Credit vs. Duration, where should you spend your risk budget?
Tune in to hear Dr. David Kelly and Andrew Norelli, Portfolio Manager, discuss the outlook for the economy and rates, and the importance in balancing credit and duration in fixed income portfolios.
David Kelly:
Welcome to Insights Now. A series of conversations designed to shine a light of clarity on the complex world of investing. So far this year, investors have had to contend with the implications of regional banking crisis, a still hawkish Fed, and rising expectations for a near-term recession. With economic risks elevated, the challenge for debt investors is to strike the right balance between risk and return in portfolios while maintaining a focus on credit quality. These two risks, interest rate, risk and credit risk, can have important implications for bond performance in an environment where the Fed may soon pivot to rate cuts, but likely in response to US recession. So on today's episode, I've invited Andrew Norelli, portfolio manager for several multi-sector fixed-income strategies here at JP Morgan Asset Management, to dive into the outlook for the economy and interest rates and what all this means for striking the right balance between credit and duration in fixed income portfolios. So Andrew, welcome to Insights Now.
Andrew Norelli:
Thanks for having me, David. It's great to be here.
David Kelly:
Let's start by talking a bit about the economy. We've seen a pretty mixed bag when it comes to economic data so far this year, but generally it does seem like the economy's continuing to decelerate here. And particularly concerning I think is where we're beginning to see the labor markets with the recent rise unemployment claims. So what are your thoughts on the balance of risk for the economy right now?
Andrew Norelli:
I concur with what you just said, and I think the rise in unemployment claims and the, let's call it gentle trend downwards in non-farm payrolls, actually understates what I perceive to be actual weakness in the labor market that's weaker than what the Fed would communicate and those two high-frequency data points would communicate. I think the trajectory is generally weaker. We can get into, if you want, some of the specifics of what I'm looking at in the labor market, but I felt that way coming into March and the regional bank frictions that occurred during that month. And I think after the regional bank frictions, certain things are clear to me.
One is that the regional banking balance system, balance sheet of the regional banking system, needs to shrink. And the balance sheet of the commercial banking system in general probably needs to de-risk. And because of those two things layered on top of a very tight monetary policy environment we already found ourselves in, which is getting tighter by the day as the Fed continues to hike, the trajectory for the economy is even, in my view, tilted more downward after the almost inevitable credit contraction that's going to follow the regional bank frictions.
David Kelly:
Okay, well as I say, we're probably in agreement on that. I suppose on the positive side, from a fixed income perspective, we have seen a fairly sustained disinflation trend so far this year, but there are some measures of inflation, particularly core services ex-housing, which still are too high for the Fed's comfort. Do you expect inflation to continue to fall for the rate of this year?
Andrew Norelli:
I do. And there are, as you hinted at, several different lenses through which to look at inflation. And for now, even after the encouraging CPI report that we got for the month of March, members of the FOMC, notably not Jay Powell, have continued to emphasize what they perceive to be really hot inflation conditions, and I just don't agree with that. So for example, John Williams said, "Core services inflation has not budged." That's a direct quote. But notice he said core services inflation, and that includes housing.
And for reasons you've probably covered in your podcast before, we understand that OER and primary rent, the housing components of CPI, are very laggy. So those statistics right now, which I believe starting with the March report, have begun a durable down-trend, those statistics are vastly overstating the actual housing inflation that's going on in real time in the economy.
So if you strip those out and get to what Powell would call core services ex-shelter, and he really means ex-housing because he doesn't care about hotels, but core services ex-housing, if you want to take a pessimistic look at it, you could say that it is flat-lining around let's say 0.3 on average per month. And that's a series that BLS does not publish but we can back out what the numbers are, 0.3 on average over the last several months. So call that a little over three and a half percent annualized. But wage growth has been decelerating for the better part of a year, whether you look at the average hourly earnings on sequential, the employment cost index on sequential, which is only quarterly, we'll get another look at that at the end of the month, or even the Atlanta Fed wage tracker, which is really a year-on-year number. Wages have been trending downward and wages tend to lead core services ex-housing.
