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Takeaways from 2022, Thoughts for 2023

What can we learn from this challenging year, and how will 2023 be different?

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We recently sat down with Dominic Nolan, CEO of Pacific Asset Management, to get his takeaways on a wild 2022 and thoughts for 2023. He also provided insights on the Fed’s latest actions, economy’s mixed signals, and opportunities in fixed income. We finished with a speed round of questions and a personal reflection.

November saw a rebound in both stocks and bonds as rates came down meaning-fully. What do you see in store for the year‘s final chapter?

It‘s been a strong Q4 for markets. The S&P 500 Index was up 8% in October and 5.5% in November. The Santa Claus rally continues with the S&P positive for the second half of the year. The Russell 1000 Growth Index was up 4.5% in November. International equities, by the way, had a huge rally in November. The MSCI EAFE Index was up 11% and MSCI Emerging Markets Index was up almost 15%. In my opinion, that performance was a reflection of the dollar decline.

With rates dropping, you had the Bloomberg US Aggregate Index (Agg) up 3.7%; high-yield bonds were up 2%; and bank loans were up 1%. In general, it’s been a very strong October and November as folks have been anticipating a Fed pivot, but I think what you‘re really seeing now is the pricing-in of a demand slowdown. If you go back to the beginning of the year, inflation was our base trigger, which was caused by monetary stimulus and supply disruptions, among other factors. So, you had rates move substantially higher in the first half of the year. Fast forward to the second half of the year and you have investors discounting cash flows. That’s why you had tech and bonds getting smoked.

What I think markets are doing now is pricing in a quote-unquote, “obvious recession.” This has been one of the few times that pundits across the board have agreed that we are going into recession. Conditions have been tightening and demand slowing, which is why I think you have rates moving lower over the past few weeks. In the early summer, the consensus was a 30% chance of a recession. Now, consensus is around 50 to 60%, so a recession is now probable in the eyes of the marketplace. One of the keys to what happens next is the Federal Reserve’s language coming out of the FOMC’s December meeting.

Expectations are for the Fed to downshift from its four consecutive 75-basis-point hikes. Do you agree with that?

The short answer is yes. From a base-case standpoint, we’re looking at 50-basis-point hike on Dec. 14, which will take the year-end fed funds rate to 3.25% to 3.5%. If the Fed does this, I would say their first pivot has happened. The next FOMC meeting is on Feb. 1, when a 25- to 50-basis-point hike is anticipated, along with a 25-basis-point hike in March. Assuming a 25 basis points in hike in February and 25 basis points in March, that takes the rate to 4.75- 5%. That would invert the curve substantially. Today, the two-year Treasury is at 4.25% and the 10-year is at 3.45%. Technically, that’s an 80-basis-point inversion on the 2s/10s. We haven’t hit that since the early ‘80s.

With the recent strong jobs and wages report, do you think the market’s taking into account the Fed might be forced to continue at a higher pace for longer?

I think that part is data dependent. On the margin, the market’s already priced in a 100 basis points in hikes. If you have substantially stronger job or wage reports, then maybe that moves it to 125 basis points. The market is anticipating the Fed hiking 100 basis points already and expectations are for the services-sector wage growth to slow down.

What about holiday spending?

Let’s take a look at Black Friday, and this is according to Bank of America daily credit card data. Spending in 2021 on Black Friday was up 19% year-over-year. It was up only 0.4% this year. Last year, the week after Black Friday, spending was up 17% but up just 1% this year. But in the first week of December, spending started to pick up. I think what’s happening is the retailers are giving discounts. A lot of them have over-ordered, anticipating continued supply-chain problems. I think discounting is going to increase, and that may entice consumers to buy more

On Black Friday and the week after, the highest growth rate in spending was all travel and experience related: Airlines were up almost 10% year-over-year. Also up were entertainment and restaurants. The sectors that didn’t fare as well were online electronics, department stores, furniture, clothing, home improvement. People didn’t spend as much on material goods. Consumer behavior has certainly shifted more to experiences, but the broader picture is that the consumer is slowing.

The year is coming to a close. Can you share what you learned from the unique challenges of 2022?

Here are three of my high-level takeaways. One, for the first time in a while, labor had more leverage than capital. If you think about the past few decades, capital has dramatically outperformed labor. Globalization and technology have helped productivity and earnings so companies could essentially work people harder and make more money. Now, companies need bodies. They need skilled people. So, the leverage of the worker is higher. You have a situation where revenues are up, but margins are down. We haven’t had that in a long time.

Two, the markets remain in a central bank world. When we look at November 2021, the Fed started a bearish narrative. Markets have been weak since then. The Fed is the world’s largest provider of liquidity of the global reserve currency. From that standpoint, markets still live in the central bank world. From a causality perspective, that was driven post-financial crisis with the Dodd-Frank Act. The money center banks aren’t the provider of liquidity. That has moved to the central bank.

