The Fed's Short Runway
Can the central bank navigate a soft landing for the economy?Download PDF
On Aug. 5, 2022, we sat down with Dominic Nolan, CEO of Pacific Asset Management, to get his insights on the markets’ July rebound, the Fed’s ongoing attempt at a soft landing for the economy, and opportunities in fixed income. As always, we finished up with a speed round of questions and a personal reflection.
Despite all the talk of a recession, continued inflation, and slipping consumer confidence and spending, the S&P 500 Index was still up 9% in July. What’s going on?
I would say the market essentially got overly pessimistic as we entered the second half of the year. Let’s look at the numbers. The S&P was up over 9% in July, though it’s still down 12.5% for the year. The Russell 1000 Growth Index was up 12% in July, but still down almost 20% for the year. The Russell 2000 Value Index was up 9.5% in July and down 9% for the year. And the MSCI World Index was still lagging the U.S. markets. So, markets have been weak for the year, but received a pretty nice pop in July.
What about the bond market?
The Bloomberg Aggregate Bond Index was up 2.5% in July, but for the year is still off over 8%. High yield was up almost 6% last month but remains down 9% for the year. Loans were the laggard. They were up a little under 2%, but for the year they’re down only 2.5%.
What’s funny when you look through to three-month performance, despite all the negative rhetoric about the economy, the S&P is positive over the past three months; the bond market is positive; and high yield and loans are down slightly. Again, in my opinion, there was simply an overshoot by investors to the downside prior to the July rally.
Where does the economy sit right now?
I would describe it as slowing, but still solid. Unemployment’s still below 4%. Current expectations for third quarter GDP are about 2%. I think inflation has stopped accelerating and a heated economy is beginning to cool a bit. The degree of cooling is essential at this point. One data point to note: July 4th holiday spending was up only 3.5% year-over-year, according to Bank of America’s credit card spending data. That’s the lowest year-over-year increase in the past three years. If the consumer starts to pare back, retailers start to discount, and housing begins to slow, that would point to at least a mild recession. But in my opinion, the economy is currently solid.
It looks like the Fed’s trying to land the economy softly on a short runway at a fairly high speed. How would you grade the Fed so far on just its moves to contain inflation?
C minus. I think the aggressive rate hikes are warranted, but they were necessary because the Fed waited so long to start increasing rates. And as a result, volatility has increased.
How is this likely to play out in the months ahead?
Today, we sit at fed funds rate range of 2.25%-2.5%. The Fed’s September meeting is going to be interesting. If inflation remains as is, I would expect at least a 50-basis-point hike, with narrative for continued tightening. If that happens, I believe the yield curve inverts, and the economy heads towards recession. Where it sits today, September expectations are for a 50-basis-point hike. Let’s assume that there will be a 25-basis-point increase in both November and December. That takes us to a 3.25%-3.5% range by year’s end. Finally, let’s assume two more hikes next year. If so, we’d be peaking around 4%.
Now what’s going determine whether we get a 50- or 75-basis-point hike in September? Today, the U.S. jobs report showed a gain of 528,000 jobs in July. This was substantially above consensus estimates and increases the probability of a 75-basis-point hike at the September Fed meeting. But the most critical factor for the Fed in raising rates will likely be the July and August Consumer Price Index (CPI) inflation prints. The Fed has been very vocal in stating that headline CPI is a factor. Assuming we see a 3.5% fed funds rate in December given another 1% increase in the target rate, I’d be surprised to see the 10-year Treasury going above that, which tells me the yield curve gets inverted. Historically, when the curve has been inverted, I believe you’ve either had a recession or an interest-rate cut within 12 months. I see the Fed overshooting because headline CPI will continue to remain elevated. We’ll see.
The encouraging part is we’re seeing lower pricing on vehicles. Gas futures are lower. Transportation prices are coming down. Airline prices are dropping. Those are indications that inflation or demand may be decreasing, but you are still seeing elevated prices for such things as food and energy. I don’t think inflation will fall enough in the coming months to allow the Fed to take less aggressive action. Hopefully we get a soft landing, but I believe the odds are increasingly against that.
So, what will it take for the Fed to back off its aggressive stance?
Either a noticeable drop in inflation or something exogenous in nature—an event that is very unexpected.
Has the economy felt the Fed’s first two rate hikes yet?
Directly, I would say no. Indirectly, sure. When you think through markets, they are a discounting mechanism. The bond and stock markets have certainly felt tightening monetary conditions while consumer markets, in particular mortgages, are feeling increases.
The Fed has been far more transparent under Chair Jerome Powell. Do you see this being walked back at all?
I don’t know if they would walk it back, but I don’t necessarily think they will be increasing their transparency. There’s a lot of the debate on whether transparency is good or not at this stage, given how uncertain things are. But I don’t think you want to reduce transparency because lack of clarity means increased risk premiums and more volatility.
We’ve had two consecutive quarters of contraction in real GDP. Are we in a recession?
That question just gets harder and harder. There are arguments either way. If you want to take the position that we’re not in a recession, the evidence would be the job market is strong, nominal GDP is up 9%, revenues are up 14%, and corporate earnings are up 6%. On the other hand, as you mentioned, we’ve had two quarters of negative real GDP growth. Sectors such as retail and financials are struggling, and if housing, which is such a large part of the economy, cracks, you can make the case that we’re in a recession. It’s a very unusual time. I’m still in the camp that we are not in a recession.
Given the markets’ performance last month, how have opportunities in fixed income shifted?
There’s the fundamental element, and there’s the relative-value element. On the fundamental side, things are slowing, which isn’t good, but on the relative-value side, I feel as though credit is attractive. Let’s take a look at yields. The Agg at the end of July was yielding 3.4%; investment-grade corporates at 4.3%; and triple B almost 5%. High yield was yielding close to 9%, but after its performance in July, that’s dropped to 7.7%. Floating-rate loans were over 8%.
I’m still constructive on credit, but U.S. investment grade and loans are probably slightly more attractive to me than high yield right now. I say investment grade because I think if we have a slowing economy and you have forward indicators of inflation rolling down, U.S. Treasury yields should stay below 3%— despite all that we’ve been through. We still have pretty healthy company earnings. So that tells me that spreads on the investment-grade credit side will start to compress on the margin over the next, let’s say, six to nine months. Meanwhile, the Fed’s aggressiveness on the short end helps the bank-loan side. So yeah, I’m a little more preferential to investment grade and loans at this time. But again, I still feel very good about overall credit the next year or two.
Let’s go to the lightning round. As a reminder, I’ll give you word a short phrase or question, and you tell me the first thing that comes to your mind. Ready?
Yield curve inversion in September.
Yes. Yes, yes.
Unfortunately ticking higher on the margin.
A lot of saber rattling.
Oil company profits.
Energy in Europe.
An unfortunate strategic mess.
How about the U.S. economy and voters?
A light red.
Record heat globally.
I think we haven’t figured out how to contain it, but I think we’ve figured out how to prevent serious illness.
Finally, basketball legend Bill Russell.
A classy champion. I think the classy is more important than the champion.
Before we end the interview, will you share with us a personal reflection?
This is an uncertain time for our economy, world and personal lives. We’re facing transitions in the job market, the economy, businesses, housing—everything seems to be in flux as people are assessing how things will play out. What I keep reminding myself is just “wait for it.” Be patient and have discipline. I think right now patience and discipline—within and outside the investing world—is key. If you’re looking to make a change, if you’re looking to move, if you’re looking to purchase something meaningful, wait for it. I think you’ll end up patting yourself on the back for being patient. You’re going get a bite at the apple. Be patient right now.
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