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 fixed income being fashionable again, 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 Kay Herr, Head of Research for the Global Fixed Income, Currency, and Commodities Group, as well as Kelsey Berro, Portfolio Manager within our Global Fixed Income, Currency, and Commodities Group at JPMorgan Asset Management.
This year, the Center for Investment Excellence podcast, will continue featuring relevant investment themes timely to market conditions. We'll be featuring guests from across JPMorgan to share their personal experiences and fresh perspectives on career investing and building better portfolios for their clients. With that, let's get into today's episode. Welcome to the Center for Investment Excellence.
Kay Herr: Hey David, thanks for having us.
David Lebovitz: I'm glad that you both could join us. So, today, obviously, we want to talk a little bit about fixed income, and more specifically how fixed income has become quite fashionable again after a difficult 2022. But before we get into the meat and potatoes and talk about the asset class itself and some of the opportunities and some of the risks, I wanted to start on more of a personal note and get to know both of you a little bit better.
So, Kay, why don't I kick off with you? You started in equities and later moved to fixed income. Can you talk a little bit about that transition, and in particular, why you're so passionate about fixed income today?
Kay Herr: Yes. So, David, with the benefit of hindsight, I think I basically spent the bond bull market in equities. 10-year was around 5% when I left fixed income the first time in '02, and it was down to 1.66%. That's the 10-year treasury when I returned to fixed income in 2019.
But I guess to answer the other question, why am I passionate about fixed income? Why do I like being in research and fixed income? I think when I think about myself as an investor, as an individual, I think I'm much better at identifying what can go wrong than about blue sky, earnings cash flow go up in huge multiples.
David Lebovitz: And I think that that's fair. You know, I've never met a fixed-income investor who wasn't predicting a recession at some point down the road.
Kay Herr: Kelsey can handle that today.
David Lebovitz: I know we'll get to that in a little bit more detail, but Kelsey, maybe turning to you to get to know you a little bit better, I'm going to perhaps state myself here, but I do remember when you were a summer analyst back in 270 Park, and now you're a portfolio manager. So, can you tell us a little bit about your past, and really what's kept you so engaged with fixed income over that period of time?
Kelsey Berro: Well, I would say it's been a very fun and rewarding adventure since starting here as an intern. I've sat on a couple of different desks over that time. So, I started on the municipals desk. That's where I got my feet wet. I then moved to US rates and inflation where I did fundamental research on the US economy and the Fed.
And then about three years ago is when I joined the unconstrained portfolio management team. And that's really exciting because we're looking across the entire fixed income landscape, and we're implementing the best ideas that are generated across the platform, which is across the globe. So, always a new challenge and always learning something new.
David Lebovitz: Well, it's great to have you both here today. Two somewhat different backgrounds, but interesting backgrounds, nonetheless, that I think will give us a lot of perspective on the road ahead for fixed income and the road ahead for the economy as well.
And so, Kelsey, maybe sticking with you and turning to markets, you know, the probability of recession continues to rise. I do like to point out that if we have a recession this year, it's going to be the most forecasted recession in the history of the data. What's your take? Will we have a recession this year? And do you think that the market is pricing the Fed correctly against the way you see the macro backdrop playing out in 2023?
Kelsey Berro: All right, David, you're starting with the hard-hitting, most difficult, but most important question. So, you know, to answer that, it all comes down to the trajectory for growth and inflation this year in the US economy, but not just the trajectory of growth and inflation, but what is your view?
We've had the most aggressive rate hiking cycle essentially in the history of the modern Fed. How is that rate hiking cycle and the cumulative lag impacts of that policy tightening going to impact growth and inflation this year? So, I'm going to skip to the punchline here.
We do not think the US economy is going to escape a recession. We still think a soft landing is aspirational at best, and the market is forward-looking. And so, we don't think it's unreasonable that the market is looking towards the end of the current rate hiking cycle and the start of the eventual easing cycle.
You mentioned that the markets are pricing Fed rate cuts, and we do think that it's not an unreasonable thing to expect rate cuts when the ultimate recession comes. So, I'll break it down a little bit into those pieces that I just discussed, inflation, and growth.
So, on the inflation side, we're really starting to see signs that inflation is rolling over, and it's going in the right direction. So, we've had a rule of thumb throughout this recovery. The rule of thumb has been, the Fed keeps hiking so long as the Fed Funds Rate is below the rate of inflation.
So, right now, the Fed Funds Rate is at 4.375%, 4.25 to 4.5. The inflation rate, if you look at the year-over-year rate, is still elevated. But when we look at the three months run rate, which is our preferred rate, core CPI is at 3.1%. So, right now, we're actually already moving into restrictive territory.
And the last three CPI prints, core CPI ex shelter was actually deflationary. So, we've had three months of deflation outside of shelter. So, we think that Fed is seeing what they need on inflation. We think the direction there is clear. What's more uncertain is the labor market, because that has really been the shining star of the US economy.