Three, despite all the speculation, hype, meme stocks, cryptos, etc., eventually fundamentals will play out. Take a look what happened to cryptos, take a look at tech. Then take a look at energy on the other side, take a look at bond prices, everything. Fundamentals will eventually play out. It just takes time and is unpredictable when.

What do you see in store for 2023?

Consensus is a recession is coming. It’s been a long time since you have agreement there is going to be a recession, and sentiment is extremely bearish. The standard view now is that the fundamentals are deteriorating. We’re going into an earnings recession. Consumer is slowing down, while the Fed is tightening. You can put the pieces together, and say, “Oh, we’re going to have recession.” The tricky question remains, “What does that mean for markets?” When you have a situation that consensus is recession, it tells me that a lot of bad stuff’s priced in already. Sentiment’s extremely bearish, which typically means there are great buying opportunities. It’s tough to know what’s going to happen.

Two, I think bonds are going to have their day. I mean, to be honest, it’s been a horrible year. Year-to-date, the S&P’s down 13%, and the Agg is down 12.6%. It’s been a really bad year. You had a ton of volatility, and you had equity-like volatility in bonds. But rates have now been reset and I think bonds are going to have their day after just getting obliterated this year.

Three, I still think we have some landmines that are coming. When I think about markets and repricing, the liquid markets—the publicly traded stocks and bonds—have had a ton of volatility this year. Those were repriced at the beginning of this year, and they have continued to be volatile. Also, there’s the semi-liquid stuff such as real estate in that category. Real estate is being repriced. Then you have this illiquid stuff, which is in private equity and private debt markets. I think we’ll see some landmines crop up. It’s usually quiet, then all of a sudden, you’ll get terrible news. I think there are things coming in 2023 and beyond due to the embedded cost of financing and the pressure that leverage has with these costs.

Do you see as opportunities in fixed income in 2023?

I believe credit is attractive, which is a view that started about five months ago. When you look through to where levels are, the Agg right now has a yield-to-worst of 4.56%. It was over 5% a month ago, so it has rallied. The average price is $89, so you still have most things trading well below par. When you look through to investment-grade credit, the yields are still over 5%, and triple-Bs are still sitting around 6%. As of Nov. 30, high-yield bonds have a yield-to-worst of 8.60% and an average price of $87. So, again, I believe there’s a ton of protection on the coupon side with high yield. And then bank loans have a current yield of 9.74% and an average price of $92.

With the protection you have with rates being much higher, I think the relative value is fantastic. I think there’s opportunity, quite frankly, in high grade and bank loans, which have been a wonderfully defensive trade. The Credit Suisse Leveraged Loan Index is down 1% this year, and your coupons are now in the high single digits. I still remain bullish on those trades. By the way, high yield has had a strong second half of the year, up over 4%. Overall, I remain very constructive on credit.

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

Fire away.

Strong job growth in November.

That would actually be bearish for the markets because that would give the Fed room for more hikes. We’re in this sort of counterintuitive element with economic data. Good economic news is bad market news.

Where have the Fed’s rate hikes had the most effect?

Liquid markets.

The least effect?

I feel like supply chains. Fed really couldn’t control that. The supply chains just needed time to open up, and the Fed could not influence that.

Consumer spending.

Weakening.

Chances of a significant recession in 2023.

In my opinion, the chances of a significant recession in ’23 are low. I would put the chances of a double-dip recession are higher than a significant recession.

Can you give a scenario that would create a double-dip recession?

Let’s say we go into the recession, and then Fed pivots, leaving rates the same and starting a more accommodative policy. That sparks a rally, and we come out of the recession. But you still have elevated rates and you still have a substantially elevated leverage mechanism that puts pressure on a lot of business models. So, demand just isn’t quite there. We don’t have the stimulus any longer, so you fall back into a recession.

Again, I don’t know what’s going to happen next week, let alone trying to predict the next one to two years in capital markets.

And just to clarify, you’re not predicting a double dip, but you’re just saying that it’s more likely than a significant recession.

If I had to put money, significant or double dip recession, I’d put money on double dip.

Okay, next word: Cryptocurrency.

Oh, that’s been shaken up substantially, but there’s probably a reemergence, but it will take a few years.

China’s easing for COVID restrictions.

Long overdue.

World Cup winner.

Brazil looks very strong, but the sentimental hope is Argentina. Just give Messi one World Cup. Now that the U.S. is out, I have no problem with Argentina winning the World Cup [Editor's note: Argentina won].

Can you share a reflection as we close out 2022?

I was asked several times last week what I would like for the holidays, and I gave a corny but sincere answer. What I want is to continue improving my relationship with time, energy, and health. Those are extraordinarily valuable relationships to me: the relationship I have with time, how I spend it and who I spend it with, and then what I can do with my energy and my health. The reality is, if you don’t have any of those three, nothing else matters much. If I don’t have time to do what I want, energy to do it, and the health to do it, all this other stuff doesn’t matter. What I want for the holidays is just continuing to improve the relationship with those facets of my life.

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 November 3, 2022, 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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