00:20:10:12 - 00:20:30:19

DAVID LEBOVITZ

Welcome to the Center for Investment Excellence, Priya. I'm looking forward to our conversation because it's been an eventful week in the market already, as evidenced by yesterday's January inflation print for the U.S. and the subsequent market reaction, both on the equity side, but also on the rate side, which is going to be the topic of conversation today.

00:20:30:19 - 00:20:56:23

DAVID LEBOVITZ

And so, you know, generally speaking, when we think about the direction of travel for the economy this year, we don't really see a terribly elevated risk of recession. We think generally a soft landing is still in play. We're thinking about the way the probabilities may be tilted around cycle extension and sticky inflation. But, you know, the base case is no recession in our view and a moderation in growth down towards something near trend.

00:20:56:23 - 00:21:20:13

DAVID LEBOVITZ

But we'd love to kick off today's dialog with, you know, letting you opine on your market view. And so what's your general macro view for 2024 and how are you thinking about the U.S. economy specifically with respect to both growth and inflation. 

PRIYA MISRA

So, great place to start? Because I feel like where you are in the business cycle is going to determine your asset allocation and returns across assets as well.

00:21:20:15 - 00:21:37:13

PRIYA MISRA

So, you know, I'll talk about what the market's pricing in, but let me start with fundamentally, where are we seeing the world we see the world base case scenario staying or the U.S. staying in a soft landing for now? You know, I think I started by saying we're in a so because I think we're in a soft landing today as we speak.

00:21:37:15 - 00:21:57:04

PRIYA MISRA

I mean, the unemployment rate is below 4%. GDP is actually a little bit above potential, but a lot of one off factors. We think, you know, GDP is probably going to get closer to one and a half to 2%, which is slightly below potential or close to potential inflation heading. It's going to be a bumpy road. That's how I saw the CPI report.

00:21:57:09 - 00:22:21:19

PRIYA MISRA

It doesn't derail our view that inflation's heading lower. It tells you it's not going to be a straight lying down to 2%. I think that's what we saw and it's going to be volatile. But overall, disinflation in the good sector, which is largely come through, disinflation in the service sector, continues at a probably a little faster pace. As you know, some of the lags around housing played through and growth slows down.

00:22:21:23 - 00:22:45:19

PRIYA MISRA

So that's how we would define soft landing. And I wanted to start by explaining what we mean by soft landing, because it's often used, some people will argue a soft landing is much weaker than it is. Soft landing is actually pretty good for all risk assets. But there's another key component of soft landing, which is the Fed that is able to reduce some of the restrictiveness of their policy, both from the balance sheet as well as interest rates.

00:22:45:21 - 00:23:06:13

PRIYA MISRA

And I think this was the big shift in December. In September of last year, the Fed said higher for longer. And personally I was worried about a soft landing playing out because if the Fed keeps rates restrictive for long, then the impact, the lagged impact of monetary policy restrictiveness starts to impact the economy. That really the Fed changed its tune.

00:23:06:13 - 00:23:29:07

PRIYA MISRA

I think they saw the improvement in inflation. They saw the narrow path to a soft landing, and they're trying very hard to keep it going. And so the shift we've seen in the Fed reaction function is one where they are saying what we can start normalizing. So that's a key component of why we think the base case is soft landing, because we think the Fed is going to start to cut rates within the next few months by the middle of the year.

00:23:29:07 - 00:23:49:14

PRIYA MISRA

We think they're starting to cut rates. We also think they're going to taper, cut to try and finesse exactly where the balance sheet should end, but to prevent staying restrictive for too long. So the combination of inflation that's declining growth that's moderating and a Fed that's starting to normalize policy allows the soft landing. But we're all markets people.

00:23:49:14 - 00:24:09:20

PRIYA MISRA

We have to look at everything, all the other alternatives. I'll talk about the two other alternatives. Alternative paths for the economy. One would be a hard landing or a recession. And that would normally imply, you know, either zero or negative GDP. A rise in the unemployment rate, I would argue above 5% would be what would be consistent with a hard landing.

00:24:09:22 - 00:24:28:02

PRIYA MISRA

We don't see it yet. But, you know, as those of us that have lived through many recessions, every recession starts looking like a soft landing. I will push back and say every soft landing also starts out looking like a soft landing. There haven't been too many, but the few that they have been. So it's hard to really extrapolate from data today.

