Vexed by Volatility
It’s been a bumpy ride for the markets so far in 2022. Will the road smooth out soon?Download PDF
On June 1, 2022, we sat down with Dominic Nolan, CEO of Pacific Asset Management, to get his insights on the volatility in the markets, the Fed’s quantitative tightening, consumer spending trends and opportunities in fixed income. Finally, we finished it up with a speed round of questions and a personal reflection.
The markets in May had plenty of volatility, but generally ended up much better than April. What stood out to you?
The first half of May was tough, but we had a big rally in the last week. S&P 500 Index was up 18 basis points, so it eked out a positive return. The Russell 1000 Growth Index was down over 2% in May, so still weak. The Russell 1000 Value Index was up 2%, so the large, more traditional companies performed better.
When you look year-to-date, the S&P at the end of May was down 12.76%, the Russell 1000 Growth Index was down over 21%, and the Russell 1000 Value Index was down 8%. On the equity side, value is having its day versus growth. The MSCI World Index is still down about 11%, tracking slightly better than the S&P.
What about fixed income?
The Bloomberg Aggregate Bond Index was up for the first time in a while, returning 65 basis points. High yield was slightly up. The standout loser for the month was floating-rate loans, down 2.5%. That asset class finally cracked a bit after being very resilient. The Agg has had a horrible year, down 9%. High yield is down 8% for the year. The standout performer so far this year has been bank loans, but for May, the standout underperformer was bank loans.
GDP has been slowing (it’s growth in April was negative), and inflation is still elevated. So why the rally at the end of April?
You could argue valuations. I think some seller’s fatigue has set in and there’s been some bargain hunting. Also, on May 25, the Fed released the minutes of their May meeting, and the market had a big rally that day. I believe the market may have been looking through saying, “Oh, it’s possible the Fed reassesses in August or September.” Now, who knows if that’s true, it’s all on the margin. But it tells me the Fed has a significant influence on the path of capital assets.
Let’s talk about the volatility the markets have experienced this year. Just back of the napkin, if you were to point to three causes for the current level of volatility, what would they be and how would you rank their importance?
The driving cause of volatility is inflation, which is having ripple effects throughout the economy and affecting the Fed’s actions. What’s been the root cause of inflation? I’d argue it’s the challenged supply chains, and they’ve been deeply affected by China’s zero-COVID policy. Labor shortages are another as we’re seeing businesses having to adjust how they operate due to a lack of labor. And third, Russia’s invasion of Ukraine, which has challenged the food and energy markets, especially in Europe.
Is there hope that the back half of 2022 will be less volatile regardless of where we end up direction wise?
Absolutely. In China, the factories and the ports seem to be re-opening and that will help supply chains substantially. China’s zero-COVID policy really hurt in April, because they’re shutting down local economies. Now, it’s beginning to open as COVID cases decrease. But we’ll see if COVID rears its head again and how the Chinese government responds.
The war in Ukraine is hard to underwrite right now. If it deescalates, that will obviously help the food and energy story.
I think labor’s going to be interesting over time. We’re starting to see corporations push back on some of the worker demands. You’re starting to hear rhetoric about corporations freezing hiring, and unemployment claims ticked up just ever so slightly. I think corporations, as they get margin pressure and stocks get hit, will start to squeeze more out of existing labor.
The longer-term ramifications, in my opinion, are a lot harder to underwrite. If you were to ask me how long this labor shortage will go on for, I couldn’t tell you if it’s going to be six months or three years. The reason I say that is because I think COVID changed the psyche of many workers, and I think it accelerated retirement or pulled forward the retirement of a swath of boomers who just didn’t feel like they wanted to go back to the office.
The more these factors start to normalize, the more inflation normalizes, the Fed neutralizes, and then you have the more normal functioning world. I certainly hope for that, but I don’t know to what degree those factors will normalize or what volatility will be like by the end of the year.
The Fed’s quantitative tightening begins this month. What are you looking for?
Well, the Fed is expected to reduce its $9 trillion balance sheet by $47.5 billion per month for the next 90 days and then about $95 billion per month after. I think they’re going to reduce that balance sheet down to $8 trillion in probably a year, which in that case you will be shrinking M2. I don’t think we’ve had M2 shrink in a long time, given we printed a truckload in 2020-21.
Just to give you some historical perspective, the last time the Fed announced quantitative tightening (QT) was in June 1017 and began QT in 2017. Rates then were sitting just below 2.5%, and a year later the 10-year Treasury was sitting over 3%. It’ll be interesting to see when the Fed stops QT. I’m of the camp that if the goal is to get the balance sheet down to a “normal” $6 trillion, you’re looking at 2025. I would be surprised if they ended up getting there. We’ll see.
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 market currently expects the Fed to hit an overnight rate of 2.75 to 3% by yearend. Do you see that changing over the coming months?
Let’s walk through the path to get there. The Fed’s FOMC is meeting in June and July, and the market is discounting 50-basis-points rate hikes at each meeting, which takes us 2% (June was a 75bps hike). Now there are three meetings remaining—September, November, and December. If the Fed does 25 basis points per meeting, you’re at 2.75%. I feel like that’s a very reasonable base case, and I would say a high probability. To me, the Fed’s September meeting will be the most interesting. If I could learn today what the Fed’s going to do in September, I think that would give us much better sense of how the world’s faring.
Do seeing any signs of inflation peaking?
