Is the Market Fed Up?
Will the Fed’s rate hikes break the economy?Download PDF
On Sept. 8, 2022, we sat down with Dominic Nolan, CEO of Pacific Asset Management, to get his insights on the market’s reaction to the Fed’s hawkish moves, expectations of Fed interest-rate hikes and quantitative tightening, and opportunities in fixed income. We finished up with a speed round of questions and a personal reflection.
August was a rough month for both equities and fixed income after a rebound in July. What happened in markets in August, and may it foreshadow a troubling September?
With the first half of the year being the worst half for equities in over 50 years and the worst bond market ever, it felt as though markets entered the second half extremely bearish. In July, the inflation print came in tamer, so markets rallied thinking the Fed may not be as aggressive. But the Fed has essentially reset market hopes with more hawkish rhetoric.
As a result, the S&P 500 Index was down 4% in August and year-to-date down 16%. The tech-heavy Russell 1000 Growth Index was down almost 5% in August and off 17% for the year. Russell 2000 Value Index fared a little better: down 3% for the month and 12% for the year. International equities continue underperforming domestic equities.
And bond performance?
Rates across the curve moved up. The Bloomberg Aggregate Bond Index (Agg) was down almost 3%. The Agg’s performance in August was as bad as any yearly performance prior to this year. Year-to-date, the Agg is down almost 11%. High yield retraced a couple percent during the month, down 11% for the year. The standout was floating-rate loans, which were up 1.5% for the month and year-to-date down about 1%. Floating rate continues to defend very well against this rough inflationary market. In a nutshell, the central banks are still dictating risk premia.
Many investors are wondering if the market is fed up the Fed. Let’s start with rates. What’s the forecast there?
For the Fed’s FOMC meeting in September, the consensus is a 75-basis-point hike. I think odds are right now about 95% chance of that happening. One thing to keep in mind: We have the Consumer Price Index (CPI) numbers coming in between now and then, but it’s going to take a big move in the CPI to swing the Fed’s rate hike up to 100 or down to 50 basis points. Consensus is also for a 50-basis-point hike in November and then 25 in December. If we get that, you’re looking at a fed funds target range of 3.75 to 4% at the end of this year.
Just this morning, Fed Chair Jerome Powell reaffirmed his stance on the Fed’s hawkishness—he said he is pleased with the tighter monetary response. So, as far as markets being fed up with the Fed, I would say it is a two-way street. We’re in a world where the Fed is indicating they’re indifferent to the market’s response. It’s not a lovey-dovey relationship, so to speak, between the Fed and markets right now.
What about hikes in 2023?
In my opinion, I think inflation numbers will roll over enough where the Fed can take a pause in the hikes, and I think there’s a greater chance of easing by the second half of ’23. If we get to 4% by the end of this year, 50-basis-point hike in 2023 takes you to 4.5%. That’s pretty aggressive.
One of the things that often gets lost in the Fed’s battle to lower inflation is quantitative tightening. What effect is that having?
Quantitative tightening technically began in June, and the initial target was to reduce its balance sheet by about $47.5 billion per month. But in June, the Fed actually sold only $5 billion. In July, it sold $21 billion, less than half its target. It wasn’t until August that the Fed hit its target of $30 billion in Treasuries by selling $39 billion. And on the mortgage-backed securities (MBS) side, the target was $17.5 billion, and in August, the Fed sold less than half of that. So, it took a couple of months to ramp up, but the Fed sold over $47 billion to match its target. Going forward, I believe the pace will be very aggressive.
As the balance sheet side, at the end of this year, expectations are for the Fed balance sheet to about be about $8.5 trillion, down from $9 trillion. By the end of 2023, expectations are around $7.5 trillion, assuming the Fed’s selling $90 billion a month, which is the current goal. So certainly, the Fed selling $47 billion in August put pressure on the bond market. Another effect of QT is decreased liquidity in the bond market. It is difficult to quantify decreasing liquidity, but one way is to measure the amount of bonds you could sell to the marketplace without moving markets. That number appears to be decreasing. I would call bond liquidity right now an ongoing concern.
How is the Fed viewing inflation in this process?
If you go back to 2021 when the inflation numbers were rapidly increasing, the Fed seemed very determined to ignore the trajectory, keeping monetary policy very loose in spite of rising inflation. Now we are seeing numbers come out that indicate inflation may be rolling over, but the Fed is digging their heels in on tightening in this situation. Their view of inflation is they want to get it to 2% and are willing to tighten as much as it takes to get there.
So, they’re being a little bit reactive to their delay in addressing inflation on the front end?
Not a little bit, a lot. They’ve been very reactive to this.
How is the economy responding so far to tightening financial conditions?
Supply has been constrained, resulting in inflationary pressures—something the world has been well aware of for the past two years. And now the global central banks are attempting to constrain demand.