And when you're trying to make a call on recession, ultimately that call on recession is going to include a rising unemployment rate. So, when we look at the levels on the labor market, they still look very healthy, but what we're seeing is on the second derivative, things are turning very negative. And I'll just give you one example.
We like to look at a survey measure by The Conference Board. It asks people, is it hard to get a job, or easy to get a job? Everybody says it's easy to get a job. Those levels are very elevated, but when you compare them to 12 months ago, it's actually declined by eight points.
A magnitude of that magnitude is typically consistent with payroll growth that's actually much weaker than what we're seeing right now. So, unfortunately, it's not a very cheery outlook. We do see further deterioration in the labor market. We do see inflation coming down that's going to allow the Fed to pause, and recession in that scenario is our base case that we're operating with.
David Lebovitz: So, I think it's fair to say that the Fed kind of understands what they need to engineer in order to put the inflation genie back into the bottle. To your point about soft landings, they're a great bedtime story. They never really happen. It sounds like we're in for a bumpy landing, if not a recession.
On the Fed, you know, you mentioned cuts a couple of times. What's the biggest risk to the expected path of the funds rate? Would it be inflation that doesn't come down the way the Fed would like to see? Is it faster deterioration in the labor market? What's the big risk to Fed funds?
Kelsey Berro: So, I just told a very internally consistent story, but we know that in reality, things aren't always that clean. So, I think the biggest risk that we're thinking about is that the Fed pauses in Q1, which is our expectation, 25 basis points in February, 25 basis points in March, but the labor market remains more resilient than we expect, and the Fed ends up needing to high rates again, continue the rate hiking cycle on the second half of the year.
Now, the market's not priced for that. That's not our base case, but as Kay mentioned, we're always looking for clouds on the horizon. And I think one thing particularly risk assets are not prepared for, is the possibility that the Fed needs to go further.
David Lebovitz: Yep. I think that's spot on. I haven't really been able to understand exactly what the equity market is seeing out there that it seems to like so much. And so, my guess here is that we're going to see some sort of day of reckoning here sooner, rather than later.
You mentioned wages. That makes me think of margins, which makes me think of fundamentals. And so, now I'd like to turn it over to you, Kay, and talk a little bit about some of the other parts of fixed income. And can you shed some light on what fundamentals are looking like, particularly across the extended sectors? And forgive me if I'm jumping ahead of myself, but how are you thinking about the potential for a default cycle this year?
Kay Herr: Wow. Kelsey was right about the hard-hitting questions. We go right to default cycle. So, I want to make it very clear, David, that defaults, especially in investment grade and municipal markets, are exceedingly rare. They really only happen in cases of corporate malfeasance.
So, let's set that aside. We can maybe delve into it a little bit more. If I look at the high-yield market in the US, for example, the historical default rate there is something like 3.2% over the last 25 years. So, if you hear people talking about an increase in the default rate, we think maybe that gets up to - does it go to 2%, something north of that, but there's a significant wave of defaults in 2020 at the outset of the pandemic.
And since then, we've been running much lower than long-term average of, I mentioned 3.2%. We've been less than 1% on a trailing 12-month basis for the last two years. So, yes, I think it's fair to say that defaults, we expect them to increase, but these are from record lows, really moving back more in line with historical averages.
I guess I should also mention that credit quality, to answer the broader question to get to that, overall credit quality is exceedingly strong, whether we're looking at corporates or State and local governments or the consumer, leverage, while it had drifted up from 2010 to 2020, the pandemic caused a spike in default rates, difficulty across consumers.
You know, I think high-yield default rates exceeded 10% in that time, but overall, credit quality is very high. Leverage has improved since the pandemic began. We've seen an incredible amount of discipline, whether on the part of State and municipal local governments who refrain from hiring and have withheld some of the rainy day funds that they've had to keep them with financial flexibility, because they also see some of those storm clouds about future recession possibility that Kelsey talked about, or on the corporate side, where leverage, if you look at net debt to EBITDA, for example, in the investment grade market, now stands at about 1.9 times, in the high yield market now stands at about 2.8 times.
And generally, while the improvement in credit quality has stalled over the last 12 months as some companies have started to increase dividends, started to increase share buybacks, and overall, we think that maturities over the near term are very reasonable for investment grade and high-yield companies, cash balances are significant, when you look at gross debt versus net debt.
And, you know, this pandemic was really met by fiscal prudence from companies, and the same is true for municipal governments. As I said, rainy-day fund balances are strong. And I think overall, leverage is in a very reasonable position, especially if you compare it to prior recessions that we've seen, and cash balances remain strong in both the consumer and in corporates.
I think you mentioned margins. We've seen the peak in earnings. In all likelihood, earnings peaked probably middle of last year. You've started to see earnings come out now. It's likely that we will continue to see weaker revenue trends and weaker cash flow this year.
