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Watching the Fed Like a Hawk

As the Fed gets more aggressive, what’s in store for rates and the economy?

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On May 5, 2022, we sat down with Dominic Nolan, CEO of Pacific Asset Management, to get his insights on Fed Chair Jerome Powell’s latest comments on inflation, interest rates and quantitative tightening; consuming spending trends; and opportunities in fixed income.

We saw a significant slide in both equity and fixed-income markets in April. What are takeaways for you?

If a 10% drop in the stock market is a correction, for an asset class with a standard deviation of about 15%, then April’s performance was just devastation for the bond market, as this asset class has standard deviation of about 4%. Let’s go over the numbers real fast. The S&P 500 Index in April was down 8.7% and off about 13% for the year. The Russell 1000 Growth Index in April ended down 12%. For the year, it’s down 20%. By comparison, the Russell 2000 Value Index was down only 7.75% in April and down 10% for the year. So, it’s outperforming the S&P and the Russell 1000 Growth. International equities were down about 6% in April and 12% for the year. So generally, equity markets are down anywhere from 10 to 20%.

And the bond market?

That’s where we get to the real carnage. The Bloomberg Aggregate Bond Index in April was down 3.8%. That alone would be among the worst years, if not the worst year, in the index’s history. For the year, it’s down 9.5%. That’s an absolute rout. High yield was down 3.5% in April. For the year, it’s down a little over 8%. The bright spot has been floating rate. It was up 17 basis points in April. And for the year, floating-rate loans are up seven basis points. Outside of floating-rate loans, these are all pretty significant moves.

From a yield standpoint, the 10-year Treasury entered the month at 2.32% and ended at 2.88%. Today (May 5), we’re over 3%, so more negative returns coming on the fixed-rate side. The good part is, investment-grade corporate debt is now yielding over 4%. High yield has crossed over 7%. Things are certainly more interesting.

As far as the takeaways, there’s still a tremendous amount of uncertainty on inflation, in particular energy and wages. At the same time, the Fed is clear about the intent to tighten monetary conditions. Those elements within capital markets are being calibrated right now and leading to quite a bit of volatility and risk premias are moving out.

The market is watching the Fed like a hawk. Thoughts on Fed Chair Powell’s comments yesterday after the FOMC meeting?

Funny enough, I think they added a little bit of a dovish twist. I’d say the market’s been concerned about the Fed being overly hawkish. Yesterday, we saw a pretty substantial rally in the wake of Powell’s press conference. The Fed’s 50-basis-point interest-rate hike was expected. The reason the markets became optimistic was that Chair Powell said that a 75-basis-points hike had not been a consideration. And Chair Powell didn’t really mention “expeditiously.” What the market is pricing in is a 50-basis-point hike at the FOMC’s June meeting and a 50-basis-point increase at the July meeting. That takes us to 2% on short-term rates. As we get into the third quarter, I think the Fed will probably hit neutral, which is around 2.5%. And depending on where inflation is sitting then, the Fed may have to move beyond the neutral. They may have to get to tighter conditions. It’s a wait and see at this time.

I think the rate of inflation is very critical at this stage. In particular, the rate of inflation at the end of summer. We’re sitting here with inflation at about 7 or 8% on the year. If we maintain that level, the Fed’s probably going to move beyond neutral. If the rate of inflation drops into the 4 to 5% range, then you’ll likely see the Fed start to back off tightening. I think that’s where things sit today.

Where do you think that leaves the base case when you’re looking at the end of 2022?

I think we get close to 3% on short-term rates.

What has the market already priced in?

I think the market’s pricing at about neutral—about 2.5%.

One more question on inflation, what can you say about wages?

The wage element is an inflationary pressure that is much more uncertain now. And just to give you some color, the ratio of job vacancies to unemployed is about two times. Chair Powell did mention that ratio needs to decrease. Pre-pandemic, job openings were around 7 million. They’re currently at 11.5 million. Essentially, the Fed would like to see job openings heading to pre-pandemic levels—around 4 million jobs.

