FOMC Shifts Focus Towards Persistent Inflation

INCORE Capital Management Insights’ Senior Portfolio Manager, Richard Consul, offers insight into the fixed income market with a look at how the macroeconomic outlook and policy perspectives present key catalysts. Consul considers the risks on the horizon and weighs in on inflation expectations.

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  • 23 mins 03 secs

Richard Consul: Welcome to the INCORE Capital Management, fixed income insights for the fourth quarter of 2021. My name is Richard Consul. I'm a senior portfolio manager with the team. Title of our presentation is FOMC Shift Focus Towards Persistent Inflation. From an overview perspective, our thoughts can really be kind of broken down into four areas. First is from a macro perspective, we continue to expect to see robust economic growth. We don't expect kind of the 6% GDP that we saw on the fourth quarter to here, but we do expect real GDP to kind of run in that 3% real GDP level for the aggregate of 2022. However, we are concerned about the tight labor market and some of the supply chain constraints that seem to be a little bit more persistent and seem to be driving kind of prices above their current elevated base effect levels. But we're really concerned about some of the sand in the supply chain gears that are coupled with what we call regulatory greenflation.

Richard Consul: And what we mean there is from a greenflation perspective, it is the focus on kind of ESG factors and other kind of net zero energy considerations that are basically putting kind of upside potential near term, at least on energy prices, specifically oil and natural gas. And this is what we call kind of greenflation concerns. From a monetary policy perspective, the supply chain delays, some of the wage pressers, regulatory, and some of the mission drifts are really contributing kind of to a more stubborn form of inflation. We've seen the fed really pivot in the last call it three to four months from this concept of transitory to a more persistent inflation perspective. We in the market have been in the persistent inflation camp for probably about three or four months. And it's good to kind of see the fed kind of pivoting to that more persistent philosophy that the market has already kind of baked into the cake.

Richard Consul: We are concerned though with the significant shift in hawkish tone that chairman Powell had at his January fed meeting minutes. And what we can see there is this year we're likely to get around five rate hikes and quantitative tightening. And fed Powell is really not concerned about asset prices as he is really focused more on kind of moderating inflation and trying to balance that against employment. And what we're likely to see is a little bit more hawkish fed here but most of it seems to already kind of be baked into the yields curve at this stage, at least five rate hikes. If the fed has to go any farther than that, that is not currently baked in and I think some of the risks to the upside in yields, if inflation tends to become more stubborn or more persistent, something that we actually believe is more likely.

Richard Consul: From a corporate credit perspective, a growing economy, improved corporate fundamentals and flowing issuance and just overall demand for yield are all positives for kind of credit markets. And it's really driven credit spreads to the tights that they're at right now. We believe that it's very likely that the corporate market kind of stays at these tighter levels, at least through 2022, unless the fed really achieves much lower economic growth rates. In which case, spreads could have some backup risk, but right here, right now, the fundamental picture seems very strong. And just the lack of kind of supply is producing a really good kind of technical impulse for credit market that leads staying where they are. From an overall positioning perspective, because of these factors, we remain overweight high yield issuers, both on the investment grade high yield and investment grade convertible side of the equation. And we really don't see that changing substantively as we go through the year.

Richard Consul: We will probably allow our positioning to drift a little less overweight as this year goes on, but still kind of maintain an overweight position in high grade investment grade names. We don't believe that you're really getting paid for some of the cuspier names as a result. We're kind of underweighting some of the cuspier things just because you're just not getting paid for those additional risks. And then we also believe that inflation will prove to be more persistent than fed expectations. That supply chain delays, wage pressures and regulatory mission drift are going to contribute to this much more stubborn form of inflation. Thus, we are continuing to maintain short duration relative to our benchmarks in anticipation of higher yields. We've already seen some of this shift up, but we believe that rates may have a little bit more room go both in the front end of the curve, as well as out into the intermediate part of the curve.

