David Lebovitz: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode is on post-FOMC perspectives and the road ahead and has been recorded for institutional and professional investors.

I'm David Lebovitz, Global Market Strategist and host of the Center for Investment Excellence. With me today is Ed Fitzpatrick, Portfolio Manager in our Global Fixed Income Currency and Commodities Group. Hi Ed, welcome to the Center for Investment Excellence.

Ed Fitzpatrick: Thanks for having me here today.

David Lebovitz: It's our pleasure. We're glad that you could join us. So obviously a lot has been going on over the past couple of weeks. We had the Fed meeting in September, middle of September, where they came out and in the event didn't hike rates but included some pretty interesting things in their forecasts of what has become.

Markets have reacted to that with the ten-year yield moving notably higher and equities finally seeming to come under a bit of pressure here which I think a lot of people have been looking for, for quite some time.

But, you know, you then take a step back and you look at what's going on in the economy. Atlanta Fed has us growing well north of 3% in the most recent estimate. That's fairly consistent with what we're seeing across the Street. And so it doesn't feel like there's a recession lurking on our doorstep but we all know that the impacts of monetary policy tend to be lagged and variable. So potentially there are some challenges to come.

And so I want to tackle all of that with you here this afternoon but let's start with the Fed. So at the September meeting the Fed remained on hold but as I noted, their economic forecasts and their interest rate projections shifted pretty meaningfully. And so what's your expectation for the Fed, not only during the remainder of 2023 but arguably more so over the course of 2024?

Ed Fitzpatrick: Yes, thanks again David for having me here. You hit it on the head. There wasn't much ambiguity around the Fed whether it'd be the statement, the SEP projections, nor the chair's press conference they were hawkish. They wanted to get across the point that they are going to remain restrictive for longer.

There's reasons for them to see improvements in inflation. But in light of the very strong growth and continued strength and resilience in the economy as you noted and as evidenced through the Atlanta Fed, they felt they weren't convinced yet that they had done enough. And they are going to take this wait-and-see approach to making the final adjustment on their policy path.

We happen to believe that there's enough evidence building that suggests inflation is going to come down sufficiently to meet their expectations for this year and next year. We also see some evidence within the labor markets both at the total employment level but as well as on the wages side that should provide the Fed with a fair bit of encouragement over the next few months and that's part of the reason why we believe that they have finished their rate tightening cycle with the most recent hike in July.

David Lebovitz: Awesome. And, you know, in terms of what this means for the economy going forward, again I think a lot of people, myself included, have been surprised to an extent by the resilience that we've seen here in 2023. What's your expectation for how all of these rate hikes that have been put in will impact the economy going forward?

And, you know, really to just kind of hone in on I think what the key question is on the minds of our clients, recession or soft landing next year?

Ed Fitzpatrick: You know, well, David we just got out of our investment quarterly and that involves our senior investors across the entire platform and the message was split. It is 50-50 between soft landing and recession.

In the past we had been more in the recession camp. But with inflation improving, as I had discussed, the runway for a soft landing has certainly increased. It remains to be seen whether or not the Fed can engineer a soft landing. It is a very difficult mission for them to accomplish. But, you know, with inflation progressing as they project, it provides them with a lot more flexibility.

I still think we're a little bit skeptical on the soft landing approach although it has the probabilities of it have risen and certainly have risen from the market pricing in that type of outcome over the next three to six months which is the focus of what GFICC is trying to achieve when we go through this investment quarterly exercise.

David Lebovitz: One of the questions that we spend a lot of time debating and discussing is, so if you're going to have a soft landing, right, how do you get there? And I think, you know, to me, the clearest path to a soft landing effectively lies in the idea that NAIRU, right, the Non-Accelerating Inflationary Rate of Unemployment, is lower than it is in the past.

And effectively, what that would allow for, right, is the unemployment rate remaining low, not necessarily where it is today but not necessarily backing up the way that we've seen it do in the past and wage growth continuing to decelerate.

And I think one of the big questions is, with average hourly earnings for production and nonsupervisory workers kind of stalling out in the 4% to 4.5% range, how does the Fed think about that? Because obviously at those levels, 4% to 4.5% wage growth is arguably inconsistent with the 2% inflation target over time.

So one eye on NAIRU as it pertains to the soft landing. The other question that we've been getting quite a bit has to do with the neutral rate and R-star.

Now people trying to observe something that is inherently unobservable is always, you know, an interesting exercise and mental exercise more than anything else. But I would love to get your perspective, one, do you think that the neutral rate has increased? Has it decreased? What type of neutral rate do you think the Fed wants to target over time? And again if you disagree with our assessment on how you get to a soft landing would welcome any of your thoughts there as well.

Ed Fitzpatrick: Sure. There are definitely foundational aspects of the market right now that suggest that R-star or the neutral rate of policy should be moving up. There is certainly evidence building but we're still at a wait-and-see approach. We've just come off of the last three years which have seen a tremendous amount of volatility and uncertainty, a lot of fiscal action, a lot of monetary policy action and now we're going through that unwind process.

