Inflation or Bust?
Are these becoming the only two choices given the hawkish Fed?Download PDF
We recently sat down with Dominic Nolan, CEO of Pacific Asset Management, to get his insights on the Fed’s trade-off between reducing inflation and triggering a recession, today’s markets, and opportunities in fixed income. We finished up with a speed round of questions and a personal reflection.
September was a rough month for both equities and fixed income. Did those losses set the stage for a stronger fourth quarter in asset prices?
From a relative standpoint, I hope so. Let’s go over the numbers. For September, the S&P 500 Index was down over 9%. For the quarter, it was down just under 5% and down 24% for the year. The Russell 1000 Growth Index and Russell 2000 Value Index largely lined up for the month, down between 8% to 9% and, for the quarter, 4% to 6%. So far this year, the Russell 1000 Growth is off 27%, and the Russell 2000 Value is off 18%. In 2022, equity markets in general have been down 20% to 25%.
What about global markets?
International markets have continued to underperform. Both the MSCI Word Index and MSCI Emerging Markets Index are down about 27% for the year after finishing down 9% to 10% in September.
Any better for fixed income?
It was pretty brutal there as well. The Bloomberg Aggregate Bond Index (Agg) in September was down 4.3%. If that 4.3% loss was for all of 2022, it would be the worst annual performance ever for the Agg. That pales in comparison to the year-to-date returns, which are down a whopping 14.6%.
If you had a balanced 50-50 portfolio (represented by the S&P and Agg indices), you would be down year-to-date around 19%. That is rough. High-yield was off 4% for September, but for the quarter, high-yield was off just 64 basis points. For the year, it’s down over 14%—bonds across the board are getting hit. The standout for the year continues to be bank loans. For September, they were down 2%. For the quarter, loans were down 1%, and for the year, loans are down 3%. By the way, down 3% would be second-worst year for the Credit Suisse Leveraged Loan Index, and yet it’s outperforming bonds by 1,000 basis points and, obviously, staying well ahead of equities.
What do you think all this means for the fourth quarter?
I would expect the fourth quarter to be better than the third, but that bar is low. The 10-year Treasury started the third quarter at 2.97% and ended the quarter at 3.80%. The yield rose by 28% in Q3, due, in part, to inflation and Federal Reserve actions. With bond yields rising, liquid assets are going through a painful repricing. In my opinion, if the fourth quarter is worse than the third quarter, that would indicate a capitulation, or bottoming of the market. Will that happen? The short-term mindset continues to be on the Fed. Will their narrative indicate any sense of neutral coming? And really, what the market’s looking for is just a backing-off from some of the Fed’s aggressive language.
Are we looking at a tradeoff between high inflation or a recession? Is it inflation or bust?
Unfortunately, we’re getting both—inflation and bust. I get the question, though, as it really sits with the Fed, as they have a heavy hand in the “bust” part.
Okay, can you break it down, starting with inflation?
Let’s look at the most recent inflation report—the August numbers. Year-over-year, inflation was at 8.3%. Obviously, very elevated. But when you look through at the recent numbers, here is the case for a Fed pivot that says they’re beginning to get inflation under control. For the second quarter, the Consumer Price Index (CPI) was 2.6%. Fast forward to Q3, the July CPI was flat and had just a 0.1% increase in August. So, for the third quarter so far, CPI is up only 0.1%. If the September number comes in at, let’s say, less than half a percent, you will have a third quarter CPI that is less than 0.6%.
How would the Fed respond to those numbers?
That, to me, coupled with the expected interest-rate hike in November, does give the central bank a window to shift the narrative a bit and indicate that they’re getting close to the end of the hikes. When I look through to the subcomponents of the CPI and compare August with June, 12 of the 15 were lower. So structurally, prices have been coming down. Where inflation sits now, second quarter CPI was over 2.5%. Annualized, that’s a 10% inflation run rate. Third quarter CPI right now is 0.1%. You might get an annualized run rate that’s between 2% and 3% based third quarter CPI numbers. Inflation is certainly showing itself to be rolling over right now.
From what you can see, where are rates setting up as of today?