Richard Consul: So as we dive a little bit deeper into the macro perspective, we can start on this chart where we look at US real GDP index since 2010. And I really want you to kind of take a couple different points away. Number one, the US economy is nine percent larger than it was pre-crisis. And a lot of this growth has been driven by the reopening economy, but it's really been driven by a lot of this kind of fiscal stimulus hangover. We see this fiscal stimulus hangover in so many different ways in our economy right now, but it's basically kind of artificially driving economic demand. And we expect a little bit of slowing of this as we see stimulus kind of roll off and we see build back better struggling to kind of get through Congress, but net on net, the economy is much larger than it was pre pandemic.

Richard Consul: One of the things that we are concerned about is with the lack of kind of fiscal stimulus kind of going forward is that we are probably likely to see a slowing of GDP forecasts, right? So like last year we ran around five percent aggregate GDP level 6.9 in the fourth quarter there, we believe that GDP is probably going to transition down to kind of a three percent level, as far as real growth is concerned. So still positive, still robustly positive, three percent GDP is nothing to sneeze at, it's a solid economic growth print. It's just that it's going to be slowing the 2021 elevated growth pace. Some of this kind of growth is the reopening of the economy. One of the best ways to kind of look at the reopening of the economy is really unemployment rates. And what this chart looks at is due to the unemployment rate going back to 2000.

Richard Consul: And one of the things we can see is we're back down to 3.9% unemployment rate, right? We're nearing the pre pandemic low of 3.5%. And this rebound in employment is being propelled by robust consumer demand and fiscal stimulus, as we mentioned in the slide prior. But despite rising COVID cases, one of the things that's really kind of optimistic for the market is that the lockdown risks seem to be decreasing. We've seen a real big spike up in Omicron cases across the board yet there seems to be this persistence of opinion by not only our politicians, but by the public itself to say, you know what, I'm just no longer living indoors, I'm going to continue to progress towards reopening. And that reopening kind of shift in theology or thought process is really something that we think is a positive for markets, right?

Richard Consul: Cause you're just taking away the risk or at least increasing the hurdle rate for locking down, right, or shutting down the economy. So some of those lockdown risks have substantially decreased. And we think that's a good kind of risk measure for not only unemployment, but the economy itself. One of the biggest issues though relates to the mismatch between the unemployed and the number of jobs open. So right now we are sitting in a situation and you can see it in this chart, in the orange, it's basically the total number of US job openings. And you can see that right now we're running at around 10 and a half million open jobs, which exceeds the 6.9 million unemployed workers. So when you think about it, we almost have a four million jobs more than there are unemployed. And what this is causing is basically a lot of wage pressure.

Richard Consul: Okay. So back in the early '70s, we used to have something called the price wage spiral, which is basically prices went up and employment contracts with coal adjustments forced the wages to go up because of that coal adjustment in their contracts. This time around, it's a little bit different than the '70s, we look at it more as a wage price spiral issue. And I think that's what the fed is really kind of focused on when they made this transition from transitory inflation to persistent, is that what they're really talking about here is that there seems to be because of this tight labor market that we find ourselves in upward pressure on wages for the first time in quite some time. And that because of the persistency of this mismatch between open jobs and unemployment, that there is likely to be a continuation of this. This is not likely to abate in the short term.

Richard Consul: And we believe this is one of the kind of biggest driving factors for the big shift in pivoting of the fed from kind of transitory to persistent language in their inflationary concerns. And it's one of the key metrics that we follow, because what we're seeing in line with these mismatch in open jobs versus unemployed is a number of quits. And people are basically now in a situation where they can quit one job and move into another job just for wages and overall benefit packages. And this switching is causing a lot of kind of disruption within large corporations that need to hire. And it's putting upward pressure that is likely to persist a little bit longer than the transitory nature that the fed was originally talking about. It's something that we believe from an inflation factor needs to be watched on a monthly basis going forward here. Where this is getting into is basically this concept of employee cost index.