00:24:28:04 - 00:24:50:08

PRIYA MISRA

So recessions tend to be non-linear. You can have a sudden shock that can worsen the unemployment rate or the cracks that we're seeing some cracks. Absolutely. In the economy deepen. So that's the scenario I would see 20, 30% chance of a hard landing. And then there's another possibility, which is a reacceleration. I struggled with that because I think policies restrictive.

00:24:50:10 - 00:25:12:05

PRIYA MISRA

But the argument is, well, policy has eased, financial conditions have eased in the last few months. Let's say the Fed starts to cut. Do we get an acceleration in growth and an acceleration in inflation, which actually stops the Fed from cutting maybe hiking? I think we're very far from that. But it's certainly something, as we are all thinking about different scenarios, we certainly keep that as a deal risk in our mind.

00:25:12:07 - 00:25:34:13

DAVID LEBOWTIZ

Exactly. And I also think with markets pricing having been priced in this very narrow path. Right, it seems laser focused on kind of soft landing, maybe Goldilocks Fed easing. Right. It's not that you necessarily see the hard landing or the reacceleration play out, you know, to its full extent, but more so that you begin to see signs that that may be in play and that ends up being a fly in the market's ointment.

00:25:34:13 - 00:26:00:08

DAVID LEBOWTIZ

And I want to I want to stick with that and ask you about the Fed, because we debate this a lot. You know, does it matter when they start to cut rates or is it more about if they cut and by how much? How do you think about that, that Fed reaction function?

PRIYA MISRA

So for anyone who trades Fed fund futures, March, May, June, if you really trading on Sofr futures, it matters a lot for the rest of us that don't trade those specific meeting wires or meeting futures.

00:26:00:08 - 00:26:18:19

PRIYA MISRA

I actually think it doesn't matter whether they start what's a few months among friends, whether they start March mid June. Today, the markets are all about July. It doesn't matter. It's the total amount of cuts. The Fed gives us this dot plot that we all look at.

00:26:18:19 - 00:26:38:00

PRIYA MISRA

It's a way they communicate the reaction function that gives us 24, 25, 26 cuts. It's a calendar date. We look at the total amount of cuts that we think the Fed is projecting that they're likely to do versus what the economic outlook would argue or daily rule or different metrics of how much they should cut versus what is priced in.

00:26:38:02 - 00:27:03:18

PRIYA MISRA

And they are, despite all the talk of too much of cuts, is priced in. You can argue that, you know, maybe the market's pricing too much in the start of the cutting cycle. When I look at the total amount of cuts were actually pricing the markets pricing in less cuts than what the Fed themselves are talking about. So to give you a sense of numbers, that dominant rate which would be the rate after all the cuts that the Fed has penciled in is 2.9, the long run dollars 2.5.

00:27:03:18 - 00:27:24:08

PRIYA MISRA

So I give you a range. The according to the Fed, the cutting cycle will end around 2.5 to 2.9. The market's at 3.6. So the market's pricing in these cuts from Fed funds is five and a half to 3.6, about 200 basis points of cuts. In our view, in a soft landing, they get to about 3%, which is close to the Fed start plot.

00:27:24:08 - 00:27:41:18

PRIYA MISRA

So there's more room for more cuts to get priced in, most likely next year or the year after in a soft landing. In a hard landing, they're not cutting to neutral, they're cutting below neutral. So that's the scenario where there's absolutely room for a lot more cuts to be priced in. But as I said, that's not our base case.

00:27:41:18 - 00:27:57:10

PRIYA MISRA

So we're not focused that much on that scenario. But if it does start to look more likely, then you can have more cuts getting penciled in.

DAVID LEBOVITZ

So let's stick with the base case because for a while now, you know, the kind of narrative in the market has been that bonds are back, right? It was the narrative at the beginning of 23.

00:27:57:10 - 00:28:17:01

DAVID LEBOVITZ

If you think that, you know, recession and aggressive set easing is not the best case view, how are you thinking about high quality fixed income? How are you thinking about duration in this environment?

PRIYA MISRA

I love high quality fixed income. Two reasons yield and not just yield. For those of us that look at inflation all the time, many of us do.

00:28:17:05 - 00:28:44:08

PRIYA MISRA

Really old DNA really is in the government bond market is at 2%. You're not taking any credit risk, you're getting about 2% real return, which we have not had positive real rates at this level since the seventies eighties. So you have to go back really a lot. So there's a yield component. You stay in soft landing, you pick up that real yield and then you pick up inflation if you're buying a nominal bond and then you can pick up you talked about high quality spread product.

