Reaching the Limit
Has our debt and the Fed finally hit their ceiling?Download PDF
We recently sat down with Dominic Nolan, CEO of Pacific Asset Management, to get his insights on the recent rebound in asset prices, current Fed expectations, impacts of the work-from-home trend, the debt ceiling, and opportunities in fixed income. We finished with a speed round of questions and a personal reflection.
Is the recent bound in asset prices a sign of what 2023 has to offer?
I hope this is a sign of things to come. We’re seeing a broad-based risk rally as January was a very strong month for markets. The S&P 500 Index was up over 6% and, over the past three months, is up about 6%. The Russell 1000 Growth Index was up over 8% and, over the past three months, up about 5%. The Russell 2000 Value Index was up 9.5% in January. One number I found interesting is the one-year number for the Russell 2000 Value Index was negative 50 basis points. So, in a brutal period, the Russell 2000 Value was about flat.
So far this year, the standout has been international. This area has underperformed for quite a while going into the year, but the MSCI EAFE Index was up 8% in January. For the past three months, it’s up 20% relative to the S&P being up 5%.
What about bonds?
The Bloomberg US Aggregate Bond Index (Agg) was up 3% during the month, which is very strong. Over the past three months, it’s up 6%. But over the past one year, the Agg’s down 8%.
If you had a balanced portfolio (60% equities, 40% fixed income), you would have been down around 16% in 2022. But just one month later, the trailing year is a -8%. A substantial move.
As it relates to leveraged finance, the Bloomberg US Corporate High Yield Bond Index was up almost 4% in January. For the past year, high yield is down 5%. Bank loans continue to be a steady asset class with Credit Suisse Leveraged Loan Index up 2.5% in January. Over the past year, bank loans have been the only major fixed-income asset class to be positive, up a little over 1%.
Where do you think the economy is heading?
I think the economy is very difficult to forecast right now. You have cross currents everywhere, obviously inflation and margin pressure. You have potentially an exhausted consumer and spending is slowing down. At the same time, the job market has been gangbusters. The market has been increasing the chances of a soft landing. The real question though: was that a head fake? We’ll see.
Let’s turn to the Fed. Have they reached their limit on impacting inflation as one of the key components you just mentioned, or do they need to do more?
They probably will do a little bit more. Just the past week, the Fed increased the overnight rate to 4.5% to 4.75%, an increase of 25 basis points. They reiterated their position on keeping rates elevated until inflation gets back to 2%, which is hawkish in my opinion. On a dovish note, mentioned that inflation has likely, quote, “peaked.”
The Fed has done a majority of what they needed to do on tightening conditions. It’s now a matter of leaving the conditions tight. As I speak, market expectations are for a 25-basis-point hike in March and a 25-basis-point hike in May, and a 25-basis-point cut in December. That is a little more hawkish than last month when expectations were for a 25-basis-point hike in March, a pause and two cuts later this year. We’ve gone from one more hike and two cuts to two hikes and one cut. I think the real mover of that was the jobs report, but the market continues to trade below what the Fed has been stating. In other words, the market is not quite believing how hawkish the Fed is saying they’re going to be.
Do you think two more hikes are reasonable?
While I do not think more hikes are necessary, two more hikes are reasonable at this time. This hopefully gets the job done in bringing down inflation at an acceptable pace. There is an increase in the camp that believes that the Fed could go to 6%. I would be surprised if it happened, but I was surprised that we’re getting to 5%. So, a bit of a guess on my end.
The jobs report was a blockbuster number with 517,000 jobs added in January. Is the labor market the healthiest level that it’s been in over 50 years, or are we missing something?
It’s very healthy, but when you look through to underlying metrics, I believe there are signs of weakening. The non-farm payrolls report came in, as you mentioned, at 517,000 jobs. Estimates going in were 187,000. It was a gangbuster report that dropped unemployment from 3.6% to 3.4%.
We are now at unemployment levels that are below pre-COVID levels. That signals a very robust job market and it’s broad based across industries. On the other side, you are seeing companies forecast layoffs. I’m just going to rattle off a few, in particular tech, that were announced in January and the first part of February: Zoom, 15%; Dell 5%; PayPal, 7%; Google, 6%; Microsoft, 4 to 5%; Amazon 16,000 jobs, which is about 3% of corporate; Meta, 13%; and Salesforce, 10%.
