Income is “in”, and the Fed has lost its mojo
Opportunities from US economic exceptionalism, noise, and divergence.
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The market’s obsession with daily data and its potential impact on the US interest rate path is noise that should be ignored. A focus on fundamentals, and the structure of debt for advanced economies, is more important in navigating today’s environment. Higher yields are here but lower risk premiums in traditional markets bear scrutiny. Opportunity begins and ends with income that offers insulation from volatility in interest rates.
The market’s attention this year has been focused on how soon, and how often, the US Federal Reserve (Fed) will cut interest rates. Most began the year vastly overestimating the potential for interest rate cuts. We had this right, so here are tips we use to avoid the pitfalls of the past two years and to capture the opportunity afforded in today’s markets.
Put your noise-cancelling headphones on and stay focused on the fundamentals
Following individual data points is a fool’s errand. A consistent return to target is required for the Fed (and other central banks) to act. Daily data is inconsistent. Inconsistency is the enemy of normalizing policy rates. Rather than depend on strategies that require a certain rate directionality to succeed, we recommend focusing on fundamentals and reducing sensitivity to those factors that are likely to be more volatile.
Don’t be shocked by US economic strength
We don't see a recession coming in the US. The economic pillars (consumer, corporations and banks) aren’t weak. Even the oversupply in certain commercial real estate sectors is unlikely to drive a recession. Fiscal stimulus, through measures such as the Inflation Reduction Act and the CHIPS and Science Act, are having a positive economic impact. The US consumer has massive wealth appreciation which should benefit the economy through strong consumer spending. The economy is healthy, the Fed has time.
Don’t take risk you are not paid to take
Markets are unusual. Cash, in the form of T-bills, yields more than the investment-grade corporate index. That is absolutely not normal.
There are only two ways to get back to a normal curve. The first path requires Fed Funds (short rates) to decline materially. That would likely be driven by some sort of economic crisis. In that case, credit spreads would widen materially. This path is good for government bonds (duration), but bad for credit bonds.
The other path is a bear steepening of the yield curve. This is the path of positive economic outlook. In this case, is neutral/positive for credit spreads, but bad for duration.
So duration could be good or bad and credit spreads could stay the same or widen. You see why we say that investors are not compensated for some risks. We prefer floating-rate or low duration securities. This is a big change from our views two and a half years ago, when we hated the US two-year Treasury note. Following nearly 450 basis points (bps) increase in short-term yields, the two-year Treasury notes now delivers high income with little downside. Duration exposure further out on the curve is another story; we don’t see the case for systematic reduction in interest rates for the intermediate/longer part of the yield curve. Longer bonds don’t exactly feel “back”.
The fourth quarter of 2023 brought a tremendous rally in traditional credit markets, and today credit spreads represent an asymmetric risk. At historically tight levels, credit spreads can widen more than they can tighten. Given that, we think there is good reason to shorten up spread duration, and the cost of doing that is nothing (actually you are paid to do it).
Earn attractive income and reduce sensitivity to volatility
We favor investments that benefit from the income afforded through floating-rate securities or shorter-tenor securities because we don’t believe investors are being paid to take on additional duration or credit spread risk.
Don’t be shocked by the strength of the US consumer
Consensus believes US consumers have spent their excess pandemic savings. But personal wealth in the US, at least for a portion of the population, is about much more than stimulus checks.
From the Brookings Institute, total household wealth in the US increased by $24 trillion from the end of 2019 to the end of 2021.[1] Increased value of equity holdings and appreciation of real estate assets were key drivers. True, not everyone has these assets, but when assessing the US consumer, the top quintile of US consumers (by income) is responsible for approximately 35%-45% of consumer spending.
Further, the home-owning consumer has a much lower mortgage payment today. If they refinanced at 2%, 2.5% or 3% during the pandemic, from a 4.5% or 5% level, they now have significant additional disposable income. This is like getting a fairly large pay raise and is a fact few have considered.
The consumer dependent on stimulus checks and exposed to rent inflation is in the lower income quintiles. But this group had the largest proportional pay increases, and inflation is much reduced.
Unconsidered is the potential power of built-up home equity. Home equity, at levels never-before seen, mean that accessing even a small portion of the home equity built-up could contribute more than US$1.5 trillion to consumer spending potential. This is more two times the COVID stimulus. That is economic upside.
Be prepared for a divergence in central bank policy
After years of aligned global policy, we expect divergence across central banks. The fundamentals that drive regions’ economies, such as regional growth, fiscal policy and local consumer debt structures are different and mean less co-ordination. Co-ordinated central bank policy means dampened volatility and more beta-oriented markets. Less co-ordination means increased volatility and more alpha oriented (idiosyncratic) markets.
“Bumpy” is the new “transitory”. Bumpy data is not conducive to the Fed normalization. We don’t believe the Fed governors will vote to cut rates until they see a clear and consistent path to 2% inflation. Why the rush? We think rate cuts could come later than the market expects, or even not at all in 2024.
The US consumer is not sensitive to changes in short-term rates. Federal Reserve Funds rates do not seem impactful. Most US consumer debt is fixed rate for a long time. Corporate debt is, by and large, fixed-rate, and is primarily sensitive to the 5- and 10-year interest rates. Commercial real estate debt (for occupied/ stabilized properties) is primarily sensitive to 10-year interest rates. Given the lack of sensitivity, for all these sectors, to the Fed Funds Rate, if Fed Chair Jerome Powell were an Austin Powers fan, he might have to acknowledge he has lost his “mojo”.
Outside the US, consumer mortgage rates reset much more frequently and variable rate mortgages are more common. As a result, the non US consumer is sensitive to policy rate changes. Rate cuts are perhaps more necessary as strain has been more directly felt from the increase in non US central bank policy rates.
A divergence in central bank policy could lead to more volatility. This is particularly true if expectations, in certain regions, are not borne out. Volatility could drive more opportunity. Today’s market is more alpha-oriented than what we’ve seen since the Global Finance Crisis and that creates opportunities for skilled, selective investors.
Be better prepared: Diversify to gain exposure to a variety of risk premia
The view of our Private Debt and Credit Alternatives team is that it is beneficial to diversify the way you earn returns by seeking out different types of risk premia and in particular finding markets that are less efficient. Avoid crowded markets.
Differentiate: some of markets may be cheap because there is real fundamental strain, some may be cheap owing to regulatory changes. Taking advantage of opportunities might mean increasing exposure to private or nonsyndicated loans that offer a higher return, pairing that with shorter-tenor investments that will help you better manage your liquidity.
Look for flexibility: opportunities change, particularly when markets are more volatile. The breadth of an investment strategy allows the navigation of a “bumpy” road. Looking at the ways to navigate an opportunity may include acquiring in or lending to it in many forms. Investment strategies may benefit from taking exposure through securities, through loans or through risk transfer risk for regulated entities such as banks or insurers. Diversification of the way returns are composed – or as we like to say it – more risks, not more risk.
We believe the inefficiencies in markets present valuable opportunities for investors, particularly given the asymmetry of the potential for spread returns from here.
[1] Source: “Bolstered balance sheets: Assessing household finances since 2019,” Mitchell Barnes, Wendy Edelberg, Sara Estep and Moriah Macklin, Brookings Institute research, 3/22/22
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