Fixed Income Insights: Excess Liquidity Supporting Growth and Low Yields

The U.S. economy has fully recovered to pre-crisis GDP levels and we are seeing robust growth as the Fed & Treasury Department continue their grand MMT experiment. Senior Portfolio Manager Rich Consul shares INCORE Capital Management's views on the macroeconomy, monetary & fiscal policy, and corporate credit. 

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  • 24 mins 10 secs

Rich Consul: Thank you for joining the Incore Capital Management Fixed Income Insights for the Second Quarter of 2021. My name is Richard Consul. I'm a senior portfolio manager with the team. The title of our presentation is Excess Liquidity Supporting Growth and Low Yields.

Overall, our perspective can really be broken down into four areas, macro viewpoint, our viewpoint of monetary and fiscal policy, corporate credit, and then overall, what all these factors kind of mean for positioning. From a macro perspective, we see robust economic growth. The US economy has already recovered to pre-crisis levels. In 2021, forecast for economic growth, our expectations are that for seven to 8% GDP growth, which would be the strongest GDP growth that the US has experienced since the 1950s. We're seeing this strengthen kind of a broad base of measures from job growth to ISM, but generally speaking of everything that's going on economically speaking it is really being driven by monetary and fiscal policy right now.

The Federal Reserve and US Treasury Department continue their grand experiment in MMT or modern monetary theory. And Congress has already issued 5.4 trillion in fiscal stimulus since 2020 of last year, and is in negotiations for another 3.9 trillion infrastructure plan. Both of these, both monetary and fiscal policy, are really driving large increase in money supply or M2. M2 is now on its fastest pace on record, exceeding the M2 supply growth that we saw after Benton Woods in the seventies and early eighties. So a lot of the concerns around inflation really have to do with this M2 money supply growth issue.

From a corporate perspective, we are very conducive on corporate credit. We see a growing economy, we see improved corporate fundamentals. We're starting to see some slowing issuance out of corporations that raised money last year, and just don't have a need to raise money again for the foreseeable future. And the demand for yield are all real positive catalysts for credit markets so we remain conducive and supportive of credit at these levels.

From a positioning perspective, what it means is that we continue to recommend being overweight high quality issuers in both investment grade and high yield bonds. But we also are recommending an allocation to investment grade convertibles. We think investment grade convertibles offer actually a very interesting upside/downside dynamic from a positioning perspective in these very interesting markets. From a duration perspective, we continue to trade rates tactically. However, we are biased to lean kind of short duration in the long end of the Treasury curve as we believe with ten-year rates around 1.3%, that investors really just aren't getting enough yield to take on that much duration risk. And we remain concerned that, that the Fed and the Treasury combined won't be able to walk the narrow path to make MMT long-term productive. It's obvious that MMT will be short-term kind of stimulative, but really it's the long-term issues that MMT brings from a currency devaluation perspective, which we believe is a concern for kind of holding long duration, hence why we're short.

Breaking down the macro perspective. This chart looks at quarterly GDP going back to 2006. And what we really want to kind of do is show the downturns for both the 08 recession, as well as the latest COVID recession to illustrate kind of two points. A, how long it took us to recover from 2008 great financial crisis, it took us 14 quarters. However, with all the stimulus that has been pumped into the system since the COVID crisis of last March, where GDP contracted by 10%, it took us less than six quarters to rebound back, basically less than half the time for us to rebound from an economic perspective, from what was a much, much deeper economic kind of pause than the great financial crisis.

Secondly, you know, the median GDP growth, as we mentioned before, is 78% for 2021. This is going to be the fastest growth rate that we've experienced in the US economy since the 1950s. And a lot of this growth is really being driven by kind of the reopening economy, as well as just overwhelming fiscal stimulus, which we'll get into. Another way to catch the temperature of the economy is by looking at ISM, services and manufacturing indices. Both ISM indices are indicative of robust near term growth. Both of them are solidly above 60. Anything above 50 is a sign of expansion. Anything above 60 is a sign of robust expansion. And we hear the Fed talk about the robustness of this economic recovery. We see these in readings of both manufacturing and services, ISM above 60.

