Fixed Income Insights: The Fed Pivots as Inflation Concerns Build

Rich Consul: Thank you for joining the INCORE Capital Management Fixed Income Insights for the second quarter of 2022. My name is Richard Consul. I'm a senior portfolio manager on the team.

Rich Consul: Title of our presentation is The Fed Pivots as Inflation Concerns Build. Our thoughts can be broken down into four different areas. From a macro perspective, inflation concerns continue to build. It's really forcing the Fed to slow the economy through raising interest rates. And when we really boil down the real issue that is affecting the market today, it's really inflation, and specifically the Fed's response to that inflation that is driving both market prices right now, and the projection of economic growth, not only for the general economy, but growth for individual corporations as well.

Rich Consul: When we look at the pace of economic growth, it's clearly slowing. And we'll get into it in the slides ahead, but as of right now, the Atlanta Fed's GDP forecast now has the US entering into a technical recession as of the second quarter of this year. So as we're talking here, we are likely in a recession in technical terms.

Rich Consul: From a headline CPI perspective, we ended the quarter at 9.1% inflation, which was the highest level recorded since 1981. So inflation continues to run hot. While we may have seen peak inflation, which is to say, inflation may come down from the 9.1 area. It's likely to continue to run above the Fed's 2% target for an extended period of time. And really when we boil it down, despite recessionary concerns, labor markets remain tight and energy markets are affected by scarcity. Both of which are really putting upward pressure on inflation, that's why we believe inflation's going to continue to run above the 2% target for an extended period of time. And the Fed is now solely focused on controlling inflation. It seems willing to produce a recession in order to address these inflationary concerns.

Rich Consul: When we look to monetary policy, we would have to look no further than Chairman Powell's statements to the effect of the process of raising rates is highly likely to involve some pain to the economy. But the worst pain would be failing to address this inflation and allowing it to become persistent, and that encapsulates what the Fed is looking to do. So the Federal Reserve has already increased interest rates 2% this year. They're likely to increase interest rates another 2% by the end of this year, with 75 basis points likely in the coming days here. And we are likely to go through a fairly extended increase in interest rates through the remainder of this year.

Rich Consul: And what the Fed is really trying to do is to control the inflation aspect. And they're willing to endure some level of a recession to endeavor in this. What they don't want to do is get into the 1970s where they don't produce enough of a recession to quell inflation. And as a result, inflation, instead of lasting a few years, ended up lasting a decade. And the Fed wants to avoid something like that.

Rich Consul: From a corporate credit perspective, fundamentals remain solid, but this hawkish Fed is really a negative. When we think about what raising interest rates does, it's really nothing more than driving the economy with the brake on. As interest rates go up, all you're doing is putting more pressure on the brake, it's slowing the economy down. And when we start to slow the economy down, while corporate fundamentals look really good right now, they can show signs of deterioration in a slowing economy. And that's something that we're looking at. But right here, right now, corporations are going into this technical recession with a lot of liquidity, decreasing leverage, and generally improving credit fundamentals.

Rich Consul: So while they look really good right now and are entering in this recession in a pretty good position, we firmly feel that with the Fed raising interest rates, that we are going to see some deterioration in credit fundamentals. And as a result, while we are, from a positioning perspective, continuing to be overweight credit, we are starting to decrease that overweight position and really being much more selective on the high quality issuers, both in investment grade and high yield. There's some high quality issuers in the high yield market that we are also continuing to invest in. But we're not taking as many flyers there, and we look for solid balance sheets on improving fundamental companies is the way you want to really be playing this recession because it's going to be probably a lot longer than I think most people are expecting.

Rich Consul: And after 12 months of being short duration, we have started to decrease our overall duration short. So we are moving more neutral to benchmark duration as we believe that the curve is now fully priced, or at least is priced pretty aggressively. The expectations of the federal reserve being very aggressive in their rate hiking policy. So while we remain short, we're not as short as we were 12 months ago, and we're not as short as we were even three months ago. So we have started to kind of decrease that positioning.

Rich Consul: So as we get deeper into the macro, this chart looks at US real GDP, going back to 2020, fourth quarter 2020. And it really breaks out GDP into its four essential areas, personal consumption, business fixed investment, inventory, net imports and exports, and government spending. And while nominal GDP remains strong due to inflation, real GDP is likely contracting. You can see first quarter GDP was negative 1.6 and the Atlanta Fed's now GDP forecast has second quarter GDP at negative 1.5%. So that would meet the technical definition of a recession, which is two negative back to back quarters of GDP growth. But despite that, we are still seeing strong employment and we are still seeing positive consumer consumption. But we are seeing a big shift in the consumer consumption basket, as inflation is really starting to affect consumer purchasing behavior.

Rich Consul: We've seen a wholesale shift from goods purchasing, which was the key purchasing for most consumers over the last two years. And now consumers have shifted away from goods such as washers and dryers and more towards leisure travel, eating out. So basically, the consumption basket has shrunk in real terms because of inflation. And what it's doing is it's forcing consumers to balance their budget a little bit differently and prioritize. So right now, the consumer seems to be prioritizing travel. Last year, they were prioritizing goods. We're seeing these big shifts and inflation and these inflationary environments tend to create these large consumer shifts. So this is something to keep our eye on because consumer preferences are going to kind of hop from spot to spot over time.

