Fixed Income Markets in Focus: On the road to recovery?

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  • 15 mins 43 secs
Certain recession indicators are flashing red. Learn how investors are evaluating bonds versus equities in light of these warning signs.

Hear Andy Sparks, managing director and head of portfolio-management research at MSCI, discuss recent trends in fixed-income markets, the effect of current inflation and central-bank monetary policies and market indicators that may point to a recession.
Channel: MSCI
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Speaker 0: Certain recession indicators are flashing red today, we will cover how investors are evaluating bonds versus equities in light of these warning signs as well as the effect of inflation and central bank monetary policies. Joining us now with more on the latest developments and market trends is Andy Sparks managing director and head of portfolio management research at MS C I. Well, Andy, great to have you back

Speaker 1: with us. Thank you very much Jenna. Pleasure to be here.

Speaker 0: So, uh what have we seen Andy across equity and fixed income markets over the past year then? What about more recently over the past few months?

Speaker 1: Well, uh for the bond market, there's been good news and bad news. So the good news is that returns in 2023 are positive um which is really good compared to 2022 when they were very significantly negative.

Speaker 0: Oh, yeah, very different story this year.

Speaker 1: That is right. The less good news is a

Speaker 1: equity returns have been I characterize them as spectacular so far this year with the MS C I USA equity index being up over 20% year to date

Speaker 1: and that's far far better than um than different bond market sectors have performed. Um also take into account of course, that there has been inflation this year. So if you look at uh large components of the investment grade bond market, um specifically us treasuries, their returns are positive but they're lower than inflation.

Speaker 1: So on an in an inflation adjusted basis, treasuries have had negative returns this year. And then in other words, in terms of what sort of, in terms of the real consumption basket that investment could buy,

Speaker 1: it, buys less. Now, after having invested in treasuries than a consumer could have had taking that invested and buy the basket at the beginning of the year. So ultimately, investors are looking for after inflation adjusted returns. And like I said, in the treasury market,

Speaker 1: which is the largest part of the um investment grade market, uh they're actually negative this year taking into account inflation.

Speaker 0: Yeah, I want to talk a little bit more about inflation. Andy, what are your expectations? And what about your expectations for central bank monetary policy?

Speaker 1: So number one last week, we had the um CP I release which was really good news for on the inflation front. Uh very significant declines in inflation uh broad based, I'm sure that number was very welcomed by the Fed, but uh

Speaker 1: I think in probably premature to take a victory lap at this point, the market as well as the FED has consistently understated inflation over the past couple of years, there have been quite a few unpleasant surprises. And so, although this month's number looked really good, one month does not make a trend. And in fact, if you go back to the prior month on CP I release,

Speaker 1: uh it was unexpectedly high and a lot of market participants were talking about stubbornly high inflation. So, uh just because we have one month um investors, I think need to be a little cautious and a little skeptical, I, I wouldn't be surprised if uh members of the fed FO MC

Speaker 1: uh continue to be pretty cautious. Um But probably internally, they're, they're probably call it cautiously optimistic that maybe we have turned a corner here. Um We'll ultimately have to wait and see if you look at the US Treasury market. If you looked at the relationship between prices of linked securities and nominal, um that gives us an idea of the market expectation of inflation.

Speaker 1: It's, it's, it's, it's for the next year, it's approximately 2% which is pretty much in line with what the fed's long term inflation target is. So we'll ultimately have to wait and see, but I think we're trending towards more optimism on the inflation front, but there will be some skeptics and we'll just have to wait and see if you look at interest rate futures, markets specific to what the market is thinking about Federal Reserve policy.

Speaker 1: Uh They think there will be one more rate hike and then it'll be, it'll stay there for the rest of the year with declines starting next year, which again is consistent with the Federal Reserve projections from the June Fo MC meeting. So there had been like as of a couple of months ago, there had been some discrepancy between what the interest rate futures market thought was going to happen versus fed policy

Speaker 1: makers with the market thinking there will be cuts in 2023. But what we've seen over the past year and a half is that each time there's been some discrepancy between what the futures markets thought versus the fed. Generally speaking, the futures market is thrown in the towel and have gone with the Fed and the same thing seems to be occurring this time around as well.

Speaker 0: And of course, one reason to be optimistic too about the

Speaker 0: economy is the labor market. The labor market has been tremendously strong and resilient. So I'm sure the Fed is taking that into account as

Speaker 1: well. Absolutely. And Chair Palace talked quite a bit about and he's been asked a lot about, can the Fed engineer a soft landing? That's what the fed has wanted as opposed to a hard landing or a stagflation sort of environment.

Speaker 1: And so MS C I, we had a recent blog where we were looking at four different macroeconomic scenarios and we looked at um projected returns across sectors in each one of those scenarios, but we did not give a probability to, to, um, those scenarios. But, um, the FED has been hoping

Speaker 1: that the soft landing could be engineered and I think there are a lot of skeptics a few months ago that it would be possible and, you know, effectively the FED has been trying to thread a thread, a needle and it sure seems like that possibility of a soft landing is growing and you might think the eye of the needle is growing a little easier to get that thread in there.

Speaker 1: And ultimately, we'll have to wait and see. So that would be generally a very good scenario for capital market participants, but we'll have to wait and see whether that happens or not. Those

Speaker 0: are very tough to achieve when you look back historically as well.

Speaker 1: That's right. But you're right, the news on the labor market has been very good, will be will be getting more economic data as well as earnings from various companies coming in.