A couple of the interesting points are here is ISM manufacturing prices paid index, which is the sub-sector of the industry is actually having its highest reading since 1974. What that's telling you is that some of the manufacturing companies out there are starting to pay the highest year over year price increases that they have experienced since the mid seventies. And we don't have to always remind ourselves just how inflationary the late seventies and early eighties got. But a lot of those price paid indices started to move up much earlier than we saw actual inflation. And it's one of the things that we're kind of watching here as we kind of set our inflation expectations going forward.

The second sub-indice that's really showing some stress and it's something that we hear a lot about is, basically supply chain stress. It's something called in ISM sub-surveys, delivery. And what we're seeing is that the supply strain stress is leading to significant delivery delays. We've seen them in microchips leading to automotive and technology delays for product delivery. We're seeing it, if you've tried to buy any type of appliances, significant delays in getting from the factory to the consumer. So we're seeing significant supply change stress, and the sub-indices of ISM continue to be indicative that these should be with us for at least the foreseeable future.

One of the ways that we can also kind of look at the economy and really the impact of the fiscal stimulus on the economy is through US savings rates. And what this chart shows is basically US savings rates going back to 2001. And on the far right hand side here, we can see the impact of the $5.4 trillion in a fiscal stimulus that Congress has passed over the last year. And we can see how much income that has actually passed on through to the end user or end taxpayer. And what we can see is that savings rates, while they spiked up into the 30s during the height of the COVID crisis, savings rates are still above 12% for the average person.

Typically, we see savings rates in normalized times somewhere between five and 8%. So we're seeing savings rates still at very, very elevated levels because of all the fiscal stimulus payments and enhanced unemployment benefits that consumers are getting through the fiscal stimulus. And we believe that not only has this been a driver of the economic rebound, and one of the reasons that the GDP has been able to recover to pre-COVID crisis levels so quickly, but is also likely to be a continual driver of some consumption trends, at least until this starts to normalize below 8%, which is definitely no time here in the near future.

Another thing that's getting a lot of publicity, and one of the things that we think when we concern ourselves with, where is inflation going, inflation is really kind of driven by this Phillips curve relationship. And what the Phillips curve is, is basically the relationship between wage increases and price increases. And it's one of the main indicators that the Federal Reserve uses to understand kind of inflation, or at least has been something that they've used over the last 30 years. One of the things that this chart shows is that labor market participation dropped during COVID. And we know that some of this has to do with the enhanced unemployment benefits passed in the stimulus, but some of this also has to do with early retirements that we've seen. A lot of people took, who were in their sixties or that baby boomer generation that we knew were going to be retiring and were retiring up until COVID, actually had delayed a lot of the retirement during the COVID and are now starting to decide to finally leave the workforce.

And what we've seen is that the US workforce participation rate has decreased by 1.8% since its pre-COVID high. Now, 1.8% doesn't seem like a lot, but that's approximately 6 million fewer workers in the labor force. What we don't know at this point is how many or what portion have left temporarily versus permanently, permanently being retirement. And why that's important is with six million fewer workers, we can see all around us the plethora of jobs and companies that are looking for workers. And that's what we're going to look at in the next page. So as we look to one of the issues that really has been created through this whole process, is that just how tight is the labor market. And what this survey, this analysis looks at is basically the total number of unemployed workers versus that US job openings or JOLTS index. Right now, the US economy currently has more job openings at 9.3 million than we have unemployed workers. Take into consideration that we also have six million fewer workers from that previous slide.