If you have a constrained supply environment and your reaction is to curb demand, that’s going to lead to a slowing global economy. So, generally speaking, things have been slowing down.
Commodity prices have been rolling over, used car prices, shipping and trucking freight rates have been substantially lower. There’s some evidence the housing market is cracking in specific markets.
Mortgage applications and housing starts are also lower. All those things are indicating a slowing economy. An outlier is the labor market, which has been very resilient. The August report was solid with jobs increasing by 315,000, but the labor force actually increased by three quarters of a million people, resulting in a higher unemployment rate. I think the thing to watch with the labor market is going to be layoff notices, which could be the result of companies becoming more bearish on the economic outlook.
Europe and China are in the news daily. What’s happening there at a high level?
Europe’s situation has the same economic elements as the U.S., but with an energy crisis thrown in. Obviously, Russia is at the core of the energy situation. They have slowing growth and an aggressive central bank, which recently raised rates 75 basis points. I would keep an eye on various sovereign debt levels given their construct.
Over in China, I think the zero-COVID policy is just crushing growth. You also have a looming property crisis. Put it all together and you have the global economy and the global housing market close to recessions—and all this happening in the face of aggressive central banks. That’s not a good recipe internationally.
Fortunately, in the U.S., we have a much better energy infrastructure than Europe and substantially more business friendly COVID policy than China. I just think it’s amazing that two individuals—Putin and Xi Jinping—are affecting billions of people. In the end, Europe’s just too dependent on Russia for energy, and the U.S. consumer is too dependent on China for goods.
Let’s turn to fixed income. Where do you see opportunities in that market?
As of today, the Bloomberg Aggregate Bond Index has a yield-to-worst of 4%—that is substantially higher than a couple years ago. Yield-to-worst for corporates is almost 5%. BBB corporates are now at about 5.25%. U.S. high yield is at 8.5%. Floating-rate loans—without incorporating the forward curve—stands at 8.3%. In my opinion, the stage is being set for a very strong return profile for credit over the next few years. Again, expect volatility to continue in the near term, but I think there’s opportunities in so many places.
Right now, the clear defender against inflation has been floating-rate loans, and I maintain a very constructive view of loans. I think you’re going to get some volatility in high yield, so that might be something to nibble at but nothing big. On the investment-grade corporate side, when you have yields of 5% in a global economy that is slowing, I think that sets up pretty well from a duration standpoint over the next two to three years.
For floating-rate loans, do you have concerns from slowing growth and higher financing costs. Do you expect elevated default rates?
That’s one of the beautiful parts about loans is you can back into both implied defaults and then get a sense of what current defaults and to some extent forward defaults are going to be. The implied default rate right now, assuming a recovery of 55% (which tends to be on the lower side), are over 5%. So that is what is built into the asset-class pricing. Loans have been defaulting at about a 1.5% default rate. The implied default rate is more than three times that. When you look through to forecast defaults, which is where you really want to look, loan default rates are expected to go up to 2-3% in 2023, according to J.P. Morgan. So, you’re sitting at a forecast default rate that is substantially lower than the implied default rate priced in the asset price.
The short answer to your question is, yes, I expect default rates to increase, but I believe much of it is already priced in.
We’ve seen a slowdown in new loan deals. Should we be concerned?
That’s just a reflection of tightening financial conditions. Again, the cost of capital is going up, and essentially the cost of leverage is compounding on top of that. There is not much pressure on firms at this time because the wall of loan maturities seems manageable until 2028.
Let’s switch 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. Are you ready?
Market performance so far in 2022.
Lockdowns in China.
Continued market volatility.
Best to get cozy with it.
Hopefully, calm. Again, a lot of saber rattling, but I hope it’s just saber rattling.
The US dollar.
Still the one.
The new British Prime Minister Liz Truss.
It’s too early, and I don’t know for sure, but she seems capital market friendly. The initial messaging has been around dealing with the energy situation before stimulus and tax cuts.
The Russian gas supply in Europe.
I think people have known who Putin has been for a better part of a decade, and unfortunately the Europeans chose to live in a world where they continued to rely on a tyrant/autocrat for their natural gas. Much of this is unfortunate, but not a surprise.
Fast food wages in California.
For those of you unaware, there’s a bill that’s creating a council that can regulate fast food employee wages (up to $22 per hour), and I think that’s extraordinarily shortsighted and is essentially forced government unionization. I just disagree with that emphatically.
Before we close, will you share with us a personal reflection with us?
I was thinking about some interactions I had this month, and I could pretty much tell by listening to some people which TV stations are playing in their house after just spending a couple minutes with them. I think we’ve all had that experience, especially through COVID. And it reminds me of a quote from Epictetus, a stoic who I think we can all learn from. He said, “You become what you give your attention to.” So, stop giving power to those who try predetermine your reality.
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