00:28:44:08 - 00:29:03:06

PRIYA MISRA

If I'm buying a high quality corporate name or securitized name, I get that additional spread. But certainly I am taking either prepayment risk or I'm taking some credit risk. But yield is a big reason why we think bonds are back. The other reason is diversification. And this is where, you know, the stock bond correlation has been all over the place.

00:29:03:08 - 00:29:23:08

PRIYA MISRA

You could have argued that bonds were not a good hedge to risk assets last year. They are. If the Fed is done hiking, inflation is heading low and the Fed's actually going to cut as the economy slows down. I would argue that those correlations come back. So if you've got risk assets, the bad scenario for you would be a hard landing.

00:29:23:14 - 00:29:44:14

PRIYA MISRA

Bonds will absolutely kick in. So they are back in a soft landing. I would argue they're even more back in a hard landing scenario. And a final reason why they're back is there's a lot sitting in cash. Cash has felt good rate for the last two or three years. If you're sitting in cash, your earning more every time the Fed raises rates and you don't lose in any other asset class, all that money.

00:29:44:14 - 00:30:04:14

PRIYA MISRA

Cash is never a strategic investment. It's a place you hide out. And sometimes hiding out makes sense when you start to think about what's the next macro environment that cash starts getting put to work. And we think bonds are attractive.

DAVID LEBOVITZ

And I think it's interesting you bring that up because we were doing some work looking at the potential for those money market fund assets to flow into equities.

00:30:04:20 - 00:30:22:18

DAVID LEBOVITZ

You know, people throw that kind of 6 trillion in money market funds out there, but importantly, not all 6 trillion is going to go into a single asset class. Right? You could have some go into equities in a certain environment. You can have a lot go into go into duration. On the other hand, I want to come back and you kind of touched on credit.

00:30:22:18 - 00:30:39:22

DAVID LEBOVITZ

And what I would say is that when I talk to people about credit, they tend to be very divided, I don't want to own investment grade, you know, below 100 over or I don't want to own high yield because I'm worried that, you know, the long and variable lags of Fed policy are going to end up creating problems in that market.

00:30:39:24 - 00:31:02:13

DAVID LEBOVITZ

How do you think about credit today? And more importantly, do you see opportunity in aggregate or is it more at the individual bond level?

PRIYA MISRA

So I think there is opportunity in aggregate. We do like credit spreads across the spectrum. So high grade corporates, high yield. I would say those aspects of high yield sector that we think is attractive loans would be one loans have actually lagged a little bit of this move.

00:31:02:15 - 00:31:33:01

PRIYA MISRA

I would say owning some of these levered loans or close securitized credit, this seasoned securitized credit people, which is ultimately credit, it's tranche out, but it's credit. So I would say there is value in sector. There is absolutely value in bonds. In fact, active management, where you can actually look at the business model, you can look at the balance sheet of companies and see, well, who did the right thing the last couple of years when rates were low, how many companies locked in funding or refinanced?

00:31:33:07 - 00:31:50:02

PRIYA MISRA

And if you did that, that interest rate increase or what the Fed did for the last two years has actually not had a terrible impact on you. Your earnings are good, you've got good leverage. And so actually owning those companies, so there's a lot we can do at the individual bond level. There's a lot you can do at the sector level.

00:31:50:04 - 00:32:18:12

PRIYA MISRA

The pushback, I would say, for people who are telling you spreads are tight, they are pricing in a soft landing. So, you know, if I wish I could say, well, they're all pricing in hard landing. And so we get a huge spread compression. I don't know if there's a massive spread compression potential. This, Gary, meaning I'm earning 75, 9020 basis points since some single-A financials have 150 range, you buy that, you pick up that hundred 50 basis points, make sure you know what you want.

00:32:18:12 - 00:32:40:13

PRIYA MISRA

That's a big thing. I tell every investor, know exactly what's in your bond portfolio, what's in the aggregate index. So know what you want, do the credit work, but you're picking up spreads. The reason spreads, update is the economy has been remarkably resilient and in a soft landing, companies that did the right thing and a lot of them did is the reason why the soft landing is persisting.

00:32:40:13 - 00:32:58:24

PRIYA MISRA

And despite high inflation, margins are holding up. So I think, yes, they are tied for good reason. There's still value in getting that spread pick up and then do the work just to make sure you're not picking up, you know, a bond that you may not want on. Exactly. And I think that that really resonates with us.