The short answer is yes. However, if somebody made a statement that they think inflation’s accelerating, they could find data for that as well. But I’ll give you some anecdotal elements. Wells Fargo came out and said wage pressures are not as great as they were in the fourth quarter of 2021. Inflation expectations were down from April. Average hourly earnings came down from 6% to 5%. Some major retailers report being overstaffed. You are seeing certain corporations mention they may freeze hiring.
The PMI slowed in May. Inventories are up, and home sales are slowing. Early this year, lumber was $1,300 per thousand board feet, and at end of May, it was at $650. So, it’s been cut in half. But again, we could take 100 data points, and a person who’s saying inflation is accelerating can point to some of them, too. But my general feel is that we’re seeing more signs the rate of inflation is peaking.
What can you see when you look at consumer spending data?
Real GDP growth in April was negative. That’s real GDP. Again, we’re in a world where inflation’s so high that the bar for real growth is very high, but nominal GDP is moving. Let’s look at the Bank of America’s credit-card spending data. This was through April. What I found interesting is consumer behavior over the past year—lodging up 25%, transit up 20%, gas up 33% (that’s probably just pure gas inflation), restaurants up 10%. Compared to three years ago, so 2019, airlines spend is up 10%. Again, that’s probably inflation more than it is just increased travel.
What’s down year over year? Clothing down 8%, furniture down 15%, and home improvement down 8%. What’s that tell you? It tells you people are getting out. They’re not staying at home.
Last month, you talked about areas of fixed income that looked interesting, but not yet “attractive.” So where do you see the fixed-income opportunities today and has any asset class gone from “interesting” to “attractive” for you?
I wrestled with this one the most, in part because our firm just had an investment meeting early in the week, and the portfolio managers gave their views of the asset classes. For the first time in a while, all three had very similar views over the next six months on high yield, bank loans, high grade credit. You look through to bank loans, they had a rough month in May, down 2.5%. But where do loans sit now? Average price of bank loans was little over $94 through May 31. The discount margin right now is over five. If Fed raises 50 basis points for each of the next two months, you’re going to get to a 6% coupon pretty quickly. So that tells you over the next two years, you may be able to clip six, probably get a point or two in total return, and suddenly you have a two-year profile where the math can take you to 7% on loans.
You look at high yield, the yield-to-worse right now is 7.1%, and BBs are yielding 5.6%. So high yield, if you’re just clipping the coupon, gives you 7%. If you get some spread compression, you’re above that, but high yield’s going to be a lot more volatile than loans. Then you have investment-grade credit, where you’re clipping 4 to 5%, depending on the credit quality. If you have inflation start to move down, you can take at 5% and get to 5%-plus. So, you have compression in math where you have three asset classes that could have a sound argument to generate 5 to 8% over the next year.
Yes. The probability of recession. If you believe recession is a higher probability, you may want to skew to investment grade because in theory rates would drop, duration’s going to be a tailwind, you avoid defaults, et cetera. If you believe recession is unlikely, then high yield can look pretty attractive. We’re going to clip 14 points over the next two years with the possibility that prices either sit or even appreciate a tiny bit. So where does that leave us? In general, credit to me is compelling.
I think asset allocators may notice that they’ve been in a world overweight in equities for some time. And very few asset allocators who I ran across were neutral over the past few years. I think about forecasts for the S&P 500 over the next two or three years, and many feel 7 to 9% is reasonable. I believe there are credit asset classes that may have a much higher probability of getting 7 to 9% with a ton less volatility.
Obviously the downside of going to credit relative to equities is equities can give you much higher potential returns. Credit is highly unlikely to get you double-digit annual returns over the next three years, but from a risk-return standpoint, credit’s really compelling to me. I’ll say the opportunity right now is in corporate credit rather than nailing down a specific area of corporate credit.
Time for the lightning round. As a reminder, I’ll give you a word, short phrase or question, and you tell me the first thing that comes to your mind. Are you ready?
Today’s stock market.
More dependent on central bank than people think.
The housing market.
Feels like Y2K.
A U.S. recession.
Possible, not probable.
On a scale of 1 to 10, how tough is the Fed’s job right now?
I’m going to say eight.
The Russian economy.
What about the U.S. labor shortage?
Unsure. I don’t have a good answer there.
Biggest secular change caused by the pandemic?
Work from home. Second, I think is the shifting of globalization.
Back to office.
Still in the dance but leaning toward employees coming in more.
Thanks for that. As we do each time to close our interview, can you share a personal reflection?
We’re in the graduation season, but I recently found a thought-provoking article geared toward new college graduates. It’s about five lessons to unlearn from school and written by bestselling author Suzy Welch, who is the widow of former General Electric CEO Jack Welch.
Lesson One: School assignments are clearly presented, but in the real world, that rarely happens. Directions for work and life are often ambiguous. You must adapt to that.
Lesson Two: Schools typically have second chances—new semesters, new years where you start with a clean slate. But in life you got one shot, so play the long game.
Lesson Three: Schools reward students a lot of times for effort; life rewards you for results.
Lesson Four: In school, the more words you use, the better (term papers, for instance). In life—and this one I probably agree with the most—less is more in business and in life.
Lesson Five: As a student, your job is primarily to impress one person, the teacher or professor. In life, it’s important in work and life situations to treat everyone with respect and meet or exceed their expectations.
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Pacific Asset Management LLC is the sub-adviser for the Pacific Funds Fixed Income Funds. The views in this commentary are as of June 1, 2022 and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Any performance data quoted represents past performance which does not guarantee future results. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Sector names in this commentary are provided by the Funds’ portfolio managers and could be different if provided by a third party.
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