guarantee future results. All investing involves risks including the possible loss of the principal amount invested.

Pacific Life Insurance Company is the administrator for Pacific Funds. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.

Investors should consider a fund’s investment goal, risks, charges, and expenses carefully before investing. The prospectus and/or summary prospectus contains this and other information and should be read carefully before investing. The prospectus can be obtained by visiting PacificFunds.com.

Pacific Funds and Pacific Asset Management LLC are registered service marks of Pacific Life Insurance Company (“Pacific Life”).

Pacific Funds are distributed by Pacific Select Distributors, LLC (member FINRA & SIPC),a subsidiary of Pacific Life Insurance Company (Newport Beach, CA), and are available through licensed third parties. Pacific Funds refers to Pacific Funds Series Trust.

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