There were a number of structural and secular changes or shifts -- perhaps even inflection points -- that we were noticing back in 2016 through 2019 that were playing out but then we saw what happened with COVID. And it's always a good reminder that while there are secular and structural trends in place, the cyclical dynamics tend to play out.

And really when we discuss what could potentially move our star higher or the neutral rate higher, you know, you look at productivity, you look at labor force participation rate but you also look at what the trend rate on inflation is going to be and whether or not it's sticky and will that provide the Fed with the flexibility to keep rates lower, all else equal.

And I think that's probably one of the larger changes right now is that inflation, while it's coming down, we anticipate it will remain stickier than it had been prior to COVID.

And to your point, there are changes we see going on within the labor market and while wages, as you mentioned, are heading in the right direction, they're still at elevated levels and there does still seem to be some imbalance between supply and demand within those labor markets.

David Lebovitz: You know, absolutely. I think while we don't see as many help wanted signs when we go out to the restaurants, they do still tend to pop up as we walk around our various homes and towns.

And so we've covered a lot here today. We've talked about what the Fed did, the big shift being in the forecasts, you know, them staying on hold I think was relatively well priced and expected. We've talked about how the lag and variable impact of higher rates should begin to impact the economy going forward. We can flip a coin as to whether or not we'll have a slowdown versus a recession but I think you've highlighted a lot of the cross-currents in the current environment, for lack of a better term, that are making the outlook so uncertain.

But, you know, at the end of the day I'm the economist, right? You're the portfolio manager. So what does this backdrop mean to you when you think about investment risk but also investment opportunity within your asset class?

Ed Fitzpatrick: Sure. And coming out of our investment quarterly we did come up with a scenario that was 50% soft landing, 50% recession risk. So it does create opportunities as well as some risks. And when we weigh these two outcomes, what we come away with is identifying opportunities and value propositions within the high quality space.

And one of the areas that really came to the forefront was short-dated securitized credit. These are bonds that are backed by collateral. They are short in duration. They have very attractive yield enhancements over Treasury. So they offer a lot of protection in case volatility does pick up.

Another area along that same theme is agency MBS. Agency MBS have been under a tremendous amount of pressure over the last 18 months but they now offer very attractive risk-rewards from a historical perspective as well as relative to other asset classes.

The same could be said for corporate bonds in the front end of the yields curve in particular some of the higher-quality, systemically-important banks.

And so those are the three areas of focus that we walked away from when we consider both the recessionary risk as well as the soft landing risk. So it's being creative in where we take carry opportunities while at the same time maintaining a high duration posture as we go into the end of the year on concerns that recession risks while downgraded modestly still remain high by historical standards.

David Lebovitz: That makes a lot of sense. And certainly the idea of embracing duration and adding back duration after a period of time when a lot of our clients have been very short in their duration stance I would agree makes a whole lot of sense. You know, the question that I ask myself is, are rates higher or lower 12 to 18 months from now? And then my personal view is that they're going to end up being a bit lower.

So one final question, a little bit of a wildcard that I always like to surprise people with. If we take a step back outside of growth and inflation and rates and what it means for fixed income opportunities, there's a lot of other stuff going on. You know, student loan payments are set to resume. Oil prices have been flirting with the $100-a-barrel marker. Who knows if the government is going to be open for business next week. That's going to make data watchers' jobs increasingly difficult if they do in fact shut down. And then there's just broadly kind of geopolitical and political risk bubbling in the background.

When you think about the biggest risk to your baseline view going forward, what would you say that it is and how, you know, can investors potentially position portfolios to play a little bit of defense there?

Ed Fitzpatrick: When we take a step back and we look at how the market is now currently pricing in the risks, we estimate that by the end of the year and even into the end of 2024 the market is still looking for a soft landing type outcome. And that's well above the 50% probability that we're subscribing to it.

Coming into this year I think it is fair to say that the market as a whole had a fairly pessimistic outlook on recession risk and risk assets were under-owned. We think that that has been corrected over the past nine months.

And so now as we head into the fourth quarter and into 2024 it does feel like the risk-reward now is skewed through the market being disappointed by the fundamental data coming out particularly for the reasons that you just highlighted. And those are the same reasons why we came out of our IQ with a 50-50 outcome. Even though the landing strip for soft landing has increased or lengthened, you have to be cognizant of these risks that are lurking behind the scenes and the majority of them all point to softer growth and risks of a more meaningful correction in both the economy and risk.

David Lebovitz: Yes. No, I think that that's a key point and, you know, it's interesting how we went from at the start of the year the most forecasted to recession on record, you know, and now everybody to your point is talking about a soft landing. As I reminded a client last week, you always pass a soft landing on the way to recession. 

And so, it looks like we should all be watching the data and time will certainly tell. So Ed this was great. Thank you so much for joining us today and looking forward to having you back sometime soon.

Ed Fitzpatrick: Appreciate it. Happy to be here. Thanks.

David Lebovitz: Thank you for joining us today on JPMorgan Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts and on our Web site. Recorded on September 25th, 2023.

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