00:32:58:24 - 00:33:21:13

PRIYA MISRA

You know, when we look at high yield, we think about it more for the total return rate as opposed to the spread compression. But we also recognize that it probably makes more sense to play in some of the higher quality parts of the high yield market. And, you know, one of the things that I was talking about on a podcast earlier was looking at that kind of invisible line between rising stars and falling angels and trying to take advantage of movement across that across that border.

00:33:21:13 - 00:33:42:17

PRIYA MISRA

But today's conversation has been great. I wanted to ask you one final question before we wrap up and that's about risk. And so you talked a little bit about correlation earlier and how correlations in stock bond correlations would turn negative in the event of a growth shock. Do you have any other thoughts on correlation and what are some of the other risks that you're watching?

00:33:42:17 - 00:33:55:21

PRIYA MISRA

Are you worried about politics? You know what, actually, I should say it's not what keeps you up at night. It's about what wakes you up at night that we really need to worry about. But what has the potential to wake you up as a good one in terms of keeping us up at night? A lot. A lot.

00:33:55:21 - 00:34:16:03

PRIYA MISRA

I mean, in a soft landing, assets are doing okay, but we wake up many times at night because that's what you pay your bond manager to do, is to worry about everything that can go wrong. A few things. So you talked about correlation. I think in a growth shock, correlations are back in an inflation shock. They're not. So if we start to see particularly service inflation.

00:34:16:03 - 00:34:35:14

PRIYA MISRA

So I'm watching wages or quits rate which is heading lower. But if you suddenly start to see the labor market becoming tighter for some reason, then those correlations don't work. So making sure we have some inflation hedges in the portfolio, credit can be one, maybe inflation linked bonds. So correlations I never take for granted depending on the macro environment, they can change.

00:34:35:14 - 00:34:55:19

PRIYA MISRA

So that's something certainly keeping us up. You talked about politics. It's an election year and we know politics matter. Unfortunately, these are binary risks. So depending on makeup of Congress, I'd say it's not just the president, it's how is going how divided is Congress That can have big implications. We're absolutely looking more at the sector level right now.

00:34:55:22 - 00:35:19:06

PRIYA MISRA

Maybe there's a macro implication for the deficit. That is something I am concerned about geopolitics. You know, we're looking at supply chain issues and things like that. If you start to see inflation moving up just that very the Fed, it's probably less of a concern this year than it has been when inflation was much higher. But certainly if there's any new flare up and we're dealing with two wars already, that would be something.

00:35:19:08 - 00:35:42:00

PRIYA MISRA

While we're talking about global issues, I will say the BOJ that has been in negative rates now for 15 years, they are likely to exit negative rate policy. If they just start that one hike, then I think that's the base case. If these actually embark on a hiking cycle, they're taking rates much higher. Some of the demand for U.S. treasuries has come from the rest of the world.

00:35:42:03 - 00:35:58:21

PRIYA MISRA

Does that start to change? And I would look at China as well as any big fiscal stimulus in China. China has been underperforming now for a few years. We don't think that as much. But so we've got a base case. But I will look at all of these global factors. And the last one I leave you with is you want bonds to be liquid for you.

00:35:58:23 - 00:36:32:21

PRIYA MISRA

So we want to make sure that we've got liquidity in our portfolios because in an event where you need that liquidity, make sure that the bond portfolio has enough assets and got they can't be all 100% liquid because then you know do don't on that Gary but making sure we prioritize liquidity risk as or the value of liquidity and government bonds give you that that's just something when things are so well priced, I want to make sure that we've got liquidity risk so that you don't have to liquidate assets in a different, more difficult market environment.

00:36:32:23 - 00:36:50:18

DAVID LEBOVITZ

Well, I think that that makes a whole lot of sense. And I like that you ended on the liquidity issue because unfortunately, we don't have time to talk about private credit. And you told me that that that wasn't an area that you wanted to dive into. So very, very nice navigation there. But thank you so much for joining me today and looking forward to having you back again soon.

00:36:50:20 - 00:37:19:10

PRIYA MISRA

Thank you, David. Okay. Thank you. That was great.

00:39:09:20 - 00:39:32:02

Thank you for joining us today on JPMorgan's Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts on our website and on our JP morgan Asset Management YouTube channel, recorded on February 14th, 2024.

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