Richard Consul: And that's what we're looking at here is basically the employee cost index. Now the ECI index measures direct wage cost and indirect wage cost like training and other benefits that you give to an employee. And it's one of the best ways to kind of see, well, how much are these wage and indirect costs increasing within a corporation, as it relates specifically to the labor component of manufacturing parts or delivering services. And what we can see is that basically the ECI index is at some of the highest levels that we've seen since the 1999 tech boom, right? That was the last time that we've seen ECI costs year over year as high as they're running right now. And it's basically one of the situations that's really kind of driving this wage price spiral that not only we are concerned about, but that the fed seems to want to kind of get under control.

Richard Consul: Now there's a lot been made about the number of workers who have yet to come back and that some of these wage labor pressures could abate if US worker participation rates increased. And what this chart looks at is the labor market participation rate going back to the 1990s. And one of the things that we can see here is that during the COVID crisis, we basically decreased worker participation by 1.6%. When you put it into terms it's around five million people who have left the labor force for assorted reasons. Now we know some of them are COVID and childcare related, but there's a big portion here that's not being talked about. And it's nearly two million workers have left the workforce from that 55 and up age bracket. And we call these basically the baby boomers that are finally retiring.

Richard Consul: And it's not just in the 65 and older camp that we used to see it in, it's actually in this 55 through 65 age bracket as well. What we consider kind of the early retirees. And a lot of people basically with the stock market at all time highs or near there and home prices kind of where they're at is that people who have the ability to kind of retire finally are taking it. And that's why we're seeing two million fewer workers from that 55 and up from this retirement bucket that are unlikely to return. So when you kind of think of it, that leaves us with about three million people who are still on the sidelines due to kind of COVID specific restrictions. And let's face it, the six million unemployed, you add three million to that, you're at nine million all in, you've got basically 10.5 million open jobs. You're still in a situation that we would consider a tight labor market.

Richard Consul: And I think these are some of the dynamics that the fed is well aware of, and it really is what's driven their significant pivoting from transitory to persistent inflation concerns. Another thing that drives inflation is really kind of the supply chain bottlenecks that a lot has been made of. But one of the best ways that we can kind of look at these supply chain kind of bottleneck persistency of issues is looking at worldwide shipping container rates. And while we've come off kind of the peaks that we saw middle of last year, we're still darn near five times higher than we were prior to COVID. And shipping costs are a significant driver of supply side inflation. And it's not just isolated to shipping on the high seas, we're seeing these similar kind of shipping rate increases across the board, whether it be in trucking or warehousing or final mile delivery, there's inflation along every segment of the supply delivery chain right now.

Richard Consul: And with oil prices continuing to go up, it's only putting additional kind of pressure on all of these rates across the entire spectrum. So not only do we see it from the demand side and the wage side, kind of driving inflation, but we also have constrained supply side issues that are showing persistency. Now, as we look at kind of the different components of inflation broken down into different segments, what this chart looks at is kind of inflation broken down into four areas, energy, commodity less food and energy, food and services. CPI ended 2021 up 6.8%, which is the highest level that we've seen since 1982. It's being driven by the supply chain bottlenecks that we just discussed on the previous slide. But it's just overall strong consumer demand combined with tight labor is really driving all of these metrics.

Richard Consul: And while inflation is up around 33% year over year specifically due to what we call greenflation or the focus on ESG factors and trying to get to kind of a net zero carbon platform, which is likely to kind of put upside pressure long term on energy prices. So the point being here is that energy prices... The old adage in commodity markets is higher prices was the cure for higher prices, which is to say when energy prices went up, typically we did more exploration.

Richard Consul: And with that more exploration, we put on more supply and long term that's increased supply, brought down prices. This time around what we're seeing is that energy prices are going up, but because of shutting down some of the pipelines and limiting some of the access to federal lands for fracking and oil discovery is that we've seen energy oil discovery last year was the lowest level that we've seen in the United States in over two decades. In a period of time of rising energy prices, we're discovering less oil, which basically tells us that long term or at least short term in the next two to three years here, we're likely to see more elevated energy prices in the form of higher natural gas and higher oil prices at least for the next two or three years, as basically ESG, what we call greenflation is kind of driving these energy prices up.