Rich Consul: So when we break down inflation, we can break it down into these four areas, services in blue, goods in orange, food in gray, and energy in green. And one of the things that we can clearly see is the two biggest factors driving inflation right now are at the green part, which is energy, and the blue part, which is services. When we think about what services are, services are really like your lawn, travel, restaurants, all of those things. And the key input to most of those servicing levels of the economy is workers. You need workers to deliver a service typically. And what we're seeing is lots of wage pressure. So while energy is going up because energy policy in the United States right now is prioritizing this shift to kind of green energy, we're also seeing workers' wages going up. And those two areas are really driving this overall elevated expectation of inflation that we're seeing right now.

Rich Consul: So CPI, again, is 9.1% as we enter the quarter, highest level since 81. But really, it's the energy green inflation or the shift to carbon neutral that is driving energy prices up and the tight labor markets that are really also driving the inflation lever outwards. And when we look at it, the Fed believes higher rates will slow consumer demand, which should alleviate these tight labor markets and should alleviate energy demand. And essentially, that's what the Fed is trying to achieve with higher interest rates. They are trying to produce higher interest rates to slow the economy, to slow energy demand and to loosen up labor markets. That's essentially what the Fed is trying to achieve with these higher interest rates.

Rich Consul: So when we look on the job side of the equation, when we think about what the Fed's mandate is, they have two criteria in their mandate. Number one is labor markets. And number two is price control. Well, when we look at the labor markets, the Fed sees a very tight labor market and it's illustrated very well on this page. So we've got orange, which is the job openings in this country, which are running at 11.2 million available jobs. And the blue line, which is current unemployment. So we have 11.2 million open jobs and only 6 million unemployed workers. That's as indicative of a tight labor market as you will see. And you can see in this graph, going back to 1999, there's really only two periods of time where job growth has been above unemployment, and that was right before COVID and essentially the time that we're living in right now. And one of the things it's creating is the US job quit rate remains around 4 million.

Rich Consul: And because of this tight labor market putting upward pressure on prices, for workers who don't have contractual arrangements where their income increases with inflation or increases with the wage environment, what we're seeing is that labor is starting to act as a free agent on its own. And if their company's not going to pay them more, they're quitting and basically finding a job that's going to pay them this elevated wage.

Rich Consul: A great example right now is you've got McDonald's on one side of this street hiring at $14 an hour and then you got Starbucks on the other side of the street that's offering $18 hour, and that's in our general area right here. And basically, the McDonald's worker is do I want to work for $14 an hour or just walk across the street over here to Starbucks, because Starbucks is going to pay me more. And it's leading to this elevated quit rate. And it's not just on the services side of things that we're seeing this, we're seeing this in technology, we're seeing it in finance. We're seeing it in plumbing and electrician work. We're seeing it pretty much in all different areas of the economy, is that basically wages are going up because the competition for labor has never been as hot as it is right now, really kind of propelling wages upward.

Rich Consul: So when we look at it, what's going to kind of quell these labor concerns. Well, raising interest rates is one thing. The other thing is labor participation. So on the left hand side, you'll see a graph of labor participation going back to 1982, and then on the right, you're going to see an employment cost index. Well, one of the things that COVID created was a lot of people left the market, not only because of COVID concerns, but during COVID, we also saw a large drop in the labor participation rate as it relates to early retirees, the 55 and older age bracket. So while we have rebounded off the lows from a labor participation perspective, almost 3 million workers still remain out of the workforce from pre-COVID. Well, about half of those people are early retirees, the 55 and older bucket.

Rich Consul: And when you talk to those 55 and older people and you ask them, well, you've retired, are you coming back in? When you look at kind of the studies, and what they're saying is generally speaking, they don't want to come back in any type of full-time manner. They're willing to take part-time jobs. They're willing to do some kind of menial task on the side, maybe consulting gigs, but pretty much the general consensus is from the studies is that people who have retired want to hold off and not come back into the workforce unless absolutely necessary. And why that's important is, if they're not going to come back into the workforce in any meaningful way, then we're going to remain at a tight labor market, even likely in a recession. And we're seeing that right now. We're likely to have two negative consecutive quarters of GDP growth, which is the technical recession yet we still have 11.2 million open jobs and only 6 million unemployed and the unemployment rate isn't moving.

Rich Consul: Well, this is really indicative of that, is that basically because the labor market is so tight because people have left, we're just not seeing them come back. And the Fed needs to balance out that labor market by hopefully creating some type of layoff to alleviate the concern. And the real concern is there on the right hand side, which is the employment cost index. Employment cost index is running at the highest levels that we've seen since the 1999 tech boom. And it's really driving this kind of wage price spiral. And once that takes a hold, it's really hard for the Fed to control. And the Fed is behind the curve in controlling it and that's one of the reasons that they're being so hawkish in their interest rate stance.