And as the economy slows, people will debate whether it's a soft landing, or recession. We will likely also see what's of more relevance to investment grade investors, which is downgrades. We don't expect downgrades to return to the level that we saw in 2020, given the increased financial flexibility and the overall reasonable leverage levels that we see in corporate.
And I think just to touch briefly on the consumer, overall, the trends are very similar in the consumer. We saw in some of the bank earnings that have started to report in the last few days, a normalization of credit trends, some increase in household financial obligations, but these are really just moving back in line to historical more normal levels, materially below numbers that we saw in 2008, for example.
So, overall, we're seeing what I would call a normalization of credit trends into very reasonable levels, and we remain, and it makes me nervous to say this, but pretty constructive on the overall fundamental credit quality, whether it's State and local governments or corporates or the individual consumer.
David Lebovitz: Well, I think what's so interesting listening to you make all of those points is, I think a lot of people get mixed up, and they don't recognize that leverage looks better today. They don't recognize that there are these cash balances sitting there.
They say, if we have a recession in 2023, it's going to mean that profits collapse, and these companies aren't going to be able to service their debts, but it sounds like there's a lot more to the story, at least as we exit the pandemic, and obviously, the implications of everything that's gone on over the past couple of years, or perhaps a little bit different than what would've been the case coming out of a more normal recessionary environment.
And so, I think we've done a great job of setting the stage here in terms of the overall macro view, the risk of recession, how we're thinking about the way that that translates through to corporate credit, munies, and more specifically, default. Let's make this a little bit more actionable. And Kelsey, I'm going to come back to you.
You mentioned that you work on the unconstrained team. You see the best ideas from across the GFICC platform around the world. How are you thinking about, and where are you seeing relative value in the current environment?
Kelsey Berro: Right. So, Kay definitely comforts us every day, making us comfortable with the credits that we're invested in, and we're doing the due diligence on every single issuer out there. But when we think about across all of the opportunity set, where should we be focused?
We prefer to remain fairly up in quality in terms of our allocation to credit. So, we have an allocation to credit, but we prefer to have it in investment grade over high yield. And tying it back to this view that the Fed is going to be concluding its rate hiking cycle soon, and yields are likely to peak around that same time, we're trying to increase the duration of our portfolios and buy bond to help us do that.
And so, we're not just looking at the mathematical calculation of duration, but the empirical duration. So, how do these bonds actually trade when 10-year treasuries rally? And so, when we're thinking about a situation where the Fed is done hiking, recession risks are rising, the 10-year treasury yield is falling, we think that investment grade is going to have a much higher empirical duration than high yield.
So, essentially, while investment grade is going to appreciate in value, the tailwinds for high yield in a recessionary scenario, is that spreads are going to widen, and that's going to offset the benefit of the treasury rally, and just another reason why we're preferring to remain up in quality, getting not only the strong credit fundamentals that Kay mentioned.
Heading into a recession, we've never been in a better place, but also the type of bonds that are going to trade and appreciate as the Fed is finishing its rate hiking cycle and recession risks are elevated.
David Lebovitz: No, that makes a lot of sense. And I think, again, the story during the first half of this year is going to be about quality and playing it close to the chest, rather than taking undue risk, regardless of the asset class that's being discussed. And so, thank you again both for joining me today. One final question, maybe Kay, first to you, and then Kelsey, we'll wrap with you, best idea in fixed income for 2023.
Kay Herr: Well, you said fixed income's fashionable again. I'm going to say income is back in fixed income again. So, let's go with high-quality, short-dated bonds, securitized or investment grade. As I said, you've got a lot of financial flexibility in the consumer and in investment-grade corporate America. And I think those are now offering attractive yields for investors.
David Lebovitz: Awesome. Kelsey?
Kelsey Berro: So, with the theme that the Fed is going to be nearing the end of the rate hiking cycle, that's also the time in which yields coincidentally tend to peak. And so, my best idea would be to be getting long duration as we approach the end of that rate hiking cycle.
And also thinking back on 2022, bonds didn't work and people were challenged by the situation in bonds because they didn't serve as a hedge to equities. And we think the main reason for that is because of the inflation situation. If inflation starts to come down, bonds start to work as a hedge to your equity portfolio again. So, the other call would be, bonds starting to work as a hedge, as an anchor in the storm in your portfolio again in 2023.
David Lebovitz: Well, in my nearly 13 years at JPMorgan, I don't think I've ever been able to talk about bonds doing so many different things within the context of a portfolio. So, thank you both again for joining me today. This was an awesome conversation, and I'm looking forward to having you back on the podcast sometime soon.
Kay Herr: Thanks for having us, David.
Kelsey Berro: Thank you.
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 website. Recorded on January 18th, 2023.
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