So for example, if the wage for your barber is no longer going up, the price of the haircut is unlikely to continue rising. So we have a pretty good leading indicator for core services ex-housing, which is absolutely moving in the right direction. And then let's look at inflation in the following lens. So going back to something I said a moment ago, housing inflation is vastly overstated in the CPI statistics. If we take the entire CPI basket and remove only housing, which we accept is overstated, the entire rest of the basket, including volatile categories like airfare, used cars, medical care, whatever outlier a pundit would want to point out, the whole basket ex-housing is running a three-month moving average of 1.9%. So in other words, excluding the two categories which we know are flawed, inflation over the last quarter has been back to target. And that's completely at odds with the commentary that we hear out of the Feds, so they are likely to hike again. But I think the totality of what I've said indicates that the Fed's in the middle of a hawkish policy error and probably making the economic outcomes worse.
David Kelly:
Well, I can see we're not going to disagree much in this podcast, but I re-share your view on the economic outlook and the inflation outlook. But putting that to one side, what do you think the Federal Reserve will do at its upcoming meeting and for the rest of this year, and indeed going into 2024?
Andrew Norelli:
Okay, I think they will hike next Wednesday, May the 3rd. And do I think they should hike? No, but that doesn't matter. I think they will hike, and the reason they will hike is they are choosing to communicate viewing inflation through the most conservative possible lens if they view the big risk as under-tightening. And when they communicate that, they caused the market to price in a nearly a hundred percent chance of them hiking next week. I think it's about 90% last time I looked. And so when the market is allowing them to hike, and some subset of the committee has communicated they intend to hike, the easiest thing for them to do is to go ahead and hike 25, and then in the statement communicate some degree of pause.
And what I think they'll do the rest of the year is I do think they are going to cut in September. So the final hike is in May that leaves them pausing for the June and July meeting. There is no August meeting, so then start cuts in September. And the market is trying to start to price that, but not a full cut's priced in. It's sort of a gentle sort of one eighth to one half cut in the meetings in the second half of the year. But the reason I feel that way about September cuts is because I do think between now and then we're going to see a significant deterioration in the high-frequency hard data and pay less attention to the leading indicators that we're looking at today.
David Kelly:
And so I think you're sort of hinting at the idea we might see a negative payroll read at some stage over the summer or going into the fall, and that certainly could change the perception of the economy. But let's move forward into 2024. If the economy does stumble into recession here, do you think the Federal Reserve has the tools to reinvigorate it?
Andrew Norelli:
I absolutely do. So if we are concerned about credit conditions tightening in the banking system because we have one or more zombie banks that have negative net interest margins because they're funding assets at high-cost liquidity facilities because they had deposit flight, I know that's a lot of causes there, but that is the case, rate cuts fix that. You need kind of a lot of rate cuts and rapid arrival of them. But those capital erosive situations in the banking system, which is inevitably going to cause credit creations to tighten as we speak, they get made better.
And to the extent we have frictions in the commercial real estate market because new construction of affordable housing or even medium to high-end multi-family properties have been put on hold because funding is not available because funding typically came from regional banks in the CMBS market, those things are improved rather significantly by looser monetary policy. I do think the Fed has the tools to fix it. And even though I'm cautious, pessimistic on the economic outlook and I think monetary policy is too tight currently, I don't think the Fed will have to cut all the way back to zero. And I don't think the Fed will have to restart QE in order to stem economic contraction if it occurs. I do think that they'll be able to do it. If we get a recession, it's monetary policy caused, and so it can be monetary policy fixed.
David Kelly:
So that's somewhat hopeful in terms of their ability to fix things if they do manage to push the economy off the rails. But let's back up to sort of the here and now. We have had, as you alluded to, a fair amount of regional bank turmoil. What's the risk that that further fit hike on May 3rd causes additional deposit outflows across the financial system? And what do you think that means for financials in general?
Andrew Norelli:
I don't know what the risk is because why should 5.05% money market yield be the tipping point where 4.8% wasn't? But at some level, there is a rate differential between deposit interest rates and money market yields that will cause a waterfall of deposit out flight. Do I think 5.05 does it? No. However, it's getting closer and if we agree that interest rate differential between money markets and deposit accounts was at least a partial cause of the deposit flight, why on earth is the Fed going to widen that differential? And so that's actually a key element of why I think the Fed shouldn't hike, but they're very likely to do so, as we said.