And one of the things that we can see, and we saw this in the 17 through 19 period of time, and we're definitely starting to see it now is that basically we've gotten ourselves into what we would consider a tight, tight labor market. And when you see tight labor markets like we do currently, what you start to see is upward pressure on wages and compensation. We can see it in the McDonald's that we drive by on a daily basis to and from work. Jobs that literally a year ago, we're probably paying eight or $9 are now saying, we'll buy you lunch and pay you $14 an hour just to come in for an interview. And you can see that the upward pressure on wages and compensation are really kind of all around this. And this gets down to the supply of labor has decreased by six million according to that chart that we showed before participation, yet the number of jobs opening in the US has never been higher at 9.3. And when you combine these two together, you're creating a situation that puts real upward pressure on wages, which can be inflationary.

So let's kind of pivot to monetary and fiscal policy. We talked about it on the overview slide, just how much Congress has passed, 5.4 trillion since April of 2020, and they're eyeing another 3.9 trillion. But a lot of this stimulus is really kind of providing one time stimulus and is not really long-term productivity beneficial. And why that's important is we're starting to reach debt to GDP levels above a hundred and all the economic analysis that we've always talked about prior to this crisis. You always want to kind of keep your debt to GDP levels below 80%. anything above 80 is a negative long-term drag on GDP.

Well, now we're firmly above a hundred because of this crisis and because of MMT. And the question is going to be, as we go forward, is as we kind of move from 105% to, as the CVO chart here is showing, into the 120s, 130s, and 140s over the next 10 to 15 years, what kind of long-term drag on GDP and productivity is that going to have. It remains to be seen, but it's one of the reasons why we are so fearful where the back end of the yield curve is. And some of the very, very much worried about what MMTs long-term prospects for our economy really are.

This page looks at one of the things that we also mentioned on the overview page, which has the growth in money supply. Now we've taken this chart, it's a year over year growth into money supply going back to the 70s and we overlayed CPI or inflation to give an understanding of how typically when M2 jumps, what kind of expectation for inflation changes should we expect. And we can put the 70S on here and from an inflation perspective, see just how large the jump was. And we can definitely see there seems to be a relationship between M2 growth and some of this inflation growth. Well, fast forward all the way to the right-hand part of the chart, 2020 through 21, where M2 has never grown at a faster rate. And while we're just starting to see kind of CPI creep up into the fives, the question is going to be, when you grow M2 money supply by more than 25% year over year at a rate that we've never seen, with the wage pressures that we're seeing because of the tight labor market, what does this mean for inflation as we go forward?

Now, we don't think the Fed is going to allow inflation to get out of control like it did in the 70s, but the Fed talking about being on a hold for a protracted period of time, the Fed has talked that they would move quicker to prevent kind of a 1970s inflationary scenario. So while the Fed is definitely trying to thread the needle of wanting to be as accommodative as possible with QE and keeping low interest rates, understand that there are risks to inflation just based on M2 money supply growth.

This page is going to basically how M2 turns into kind of long growth in what this chart looks at is deposit growth versus loan growth at the banks. So a lot of the M2 money supply that we talked about on the previous page, jumping by 25%, we can clearly see on this chart, that deposit growth year over year is also increased by 25%. It's a one-to-one kind of relationship and theoretically speaking, quantitative easing, when you inject this type of money into the system, what the Fed is really trying to do is, is propel loan growth with it. Well, what we've seen is that basically while deposit growth has increased by over 25% year over year, loan growth is actually negative. And we've seen from a banking perspective what this has done is put downward pressure on loan to deposit ratios at the banks. IE, banks are sitting on just eight on of liquidity and a ton of cash.

And when you think about kind of where interest rates are, one of the reasons that interest rates really are so low is even though inflation is running at 5% and there are upside inflationary pressures in the system, one of the reasons that yields continue to remain low is that basically yields are nothing more than borrowing rates and right now banks have far more supply of liquidity to give out then it is demanded by the market. There just isn't as much demand for loans as there is the banks willing to supply them. When you have more supply of money than demand for money, that drives interest rates down. And that's one of the things that we find very, very interesting when we look at money supply, when we look at wage pressures, when we look at how strong this economy is, is that there seems to be an non-economic reason that yields are below 1.3%.

