Portfolio Manager Andrew Norelli discusses the opportunity in fixed income strategies in light of recession risk and an uncertain interest rate environment.
Do you think a recession still probable? And if so, why are yields rising?
Recession is still a probable outcome, and even though data over Q3 2023 was strong, long-term rates rose by more than short-term rates. Part of what has driven long-term rates further than shorter rates is market optimism about an economic soft landing. Also, a related view holds that elevated long rates are justified because the neutral policy rate (r-star1) is higher now than it’s been in a decade.
And finally, some of the rise in yields has been attributed to a resurgence of the idea among investors and central bank policymakers that the current bout of inflation may be sticky. That has occurred even though sticky inflation is incompatible with soft-landing optimism, an idea that has also surged among market participants.
We still see the trajectory of inflation statistics staying on a downward path in the near term. However, the medium-term inflation outlook has been clouded. One thing is a significant acceleration in supercore inflation (core services ex-housing). There are also the optics of a recent rise in year-over-year headline inflation, partly due to base effects, and partly due to rising energy prices.
Against a backdrop of plausible concerns from investors and central banks that inflation may persist, it has been difficult for a sufficient demand to emerge for duration. Even a significant inflow into fixed income products during the first three quarters of 2023 has been insufficient to halt the rise in rates.
Quantitatively, simplistic valuation measures, such as the level of real yields, the level of forward rates and the comparison of nominal rates to nominal GDP, haven’t really exceeded their long-term (pre-global financial crisis) averages.
Combined, all of these factors have enabled term rates to rise.
Why do higher rates matter for estimating the odds of a recession?
Whatever the drivers, this summer’s bear steepening of the yield curve—in which longer-term rates rose more than short-term rates—has potentially increased the probability of a recession.
U.S. borrowers—whether households, corporations, state and local governments, or commercial real estate owners—rely overwhelmingly on longer-term, fixed-rate debt. So while the Federal Reserve (Fed) directly controls short-term rates, it has less control over the long-term rates that are more relevant to borrowers, since they drive fixed-rate borrowing costs.
Long-term rates matter more as a restrictive force on economic growth and by extension, on inflation. High and rising long-term rates are acting as continuing and intensifying headwinds to economic growth. When we factor in this summer’s rise in energy prices and core services, we have an economy in which capital is expensive and the consumption basket is getting more expensive.
Are these conditions consistent with a recession? They are not, but they are consistent with a fragile economy that can fall into recession with the emergence of an external disturbance, especially given that the U.S. economy is at or near full employment. I would characterize the economy as more fragile than it was six months ago for these reasons alone.
In short, optimism about a soft landing, pessimism about sticky inflation and doubts about the efficacy of tight monetary policy can eventually lead in each case to the opposite outcome.
High-quality duration diversifies risk assets if the global economy enters a recession … Duration is the risk premium that does better.
What other themes are likely to influence the demand for duration?
Globally, central banks will struggle to keep monetary policy this tight—or to tighten—if job losses pile up. Even those central banks with unitary inflation-fighting mandates, such as the European Central Bank, will find it difficult to remain tight as people suffer a deteriorating quality of life. From an investment perspective, demand for the surety of returns in high-quality fixed income will likely increase.
However, at least at first, investors and policymakers could remain overly steadfast in their concerns about lingering inflation risks, because of a fear of stagflation. Even if inflation concerns are rooted in supply constraints in energy, autos and housing, as long as the concerns linger, the demand for duration may not be sufficient to bring rates lower.
Still, I think stagflation is unlikely to persist in advanced economies that have shrinking money supplies. If economic growth deteriorates, a continuous rise in prices (remember, inflation means rising prices, not merely expensive prices) should be unsustainable. Lack of affordability should cause aggregate demand to wane, thereby keeping inflation in check.
Were a wage-price spiral to occur, it could make stagflation more likely to endure, but the U.S. economy is moving further away from such a scenario right now. Wages are decelerating by virtually every measure, despite the recent high-profile industrial actions. Labor’s bargaining power is declining when you observe the entire U.S. economy. If economic growth begins to contract and job losses tick up, labor’s bargaining power will further decline.
What are the investment implications?
Big picture, I still feel strongly that high-quality duration diversifies risk assets if the global economy enters a recession. I’m cautious on duration over the short term, but quite constructive over the medium term.
How do you position portfolios that can access riskier fixed income, such as high yield and emerging market (EM) debt?
Spreads on riskier fixed income tend to peak during recessions and not before. Even though public credit market fundamentals today are higher in quality than during prior late-cycle periods, I still think spreads widen in a recession, if it happens. The economic fragilities I highlighted earlier intensify that view.
In our portfolios, we are currently running low allocations to corporate and EM credit, preferring higher-quality and shorter-duration securitized credit, with their attractive yields and lower sensitivity to spread widening.
That said, all-in yields are attractive for high yield and emerging market credit. If risk-free rates ultimately decline and spreads widen, risky bond prices might not actually decline that much. Higher-quality fixed income historically outperforms, though: Duration is the risk premium that does better. Also, should there be an initial stagflationary phase of the end-of-cycle, spreads would widen while risk-free rates wouldn’t decline much, and might even rise.
Both of those possible outcomes suggest underweighting riskier fixed income as long as a recession remains on the horizon.