So I do think there will be incremental deposit flight. And from some troubled banks that we've heard from their management teams only in the last few days, there isn't a whole lot of room left for deposit flight with remaining assets on their balance sheet that they can fund at the discount window or Federal home loan banks or the BFTP. So more deposit flight from troubled banks would likely result in more FDIC takeovers, which is not a good look for the market or for the economy.
David Kelly:
So given all of that, what are your thoughts, going forward for us this year, on credit versus duration?
Andrew Norelli:
I think it is a sequencing trade. So the environment we've discussed over the past 15 minutes is one in which duration is your friend. And partially that's because I think that the correlation between high-quality bonds and stocks has reverted back to right-way negative correlation. So if the economy suffers and inflation is trending downward, then that economic data will result in the market pricing in more cuts. And so that revives the classical correlation where duration is an asset hedge. So for example, in the portfolios I manage, the duration posture and the composition of that duration is very different than it was in 2022, and in a word, longer. So duration is your friend.
Credit, on the other hand, I will say that other than financials... And I've sort of hinted at my bearishness on financials. Other than financials, credit fundamentals are pretty good, especially in the high-yield corporate bond market, where leverage ratios are generally low, better than they have been. in prior recessions. You had credit cleansing in 2020 with defaults. You had well-timed refunding of debt coming due when spreads were tight and rates were low during COVID. So there's a lot of positives on credit, but credit tends to peak and spread during the recession. So for the 40 or 50 year life of the high-yield bond market, spreads always peak in the recession. They don't stay there for long. But the short answer is I think we're going to have better opportunities to add credit if our macro view is borne out. So we're underweight credit and overweight duration if I paint with a broad brush in the portfolios that I help to manage.
David Kelly:
So can we try a slightly finer brush here? I mean, obviously in the area of credit, we've talked about some of the challenges facing the banking industry because of these increase in short-term interest rates. But do you think that there are some high-grade corporates that would be appropriate for right now?
Andrew Norelli:
Yes. So let's call it industrials or maybe even single-A IG credit and maybe high triple-B IG credit that's not financials. Because it's perfectly reasonable to assume that if we do get an economic downturn, Treasury yields will decline by more than the spreads widen. So in other words, you're getting a carry pickup in higher-quality IG credit compared to Treasurys. And even in a recession, the all-in yields actually decline and bond prices stay the same or go up. So you may underperform Treasurys, where the actual optimal thing to do would be to buy all Treasurys, let Treasury yields decline, then rotate into IG credit. That is a harder needle to thread.
So I think that investors can feel comfortable that the bond price is unlikely to get a whole lot cheaper in high-quality fixed income no matter what happens in the recession outlook, the thing that would kill it is a surprising rise in inflation. But that's not my view. And if we have time, we can talk through the reasons. But based on the more high-probability economic outcomes, I think that investors will do considerably better in high-quality fixed income maybe than equities.
David Kelly:
I think you and I, we agree on the inflation outlook. And we both, I think, think that a strong revival inflation is unlikely here. But I have to end on a slightly ominous question that I'm getting asked more and more in the last few days, which has to do with the debt ceiling. Is there a greater risk this time rather we actually reach the X date and have some default-like event? And what would the short or long-term consequences be for the bond market if we defaulted on our debt?
Andrew Norelli:
I was kind of hoping you weren't going to ask me about that. But if you'd asked me a week ago or two weeks ago, I would've said we're very unlikely to cross the X-date and if we do cross the X-date, then Yellen will put in place this break glass in case of emergency of prioritizing debt payments over all other Federal expenditures, including salaries of Congress members and to avoid a technical fault on debt. I still think that's the most likely case. However, a few things have happened. The Republicans are trying to, and I think failing, to get a bill through that would codify prioritization of debt payments as explicitly legal because it's not clear that it is explicitly legal. It's not clear it's illegal either. It does seem like a rational thing for the Treasury to try to do. Defaulting on bonds would be considered an actual credit event, whereas defaulting on payments to suppliers or defense contractors probably wouldn't. In a traditional bond that wouldn't.