Base case is there will be a 75-basis-point hike in November, another 50-basis-point hike in December and another 25-basis-point hike in February. That’s 150 basis points over the next four months. That would take short-term rates to the 4.5% to 4.75% range. Will we get there? I’d say if inflation continues to show it’s rolling over, the answer should be no. I would find it troubling if the Fed continues to be that aggressive. Again, if we get a third quarter CPI print that is around 0.5%—which is an annualized 2%—the Fed’s November messaging could show an indication of what neutral means, which, in my opinion, would lead to a Santa Claus rally in the short term.
As it relates to longer-term rates, the 10-Year Treasury getting close to 4% is an adjustment for me. I am surprised that it’s gotten this high. When you think about it, if the Fed is aiming long term to get to a 2% annual inflation rate (which I think is aggressively low), and they are willing to break the economy to get it there, then that suggests to me that a 4% Treasury is too high. I will continue to believe that 4% is too high unless the Fed indicates that they are upping their range of long-term inflation target from 2% to, say, 3%. I don’t expect that to happen anytime soon, but from a rate standpoint, a 10-Year Treasury close to four feels high to me.
How does quantitative tightening (QT) factor in? Is that affecting the long end of the yield curve?
Certainly. I mean, QT is really a technical element at this time. The narrative is out there, and the markets are discounting the Fed selling. As it relates to what is actually happening, QT started in June, with the initial target being $30 billion in Treasuries and $17.5 billion in mortgage-backed securities (MBS). As of September, $95 billion was target ($60 billion in Treasuries and $35 billion in MBS). As of the most recent data, the Fed’s target since June 1 was $238 billion, but the Fed has actually reduced its holdings by about $117 billion—about half its target. That said, the Fed has increasingly ramped up month after month.
Does the Fed have an appetite to catch it up to their target?
I think it’ll permanently be under forecast. In theory, if the Fed reaches their monthly targets for the next 12 months, they will still be under their overall target because of the slow start.
When you look at the Fed’s unprecedented tightening and the effect it’s had on the strength of the dollar, how do you see that playing out in capital markets?
That’s a great question. The ripple effects from a very aggressive Fed are essentially pushing dollar strength outward. What we’re doing, really, is exporting inflation. We have aggressive rate hikes here, which strengthens the U.S. dollar, and because we are the reserve currency, it pushes out inflation to other currencies, weakening them.
The ripple effects result in more volatility. What that does is it reduces the margin of error for other financial entities. Thus, if you make a mistake, such as Britain did by announcing it would roll out tax cuts during an inflationary time, your currency gets hit and your bond yields soar. That recently happened, and the Central Bank of England reacted by flipping from quantitative tightening to quantitative easing. The real effect of all this with other central banks and levered businesses is it reduces margin of error quite a bit.
Do you see Fed policy taking into consideration the interconnectedness of the global economy?
At this point, the Fed seems very focused on breaking inflation in the U.S., and if they’re willing to break the economy to break inflation, then other central banks are probably a secondary concern. We’re pushing it off and saying, “Well, that’s your problem, Bank of England. That’s your problem, ECB. You address it the way you need to address it.” The Fed seems very focused domestically.
Do you see the economy slowing?
Yes. In viewing credit-card data from Bank of America through from early August through Sept. 20, if you remove numbers from hurricane-impacted Florida, total spending has declined about 10%. When you look through at spending year-over-year in lodging, restaurant, and airlines, 2022 had been tracking slightly above 2021. But right around mid-summer, year-over-year spending started to track below 2021. The signs are pointing to a weakening consumer.
With that weakening consumer, the current investing landscape looks pretty challenging. Can you talk about what’s happening in credit markets?
Sure. Let’s take a look at four areas of the liquid credit markets. I’ll start with bank loans. Bank loans have been a good defensive asset class against inflation throughout the past year, despite being down 3% for the year. When you look through to opportunities, the current price on loans—and this is index data as of Sept. 30—are at $91.60. That’s low relative to historic norms. In fact, the only times they were lower were during the Global Financial Crisis of 2007-2009 and a brief period during COVID. The coupon for loans right now is 6.6%. The Fed rate increases have yet been fully reflected in coupons, so the coupon may be still going up. That makes the four-year yield on the asset class 10.16%. So, over the next year with your 6.6% coupon, to lose money in that asset class, prices would have to drop below $84, where much of the universe would be trading close to distressed. To me, there’s just a ton of protection with that coupon.