Speaker 1: So it all is accumulative. But um so far, I think the uh economic performance has surprised the participants to the upside so far this year.

Speaker 0: Although of course, one reason to be cautious could be the inverted yield curve. Some might say, what, what would you say in response to people looking at the inverted yield curve and other data out there predicting a recession,

Speaker 1: it's very steeply inverted.

Speaker 1: And uh you know, there's been a lot of uh research including academic research looking at uh at whether that is a good predictor of uh economic downturns and it, it generally has a pretty good record, not perfect.

Speaker 1: And I would say in particularly in the current environment, I think investors need to be concerned about false signals and take into account. The FED has two different criteria that it is, it's focused on and that is really their, their goals are A to have maximum employment and B to have stable prices. And

Speaker 1: the sort of narrative, the causal factor for maybe why in the past a uh steeply inverted yield curve oftentimes led to recession is the view that the economy was slowing and the fed to prevent it from slowing too much would have to begin easy. And but

Speaker 1: this time around maybe partly a little bit because you know, this, this feeling that a soft landing is maybe more achievable. Now, the FED may be more focused on inflation this time around. And chair poll has definitely talked about this over the past few months. And so the idea is that the fed has had

Speaker 1: to be very vigilant, it's had to keep and raise rates significantly and keep them high. That's the projection for this year, as we mentioned a little earlier. But um ultimately, Chair Pal has also said, if they have really good news on the inflation front, they can begin to talk about being less, less aggressive in keeping rates high

Speaker 1: and possibly even leading to cuts and that could occur even in the absence of a concern about a recession. And so

Speaker 1: if you look at, if you look in the rearview mirror and just look at empirical data, you might think, OK, we're headed for a recession and a lot of people are focused on the inverted curve as signaling flashing those red lights that a recession is on the way. But like I said, there are some other scenarios, particularly if you combine the possibility of a soft landing with, with the reduction in inflation that does take some pressure off the fed

Speaker 1: and they may begin to talk about easing a little earlier than expected. And maybe this time around the inverted curve will not result in a, in a recession. We'll see.

Speaker 0: And finally, Andy, what are investors thinking about in, in light of all of this when it comes to their allocations to bonds versus equities? I mean, they haven't performed as well as, as equity this year as you mentioned, but those yields are pretty high.

Speaker 1: They are. And that's AAA crucial thing. And we like looking at real yields in, in the bond market and we, we look at them for short maturities, mid, mid maturities and long maturities and across the board, they're pretty high by the standards of the past 12 to 14 years. And it's particularly true in the short end, but even out at the 10 year it is. And so um yields are still relatively high.

Speaker 1: And if you look at, uh, measures of valuation in the equity market, so we like looking at, um, at the, uh, forward, um, at the, uh, forward earnings yield and the equity market. And if you look at the relationship between that forward equity earnings yield to, um,

Speaker 1: to real yields from the bond market, uh, it, it sort of seems that the equity yields seem a little bit on the tight side compared to his relative to bond yields by the standards of the past 20 years. And so if you just use that as a measure of valuation, you might say that bonds look cheap. But the, the important question for investors, they might be cheap,

Speaker 1: but could they get cheaper? And so as tempting as it is to say, OK, now is the time to rotate into bonds just given, given the sort of relatively attractive yields. I think it is important that investors look at what could go wrong here and I won't go down a laundry list. But you know, several things, number one, as I mentioned before, we did have this blog looking at various macro scenarios and,

Speaker 1: and um the worst one for uh for capital market participants is the stagflation scenario where and like I said before, it's probably premature to declare victory on the inflation front. Um unexpected things could happen.

Speaker 1: So there could be some downside attached to that. So in terms of the bond market skeptics just focus on that is one reason to be a little cautious on bonds. Um Another reason could be let's just call it a debt overhang.

Speaker 1: And uh everyone knows there's been a lot of fiscal stimulus. The congressional budget office has put out its forecast over the next 10 years and it looks like there's going to be growing Treasury is issue, not just in absolute terms but also relative to GDP. And the question is who are going to be the buyers for that?

Speaker 1: And we'll, we'll ultimately have to wait and see. Uh I'd say one potential vulnerability for the um for the fixed income market are foreign buyers. And if you look at foreign holdings of treasuries um over the past year or so year, year, year and a half, um those holdings have gone down in absolute terms even though the amount of treasuries has gone up.

Speaker 1: And the question is whether that trend could, could continue. And so that is I think 11 supply and demand imbalance that investors should be focused on. Another question in terms of um are there going to be enough buyers for bonds? Is to think a little bit about the trend towards alternatives in portfolios and investors, institutional investors. Um Adding allocation to alternatives

Speaker 1: that's generally being funded from the public markets in their um in their portfolios could be equities could also be fixed income. Private credit is a pretty hot area among a lot of investors these days and as clients sort of seek alternatives to the public markets that, that could put some, some pressure on, on bond yields as well.

Speaker 1: So, um we'll, we'll ultimately have to wait and see. But these demographics are important and you know, are there going to be enough buyers given the increasing debt? And so I think a lot of investors want to say, well, yes, from a yield perspective, the sector does look more attractive now, but um maybe yields are going to continue going up and uh we'll ultimately have to wait and see on that.

Speaker 0: Well, Andy, you better leave it there. Thank you so much for joining

Speaker 1: us. Thank you very much, Jen. Always a pleasure, of

Speaker 0: course. And thank you to everyone watching. Once again, that was Andy Sparks, managing director and head of Portfolio Management research at MS C I and I'm Jenna Dagenhart with asset TV.

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