But the documents governing Treasurys don't contemplate things like cross defaults or acceleration because that's just not a thing that happens in un-defaultable government bonds. So it would be legal limbo. I still think even though the administration has said, "A default on any Federal obligation is a default, not just bonds, so therefore we're not considering prioritizing debt payments," I think behind the scenes they probably are because it's the most rational thing to do. I think the probability that we surpass the X-date is greater than it was a couple of weeks ago, just reading the rhetoric. And the further we get from Silicon Valley Bank and the crisis that that caused for a period of time with depositors in SVB didn't know whether they would get their money back, the greater the time after that period of chaos, the lower the calls to Congress members begging them to stop creating crises. And the debt, if we defaulted, it would be a crisis.
One quick comment and then I'll talk about, briefly, the long-term implications. There is this idea that the 14th Amendment to the United States prohibits a default. So the words are, "The validity of the public debt of the United States shall not be questioned." It's a short sentence. And in the past, presidents have used that 14th Amendment as a reason to go ahead and just pay the debt, either through prioritization or even running an overdraft at the Treasury General Account with the Fed. That would get questioned as well. So there are avenues, I think the most likely of which is debt prioritization. But the long-term implications for risk assets would be significant because whether it's correct or not, the market would once again question the reserve currency status of the dollar. And reserve currency status of the dollar enables, essentially, foreign debt financed prosperity, incrementally at least in the United States, which is baked into the earnings power of our public companies. So it would be a pretty tough risk off period.
What happens to Treasury yields is less clear. An academic would tell you, "Well, Treasurys are going to go down and price yields higher because the US defaulted and therefore we should run more term premium." However, any default that does occur is going to get cured, maybe cured with extra interest. And that market would recognize that instantly. And Treasury securities do have a big flight to quality and would retain much of it in a big risk off. So gun through my head, I think Treasury yields actually go lower in a debt ceiling debacle, passing the X-date, threatening default. What's the probability? I'll give it 45%, a little less than 50/50 getting to the X-date without a resolution, and that's up from 15% two weeks ago.
David Kelly:
That's a scary thought. Well, let us hope it doesn't come to that. Obviously, it would be an extraordinary [inaudible 00:18:52] for us to default in our debt, so let's hope it doesn't come to that. But Andrew, thank you again for your... I know you've been with us before on this podcast, and it's always illuminating to hear your thoughts on the outlook. So thank you very much for participating today. And thank you all for listening.
Andrew Norelli:
It's been a real pleasure. Thank you, David.
David Kelly:
Please tune into our next episode, where I'll be joined by fixed-income portfolio manager Rick Taormina for a conversation on the outlook for municipal bonds. Until then, I invite you to read or listen to my Notes on the Week Ahead podcast, where every Monday I share commentary on the latest in markets and the economy to help you stay informed for the week ahead. For even more timely insights, you can also follow and subscribe to my content on LinkedIn.
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Risk Summary
Investments in bonds and other debt securities will change in value based on changes in interest rates. If rates rise, the value of these investments generally drops. The value of investments in mortgage-related and asset-backed securities will be influenced by the factors affecting the housing market and the assets underlying such securities. The securities may decline in value, face valuation difficulties, become more volatile and/or become illiquid. They are also subject to prepayment risk, which occurs when mortgage holders refinance or otherwise repay their loans sooner than expected, creating an early return of principal to holders of the loans. Investments in derivatives may be riskier than other types of investments. They may be more sensitive to changes in economic or market conditions than other types of investments. Derivatives may create leverage, which could lead to greater volatility and losses that significantly exceed the original investment.
The Core Plus Bond Fund could experience a loss and its liquidity may be negatively impacted when selling securities to meet redemption requests by shareholders. The risk of loss increases if the redemption requests are unusually large or frequent or occur in times of overall market turmoil or declining prices. Similarly, large purchases of Fund shares may adversely affect the Fund’s performance to the extent that the Fund is delayed in investing new cash and is required to maintain a larger cash position than it ordinarily would. CMOs are collateralized mortgage obligations, which are issued in multiple classes, and each class may have its own interest rate and/or final payment date. A class with an earlier
final payment date may have certain preferences in receiving principal payments or earning interest. As a result, the value of some classes may be more volatile and may be subject to higher risk of nonpayment.
Securities rated below investment grade are considered "high-yield," "non-investment grade," "below investment-grade," or "junk bonds." They generally are rated in the fifth or lower rating categories of Standard & Poor's and Moody's Investors Service. Although they can provide higher yields than higher rated securities, they can carry greater risk.