Let’s move to high yield. The Bloomberg US Corporate High Yield Index’s average price is $83.86—that’s almost 17 points below par. You have a duration about four years. Your yield-to-worst is 9.7% right now. High yield’s gotten smoked, down 14% for the year. So, bank loans are down 3% and high yield’s down 14%, yet the yield of loans is still higher than high yield right now. High yield is attractive, but I would say I like loans more than high yield at this point.
Looking at investment-grade credit, the average price is currently $87, and the yield is 5.6%. If you get any settling of the Fed in the economy, there’s value there, in my opinion. But if you step into U.S. credit, be prepared to take on some rate volatility.
If you don’t want to take on the rate volatility, let’s talk about the short end. The average price of short-term investment-grade credit, according to the Bloomberg 1–5 Year US Credit Index, is $94 and the yield is 5.25%. So, you have short-duration investment-grade credit yielding over 5%. If you stayed short and you didn’t want to take longer duration risk, you have investment grade yielding over 5% and floating rate yielding over 10%. That, to me, provides such a ton of protection without much interest-rate risk. When you think about rates on the short side, the market’s already pricing in a 125-to 150-basis-point increase. For you to lose money as it relates to interest-rate risk, the Fed would need to be aggressive and push rates well into the 5% range.
Can you rank those four asset classes in order of what you find attractive?
I’d put short credit and bank loans 1A and 1B. It just depends on if you want investment grade or loans given your appetite for risk.
And then a step below, I like investment-grade credit. But remember, I’m also in the camp that I think the 4% Treasury is too high. I expect an investor would benefit from duration sometime in the next 12 months, so because of that, I rank U.S. credit above high yield. All that said, I like high yield as well. Right now, the duration is relatively low. The prices are low. The yield’s high. We’re at a point where I find my least favorite of the four asset classes attractive.
Let’s get to the lightning round. As a reminder, I’ll give you a word, short phrase, or question. You tell me the first thing that comes to your mind. Ready?
Percentage chance that the Fed overshoots.
Will the Fed accept an inflation rate higher than its 2% target?
Give me a little bit of time on this one. I really hope they do. I think that is very critical in determining the length and depth of any recession. Look, the Fed is anchored at 2%, and you could say that’s a fair anchor relative to the 2010s. But should that be the number in the 2020s? Should the anchor be higher for this decade? Inflation this decade will probably be higher than it was last decade. Let’s assume that’s the case. Then the acceptable rate, in my opinion, should be higher, and if they don’t move higher, then you have a situation where we could be rolling over while the Fed is not easing, thus extending a downturn.
Speaking of recession, a global recession?
Most likely, it’s happening.
All right, on a scale of one to 10, what impact would these four factors have on the global economy? First, peace in Ukraine.
Eight out of 10.
Right now, seven out of 10. The economy especially needs microchips.
More relaxed COVID policies.
Probably four to five because they have been relaxing. They’re not the pain point that they were maybe three months ago.
Inflation under 3%.
That would be a nine.
Okay, let’s go to other topics. The housing market.
The future of Credit Suisse.
Merged with another entity is my hunch. Let me expand on that. There’s a lot of uncertainty about Credit Suisse. The bank has been probably one of the most poorly managed institutions maybe in history. There’s a lot of concern not about the balance sheet but more off balance sheet. While their off balance sheet may still be fine, the confidence isn’t there. You hope it’s more of an operational issue as opposed to a balance-sheet issue. Either way, they need help, and if it’s operational help, that comes in the form of a merger with another bank. If it’s balance-sheet help they need, that’s going to have to go to the European Central Bank. So, you hope it’s operational.
Tesla’s current 68% EV market share.
It’s going to be lower going forward just because of the sheer competition. I think something like 200 EV models will be coming to market in the next three years. That competition alone should shrink Tesla’s current market share.
British Prime Minister Liz Truss walking back her tax cut for the wealthy.
It was shortsighted and hasty trying to cut taxes. It was good to walk it back.
Now it’s time to turn away from markets and economies and turn toward the personal. Will you share a personal reflection to close?
As we get closer to the end of the year, I find myself reflecting on the things I wanted to do this year and telling myself, “Listen, if I haven’t started it, I need to begin. If I’m doing it now, I need to continue. And if I’ve done everything I need to do, then I should just relax.” Take inventory of the year.
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