Rich Consul: So from a corporate perspective, we're going to shift here to corporate fundamentals. On the left hand side, you see an EBIDA margin chart. And on the right hand side, you'll see interest coverage, two really good credit metrics to always kind of look at at the health of corporations. What we can see is, while inflation is elevated and growth concerns, and a hawkish Fed are increasing risk to corporate credit, companies are maintaining really good conservative fiscal policy. On the left hand side, EBIDA margin is still running at some of the highest levels that we've seen since prior to the great financial crisis in 2008. And when we look at interest coverage ratio, which is basically how much coverage do they have on interest through EBIDA, you're still on the high side there at over 12 times. So corporate balance sheets look really, really good. They're going into this recession with very strong liquidity levels and very strong general profitability and corporate leverage.

Rich Consul: Another thing that we're really looking at is the issuance of corporate credit. So companies during COVID, during 2020 and 2021, really took low interest rates and the Fed's overwhelming amount of liquidity that they're pumping into the market through quantitative easing to borrow. Pretty much every Fortune 500 company came out during those periods of time and termed out most of their corporate debt. And we can see on a left hand side that during 2020 and 21, the duration of investment grade corporates really extended. It went from eight years, prior to 2019 to nine and a half and eight and a half years of duration in 2020, 2021. And corporations basically termed out their debt. So the point being here is that corporations aren't going to need to really borrow for liquidity purposes in this recession that we find ourselves in because they really already borrowed before we got here during the COVID economic pause.

Rich Consul: And then the other part is on the issuance side. So we could see on the right hand side, that gross issuance after this peak of 2020 and 2021 has started to come back down and is forecasted to be basically back in line with what we saw in 2017 from an issuance perspective. So issuance is expected to really slow down here versus prior years. And with debt termed out and corporations not really needing to borrow, add on to that their liquidity position right now, and EBIDA margins where they are. And corporations really are in a situation where they don't need to borrow. It's already termed out and they've got a lot of liquidity. And right now financials are solid. So corporate balance sheets look really good. It's really going to get down to how much pressure is put on them by rising interest rates by the Federal Reserve. And that's what remains to be seen, but going into it right now, they look pretty darn solid.

Rich Consul: So from an FOMC and monetary policy perspective, with inflation continuing to run hot, the FOMC is pursuing an aggressive monetary stance. They're willing to take on a mild recession to raise interest rates to hopefully slow or quell inflation concerns. And what we've seen is, we came into this year with those red dot plots for expectations for 2022 for only three rate hikes. That's where we started the year with the Federal Reserve. We are now, with expectations of around three and a half by the time we in this year. It's been a huge shift up in if the interest rate expectations from the Fed. And the FOMC seems willing to raise rates into this likely recession to control the inflation. And that's what we're really seeing the expectations in the dot block for 2022 and 23. Expectations are for the terminal interest rate level for Fed funds being somewhere between three and a half and four during this economic cycle. The Fed will likely have reached that by the end of this year.

Rich Consul: So 2023 now is going to come into focus on, will the Fed be able to maintain these interest rate hikes or now the curve is actually starting to expect some types of easing in 2023. But right now the Fed is fully focused on controlling inflation and is on that path. And the question only remains is how much more, what kind of higher unemployment rate is the Fed willing to accept before they kind of start backing off? That's the real question that we think they are forced to struggle with.

Rich Consul: So to summarize, from a macro perspective, we remain strong in nominal terms, GDP wise, but weak when we adjust for inflation. And the pace of economic growth, while strong in nominal terms, is really slowing in real terms. And we've likely to have entered a technical recession as of the second quarter of this year. Higher interest rates are having a direct and negative impact on durable good sales and housing sales. We've seen both of those really start to slip this year, but services spending remains strong for the time being. And like we said earlier, we're seeing large shifts in personal consumption basket as inflation is really starting to affect the consumer. And that's one of the things that we really think we need to be watching for as we look at individual corporate credits.

Rich Consul: From a credit perspective, fundamentals generally remain very resilient and very strong, but technicals remain negative. Technicals being, if the Fed is going to continue to raise interest rates and slow the economy, then these fundamentals should show some signs of deterioration in a slowing economy. But overall solid corporate fundamentals combined with termed out debt maturities, and slowing issuance remain positive for corporate bonds. However, the hawkish Fed and growing geopolitical risks have begun. We've begun to kind of moderate that overweight. So we still remain overweight. We're just not as overweight as we were a couple quarters ago, as spreads are likely to kind of widen the near term here, but corporate fundamentals still remain strong.

Rich Consul: From a duration perspective, like we said earlier, we're closer to benchmark, but still slightly short duration. Our thesis about 12 months ago was that the Fed's talk of transitory inflation was ridiculous and that they were going to have to shift to a more persistent conversation. And that higher persistent inflation required them to raise interest rates more. Well, that thesis has played out. Our strategies have done quite well by being short duration over the last 12 months. But we've started to moderate that short duration position and are getting closer to neutral with a short duration bias specifically across the intermediate to long end part of the curve.

Rich Consul: Again, thank you for joining. My name is Richard Consul. I'm a senior portfolio manager on the INCORE Capital Management team. If you have any questions or concerns, please reach out to your sales director who will put you in contact with us.