And some of that economic reason is just that the cost of money, the cost to borrow, there's just too much supply of money versus not enough demand. And that just brings down overall real yields like we've seen across the curve. That's why this loan deposit ratio is a very important metric and is something to kind of watch because increased loan demand will be necessary to turn money velocity, to turn into inflation through money. Another thing to kind of watch here, especially as the Fed is starting to consider taper, they're not even, they haven't even gotten to taper, but they're starting to consider taper, is that just how big the balance sheet of the Federal Reserve has expanded over the last year. And what this shows is Federal Reserve, Treasury ownership, not only as a percentage of the market, but also as how much it's grown versus the overall issuance.

And there's a couple interesting things to point out here. The Fed over the last 12 months has purchased over 48% of all US Treasuries issued. They've purchased over 75% of all the agency mortgages issued. The Fed is the single largest purchaser of Treasury and MBS issuance in the country through their quantitative easing program. So right now the Fed's ownership of US Treasuries and mortgages is at its highest level ever. And the balance sheet taper, when we think about it in the order of precedence, before you can start raising rates, the Fed needs to start tapering their quantitative easing. And at this stage, the Fed is the single largest buyer of treasuries. They're the single largest buyer of mortgages. And it's going to be interesting to see how the Fed kind of threads this needle, especially if Congress passes another $3.9 trillion in fiscal stimulus.

A lot of the reasons that the rates are down where they are is really not only just the liquidity that we talked about at the bank's balance sheets but really just the fact that the Fed has taken down so much of the supply of both treasury and mortgage issuance right now. From a credit perspective, spreads have returned to pre-crisis levels. Excess liquidity is just searching for yield. So when we talk about the banks and we talk about kind of the Fed buying all the risk-free assets in the form of treasuries and mortgages, it's forcing investors with to liquidity into yield products, and that has just brought corporate yields, OES bond yield, OES's spread down to levels that we haven't seen since pre-crisis levels.

But one of the interesting things that we're kind of looking at is also OES adjusted for interest rate levels. And why that's important is the spread widening that we saw in the COVID crisis as a portion or a ratio of the overall yield of available five-year treasuries was the largest sell-off in percentage terms even greater than the financial crisis. So it's just something of interest. I'm not sure that there's much to kind of take away from that aspect, but just to understand that spreads have returned to pre-crisis levels, but that spreads as a percentage of all-in yield have never been as large as they are right now. And what that means is that basically when you get spread widening, you just have less overall yield buffering you against duration loss. And I think that's one of the things that we have to be cognizant aware of is that duration has expanded in the corporate index and that the all-in yield or the roll-down has never been lower right now as far as compensation is concerned to credit investors.

But just because the spread isn't there, and there's not a huge opportunity there from a spread perspective, as we've seen over the last year, it doesn't mean that credit is bad. Like we said in the overview, we're very positive on our credit, but the chart on the left-hand side looks at issuance. 2020 was a huge issuance year. We expect 2021 to be the lowest issuance year that we've seen in over eight years. We've also seen high yield default rates expectations get back down to the 1% level. So we're talking about two situations that are very, very conducive or positive to the credit market, which is improving fundamentals and shrinking supply. And when you add the overall liquidity in the market and the demand for yield, all these things are just telling you that right here, right now, even though there's not a ton of excess spread available in the credit markets, you're kind of being forced to be in and participate in that because of the other positive kind of dynamics for credit at this point in time from issuance and fundamental improvement perspective.

So overall, we're positive on the macro environment. We think 2021 is going to be a robust economic growth year, probably the best growth year that we've seen since the 1950s. We remain positive on corporate credit as improving corporate fundamentals. Slowing issuance and demand for yield are all positive catalysts. And from a duration perspective, we remain mixed as wage pressure and price inflation is evident, but global accommodative monetary policy and kind of Delta varying concerns are really driving yields of rates lower. Overall, thank you very much for attending. Again, my name is Richard Consul, and this is our Incore Insights piece for the second quarter of 2021.