A lot of those companies had to staff up during COVID, and they’re now readjusting. Those could be argued as efficiency numbers. Currently, there’s a need for service-level jobs, and those numbers can help drive unemployment lower. But when you look through to middle-management and above roles, I think there’s going to be a swath of companies laying off high level professionals. We’ll see how it all shakes out. But nonetheless, the job market and job picture look good at this time, despite these tech layoffs. I don’t think the job market is as healthy as a 3.4% unemployment rate would indicate, especially with tightening conditions. But again, we’ll see how this plays out.
A key difference from prior to the pandemic has been the work-from-home shift, which can be seen as a type of domestic outsourcing—or hiring of remote U.S. workers. How has that been impacting the economy?
When you look through, there are now three times the number of remote jobs compared to three years ago or pre-pandemic. This equates to about 15% of the U.S. workforce. According to a 2022 McKinsey & Co. survey, employees seem to prefer hybrid work, and employers now have more options to pay less. Essentially, employees save on travel to and from the office, they save time, energy, and even clothing costs. At the same time, employers can save on rent, insurance, utilities, etc.
When you dig deeper on employee sentiment, the McKinsey survey said 58% of workers were offered partial remote jobs during COVID, with 87% of them accepting. Of the 87%, 32% of went all five days remote. When combing through the underlying data, the average is typically three days remote, and that tends to be across industries, education and income levels. Older/more experienced workers tend to be slightly more remote than younger. If you’re new to the industry or company, you’re probably in the office more and vice versa as you gain more experience. I believe this adjustment is a secular change, which shouldn’t be a surprise to people.
Longer-term effects will be interesting. I think this trend puts pressure on expensive/high density cities. You lose some pricing power because there’s less need to go in the office. When you think about cities like New York, San Francisco, downtown Chicago, much of the buzz is about having so many people, which creates energy, restaurants, nightlife, etc. With more people working from home, you start to get in the feedback loop of less people, less energy, less desire to come in, etc.
I think it makes the suburbs more attractive. I think cheaper cities and cheaper states are more attractive which drives different leverage for workers and employers. Ultimately, it should come to a more efficient place for companies, which is great for our economy. At the same time, long-term effects of having virtual companies—or having folks trying to navigate a career that’s based in a virtual setting, remain to be seen.
As investors, should we be worried about the debt ceiling?
Not yet. In looking through—and there’s a lot of game theory going on with both Congressional Republicans and Democrats—there’s probably going to be some pain, but I’d be surprised if there was a technical default.
The real thing to watch is going to be the approach to spending and, in particular, cuts in the budget. That is what will affect capital markets and the economy. To me, the debt ceiling is the spark to ignite budget discussions, and I don’t see a camp where they’re going to want to increase spending or the deficit, but to what extent do you cut spending?
As much as we can agree or disagree on how much Congress should be spending, more money in a system is correlated to growth—and one could argue inflation. If they cut too much, then you have the U.S. government—which is one of the biggest spenders in the world—negatively impact the economy, companies, jobs, etc. I expect the debate to heat up by June.
Are you still broadly constructive on credit, and where do you see the biggest opportunities today in fixed income?
We’ve seen a nice start to the year. The Agg is up 3%, has a yield of about 4.5%, and has an average price of around $90.80. High yield is up more than 3%, has a yield of more than 8%, and has an average price of around $89.50. Bank loans are up 2.5%, have a yield over 9% and a price of around $93.50. Investment-grade credit yields over 5%, with prices of around $92. What we’ve seen is a nice little tick off the bottom. Even with this, bonds and loans are still trading in the high 80s to low 90s.
Looking at the landscape, growth rates are holding, inflation is rolling over, potential government budget cuts, things are slowing down. All of that tells me that rates have room to move lower, and thus, I remain very constructive on fixed income.