Richard Consul: But with the tight labor markets, you're likely to see service level inflation run to the high side. And with supply chains bottleneck that we're seeing that commodities in general are likely to have persistency and upside pressure to them as well. So really when you kind of break down a lot of the different components here, a lot of people have talked about some of the inflation is the reopening of the economy and some of it is non reopening. And that all these things are kind of net themselves out to a higher base level and bring down inflation. We are on the side of these things are likely to be much more persistent than a lot of people are currently writing about. And it's one of the reasons we believe that that has had to make such a heart pivot from transitory to persistent inflation.

Richard Consul: So from our perspective, we're expecting CPI to slow down from the 6.8% that we saw last year, but still run well above kind of the thread two percent target going into 2022. So as we pivot a little bit to monetary policy, what this looks at is kind of the dot plot evolution. And the dot plot for those who aren't aware is basically it's the feds forward forecast on where they expect interest rates to kind of be at the end of each one of these years. And what we're seeing is that the fed from it's meeting in September to it's meeting in December has increased their expectation for end of 22 rate hikes from basically around two to four. The market right now is actually pricing in five. So the market is a little bit ahead of the fed. They believe that the fed is going to have to talk a little bit more hawkish, or at least fewer their dot plots to the more hawkish side of things as this year progresses.

Richard Consul: But as we saw from chairman Powell's speech in January here, they are very concerned about the persistency inflation. They do believe labor markets are tight, and they believe that they're going to have to raise rates and do quantitative tightening, which is allowing the balance sheet to kind of roll low all this year. And the only question is going to be at what point can the economy no longer take higher interest rates. And I think that's what the fed is going to have to struggle with as it communicates going along this year. From a credit perspective, we continue to have kind of a stable outlook for 22. High yield default rates, which is illustrated on the left hand side is still going to run below the average two percent default rate that we typically see in high yield, which is the historic average.

Richard Consul: So it's going to run below that, which is good for credit fundamentals. We're also seeing US investment grade corpse, which is on the right hand side, starting to decrease their leverage. You can see that it spiked up into two times leverage during the pandemic, but that the companies have started to really focus on de-levering the balance sheet over the last call it 12 months. And we believe that this curation of balance sheet fundamentals is likely to kind of persist as we go through 2022. The good part is corporations issued a lot of debt in 21, right? And a lot of corporations are sitting on very high levels of liquidity, which basically says that they're going to need to issue less debt going forward. So when we kind of look at credit metrics, we got a couple different things.

Richard Consul: Credit fundamentals are improving, but you also have a supply dynamic, which is to say supply is likely to be much shallower than it's been over the last 18 months. And with good curation of fundamentals and less supply, two things that are very supportive to kind of maintaining current type credit spreads. So in summary, from a macro perspective, we believe the economy is still positive, but it's going to slow down. The face of economic growth while above trend has downshifted so much as we enter 2022. And we believe that we're not going to run at that five percent GDP level, that it's going to be probably a real GDP number around three. We continue to see credit as a positive, improved corporate fundamentals, slowing issuance and demand for yield. We'll be supportive of stable to tight credit spreads, at least in the near term.

Richard Consul: So we continue to be overweight credit because of that. And then from a duration perspective, we believe inflation will prove to be more persistent than fed expectations as supply chain delays, wage pressures, and regulatory and mission drift contribute to a more stubborn form of inflation. Thus, we are maintaining our strategies short duration relative to benchmarks into anticipation of higher yields. The fed has said it as much, they might be a little bit behind the curve and inflation is looking a little bit more persistent. If inflation is more persistent, you're going want to play duration a little bit to the short side and that's one of the key reasons that we have that positioning in our fixed income portfolios. Again, my name is Richard Consul. I'm a senior portfolio on the INCORE Capital fixed income team. If you have any questions or concerns, please feel free to reach out to your customer service representative who can get in touch with us for any questions. Thank you and have a great day.