You also saw an annualized 5.5% quarter-over-quarter increase in the Employment Cost Index. Right now, labor has leverage. And I would say we had a decade where capital had leverage over labor and exploited that leverage. You have a situation now where labor seems to have leverage over capital, and labor is pushing that forward.

Are you expecting the leverage that labor now has to be a persistent contributor to inflation for at least the near future?

I think so. We’re in a situation where we need more labor, but you’re seeing quit rates that are high and folks jumping to other jobs or getting pay increases. There’s going to be an equilibrium when people have to get back to work, and I think, on the other side, capital has to be willing to pay labor more.

What are you seeing in consumer spending?

I’ll touch on earnings first. What we’re seeing generally with earnings is that they’re strong, and the misses have come predominantly from inflationary pressure. What that tells you from an earnings standpoint is demand is there. And the misses are coming primarily because of inflation from wages and raw materials, which are inputs.

My general takeaway is if you’re a price setter, you are far better positioned than a price taker. What do I mean by that? Let’s look at autos. When you think about the price setter for autos, it’s really the manufacturers and dealers. Vehicles are still selling well above MSRP (manufacturer suggested retail price), and buyers are still taking that price. I think that gives you a pretty good sense of where demand is.

Now, the price takers are essentially the supplies to the OEMs. So, if you’re a vendor that supplies Ford or GM, you’re in many ways a price taker there. Ford’s willing to pay you this, GM’s willing to pay that, and the price taker is getting squeezed. So, raw materials are coming at a higher price, but your end-client really sets the price to you. For autos in general, the manufacturers are doing well. And the dealers, if they have inventory, they can sell them above MSRP. That’s going well.

Here’s another indication of demand: airlines. Now, the major airlines came out and said second-quarter revenue was higher than 2019 despite significantly less flying capacity. Why is that? Pricing. People are paying up to travel. Also, business travel’s recovering, and international is reopening. The airlines that are able to set pricing right now, they’re passing inflation costs through pretty well. The street was expecting a little more pressure due to rising fuel prices, but the airlines have been able to pass that through.

Overall, what we’re seeing is that for every 1% of inflation, corporations seem to be able to generate 2 to 3% of incremental profits. So, when you look through to consumer sectors, demand has not lessened much. On the margin, it’s probably fallen a little bit due to pricing, but demand is still there. There’s still a ton of consumer savings, and people are paying up. You’re seeing wage inflation help that demand profile as well. Why I’m sharing this is the markets are getting hammered, but the economy is strong.

Now, when we look at opportunities in fixed income, I believe you’ve emphasized floating rate for something like the past 16 months? Can you walk us through the expectations for floating rate as the Fed continues its hiking program?

Well, the beauty of floating rate is it’s one of the few asset classes in the world of debt where you can have your yields increase without having your prices decrease. That’s the magic of it. So, the Fed raised interest rates 50 basis points today. The overnight rate goes up. It’s about a one- to three-month lag for the underlying collateral or underlying loans to ratchet up their payment, depending on where they place their coupon on the curve. But as the Fed raises, you’re going to see an increase in coupons. Now, the part about this particular raise that was important is a little more nuanced, but a lot of this debt has what they call floors. There was a minimum LIBOR or SOFR setting of 50 or 75 basis points. Now, we’ve seen the rates blow through that quickly.

As the Fed continues hiking rates, I believe you’re going to see those coupons increase. Secondarily, this volatility is preventing a lot of the underlying companies from refinancing. Usually when you have a Fed increase, it’s in a very constructive time for capital markets. As a result, companies have traditionally been able to refi. Well, loans are still trading at $97, $98 in price, which means they’re going to have a tougher time repricing or lowering their coupon payment. We’ll see how long that balancing act can last. But if the Fed goes to 2.5%, that will be an increase of 200-plus basis points on coupon, assuming a company does not refi, and yet your price doesn’t have to move. By the way, since the beginning of the year, pricing for about 70% of bank loans were trading above par. What that tells you when it trades above par is the market’s telling the company that its profile’s strong enough to refi. We’re sitting now where it’s less than 20%, so this balance is very nice for the asset class. The Fed being aggressive on the forward curve is also another reason to be constructive on the asset class. In my opinion, the trade is still there.