A little disconnect here is the bank-loan trade. There are consistent outflows in the asset class. It has been such a great trade for many months, and contrary to many opinions, I believe it remains that way. At the same time, investment-grade credit is still yielding above 5%, which to me looks great as well. I love the barbell. Between the two, investors may get mid to high single-digit yields and some tailwinds. Defaults are expected to rise, but that is priced in right now. We’ll see if there’s another selloff this summer, but right now, I remain constructive on credit.
How does duration come into play?
From my experience in the industry, I think a lot of investors believe they can time the rate market. The short end of the curve is dictated largely by the Fed, but the belly and the long end is extraordinarily difficult to get right, and I think a lot of investors mistakenly think they can get it right.
Is there some value in going out on the curve? I believe there is at this time. But understand there is volatility you’re going to take with it. Does it make sense to move a little bit out? Sure, I think that is reasonable. But what I’ve recently heard a lot of advisors say, “Oh, I just want to move out of short and into duration,” and I really feel like it’s because they’ve heard from big money managers that’s what they should do.
I think a trade like this should be on the margin. I’ll walk you through. Loans are yielding 9%, and the Agg is yielding 4.5%. Over the next year, if you just clipped a coupon, it’s four-and-a-half points more on loans. To get four and a half points with investment grade duration, you’ve got to hope that rates go lower. How much lower? Some back-of-the-envelope math here. To get four and a half points means you need rates to drop another 75 basis points or so to break even and we haven’t even accounted for volatility. To me, if you have full conviction that rates are going to drop at least 75 basis points on the 10-year Treasury, which would take the 10-year inside of 3%, then sure, make a meaningful trade. But even then, I don’t think you go all out. For equity, as I would say, if you believe growth is going to outperform value, do you put everything in growth? No, you overweight. I think a lot of advisors think they can get the timing right, but the best in the world have trouble doing this and oftentimes don’t.
Let’s do a lightning round. I’ll give you a word, short phrase or question, you tell me the first thing that comes to your mind. Are you ready?
When will the job market cool?
All right, I’ll take that as when will employment go above three and a half? I’ll say Q3.
The next Fed meeting in March.
A raise of 25 bps.
ChatGPT after its first few months of use.
Oh, I am so interested in where this thing’s going to go. And anecdotally, I just used ChatGPT to create a three-day itinerary for a trip I’m planning. It kicked out a quality list in 30 seconds. That was pretty cool. People are going to have a lot of fun with it, but others are going to use it for dangerous things. It will be interesting, for sure.
The two most important economic indicators today.
I think CPI is critical to the Fed’s next moves and the jobs number.
On a scale of one to 10, how much should we worry about tech layoffs?
I would give it a three. Seeing a lot of company layoff numbers below 10%. When it’s below 10%, that’s signaling efficiency to the market. When you see job layoffs that are 15% to 20% is when I think there’s a problem.
The surging trade deficit.
I think that’s a byproduct of China reopening. They’re making products again. Supply chains are coming back online.
The debt ceiling and its market impacts.
TBD. But I guess knowing how Congress behaves, it’s going to be a net negative in the summer.
I think time works for you if you’re a buyer. Given that though, if you see something you like, I’d recommend going in.
Still have secular problems.
What about streaming services?
It’s funny, has their growth peaked? Probably. So, they might be entering a different phase of their business, maybe even a mature business where companies start to consolidate. That’s how fast business models are moving.
California energy prices.
I don’t know how prevalent it is across the country, but gas bills in January were absurdly high—four to five times that in November. To me, this is reflection of how much a marginal buyer or marginal demand can affect pricing in this very delicate leveraged world. You have companies such as Sempra that will take some of their net gas they normally ship through the West Texas pipeline and now ship to Europe due to shortages caused by the war in Ukraine, thus your marginal supply is lower. It’s a real reflection of just how delicate certain supply chains and the supply demand balances are.
As we end this interview, can you share a personal reflection that might resonate with us?
As many people know, Aristotle Capital Management recently agreed to purchase us from Pacific Life, and we’re going through this transition. We have had many meetings, and, prior to one meeting with Pacific Life, I told some Aristotle executives that Pacific Life likes a supportive framework. And the Aristotle folks just looked at me and said, “No problem, compliments are free.” It is something that has sat with me: Compliments are free and can be immensely valuable.
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