Are there any other interesting fixed-income asset classes right now?

This is where it gets kind of fun, right? The 10-year Treasury’s now over 3%; high-grade corporates are at 4.3%; triple B corporates are at 4.6% and heading towards five after today. High yield has crossed over 7%.

So, let’s suppose we’re in a world where you believe inflation is going to level off, and the Fed’s going to sit at around 3%. In that scenario, your coupon and high yield are going to be 7 to 8%. And there’s probably an opportunity where you get some spread compression or even rates settling lower. Now the return profile could be above coupon over the next few years.

Corporate credit, which is much longer duration, is sitting at 4 to 5%. If you actually have some settling of inflation in a year or two, now your return profile for high grade could be above coupon as well. I guess the question is: why am I not as constructive yet? Because we’re still uncertain where inflation settles. To me, the volatility that you would have to take right now in exchange is too uncertain. The beauty of where we sit right now is many areas of the fixed-income market have become much more interesting. Now, let’s see where things settle out. The biggest uncertainty is still inflation. And I would expect to have a much better sense of that over the next two to three months.

Let’s switch gears and go to the lightning round. As a reminder, I’ll give you a word or short phrase you tell me the first thing that comes to your mind. Ready?

Sure.

What’s been the economic story of 2022 so far?

Inflation.

Will market volatility get worse before it gets better?

Yes.

What about the old adage, “Sell in May and go away”?

I might flip it.

Did the Fed misread the threat of inflation?

Misread is too strong. I would say they underestimated. It’s all on the margin. I just think they were late. They saw, and they didn’t act as quickly as they should have. And I shared their same view, so I missed it as well.

If you could wave a magic wand and fix one thing dragging on the economy, what would it be?

Putin and COVID.

That’s two things.

If I have to say one thing, it’s Putin. There are lives and war involved with Putin.

On a scale of one to 10, how uneasy is the market right now?

An eight.

Name the biggest factor that’s different in this rate-hiking cycle than the previous one.

Wage inflation, for sure. That’s a big one. When you think about the previous hiking cycles, it was to either curb asset prices or perhaps some leverage, but in this particular case, you’re having wage inflation.

On a scale of one to 10, 10 being most difficult, how tough is the Fed’s job ahead?

It’s in a very tough spot right now because I don’t necessarily think raising interest rates does much on the inflation side because inflation’s being driven by, my opinion, COVID-related factors and obviously distortions in the energy market from geopolitical elements. At the same time, the Fed has to curb inflation without causing a hard landing. I think it’s a nine in degree of difficulty. This is a tough one for them.

Will Chair Powell be more or less popular with the American public after this rate-hiking cycle?

All the Fed chairs have been less popular after any volatility because they’re blamed for a lot more than they should be. He’ll be less popular.

It’s spring, and Major League Baseball is in full swing. What’s a tweak to the rules baseball can do to reinvigorate America’s pastime?

I’m a big baseball fan. I think baseball should have a hard salary cap. That to me is one of the big reasons why the NFL has been so popular. In baseball, you really can’t have a Green Bay-sized market consistently be competitive. The Kansas City Chiefs can’t consistently be competitive if the NFL salary structure was like Major League Baseball’s. But the NFL is able to keep small-market cities very competitive. And as a result, you just have a much more interesting, competitive league. I would love to see more balance in Major League Baseball, but I don’t think we’re going to get there.

Finally, can you give us a personal reflection for the month?

I’ve been having these little poker nights with longtime friends over the past six months. And as we get older, one of the things we talk about is how we want to be judicious about who we spend our time with. We naturally become more like the people we spend the most time with, so we should choose that wisely. But also, we should choose widely. Because in essence, life is too short to live lonely or narrowly. That’s my two cents, and I take that from the Daily Stoic email, a favorite read of mine.

For Financial Professionals Only — Not For Public Distribution

Pacific Asset Management LLC is the sub-adviser for the Pacific Funds Fixed Income Funds. The views in this commentary are as of May 5, 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.

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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