MASTERCLASS: Fixed Income
- 01 hr 05 mins 59 secs
With the Fed rapidly increasing interest rates to try to reign in inflation, 2022 has been a very challenging year for fixed income investors, but it has also led to higher yields and new opportunities. Four experts share key considerations for fixed income investors in 2023 and give guidance on portfolio construction during uncertain markets.Channel: MASTERCLASS
- Qi Wang, CIO Portfolio Implementation - PIMCO
- Christian Pariseault, CFA®, Head of Institutional Portfolio Managers - Fidelity
- Laird Landmann, Generalist Portfolio Manager, Co-Director for Fixed Income - TCW Group
- George Bory, CFA®, Chief Investment Strategist, Fixed Income - Allspring Global Investments
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Jenna Dagenhart: Hello and welcome to this Asset TV Fixed Income MASTERCLASS.
With the Fed rapidly increasing interest rates to try to reign in inflation, 2022 has been a very challenging year for fixed income investors, but it's also led to higher yields and new opportunities.
Joining us now with some key considerations for 2023, we have:
- Qi Wing, CIO Portfolio Implementation at PIMCO.
- Christian Pariseault, Head of Institutional Portfolio Managers at Fidelity Investments.
- Laird Landmann, Generalist Portfolio Manager and Co-Director, Fixed Income at the TCW Group.
- And George Bory, Chief Investment Strategist, Fixed Income at Allspring Global Investments.
Well, everyone, thank you so much for joining us today. And Chris, kicking us off here. With the yield curve significantly inverted, does that mean that we're headed toward a recession?
Christian Pariseault: Thanks, Jenna.
Timing the next recession is complicated and gaging the severity is equally challenging. As we know, the yield curve's a tool for monitoring investor sentiment, rate expectations, overall economic stability, but the timing is never precise.
So the yield curve's been inverted since early July, but not always reliable. As the old saying goes, "The yield curve is predicted nine out of the last seven recessions." In fact, inverted curves between 1966 and 1998 were not followed by recessions, and you can have anywhere between a four and a 19-month lead time, on average, making it very difficult.
But here's what we do know in the economy, that we are in the late stage of the business cycle, we're experiencing moderating growth, tightening credit. We've got earnings under pressure, we've got contractionary monetary, monetary policy, and inventories are growing.
So when we look at the business cycle and when we think about whether we're going to have a soft landing or not, our feeling is that we're a bit cold for a soft landing, but too warm for a full bore policy response.
So our business cycle framework that we use is comprised of three components, mainly. We've got the profit cycle, we've got the inventory cycle, and we've got the credit cycle. Our models use leading indicators for these cycles. We avoid the lagging indicators that can be subject to revisions like GDP, payroll, industrial production.
With the late cycle probability breaching prior all-time highs, we're looking at signals with profit inventory, credit cycles, they continue to signal recession in 2023, not a soft landing. So we've got some fundamentals that are at historically strong levels. Fortunately for the real economy, this might allow the recession to be shallower than average. But unfortunately for some of the capital markets, because of that strength, we may have seen the last, at least for now, with the crisis era monetary fiscal easing that occurred in the prior two recession.
So we do expect a steeper yield curve as we get closer to a Fed pivot. In December's Fed meeting, the Fed moved 50 basis points as opposed to 75, which we've experienced in the last couple of moves. The Fed tends to cut rates before the onset of a recession.
So the question is, is now the right time for portfolios to add duration? And then the other variable that we have out there is central bank tightening that if you take a look at the US, the Eurozone, Japan, the 12-month change was quite significant during 2020-21 to meet the crisis of COVID. Cumulatively, we saw the 12-month change up to about 9 trillion combined for the US, Eurozone, Japan, and now we're in contractionary phase. If you look at the US year to date through September, they've actually liquidated 44 billion in Treasury holdings and the estimate for total for Q4 will be 180 billion.
So you've got a tighter Red and you've got quantitative tightening. That is an added factor that we're not really used to seeing. So the monetary impacts will be to be determined, but we're probably looking for a slowdown in 2023.
Jenna Dagenhart: Qi, turning to you. PIMCO leverages a top-down, macro-oriented process combined with a bottom-up, specialty desk orientation. And today's environment is one that has more uncertainty given the health of the economy, slowing growth, and potential recession as we just discussed.
How does PIMCO think about portfolio construction given these more uncertain markets?
Qi Wang: Well, the market is always uncertain and I agree with what Chris said about we're going to slowdown and there might be a recession.
But I think the different angle this time is the 12 years since the financial crisis, when you think about a slowdown recession, is a two-factor model whether you have a disinflationary growth or you go to recession. And in the recession the Fed or the central banks can introduce liquidity very quickly.
And this time, I think to that fundamental economic analysis, A, there's a distinction between soft lending or hard landing and also, I think you have to introduce the possibility if a stagflation type of scenario where inflation doesn't come down a lot in a recessionary scenario, so there is a limit to central bank liquidity injection.
Also, I think there's this struggle between the financial liquidity and the real economy liquidity. Maybe financial liquidity is not there and then the gross model of the real economy actually demands more liquidity.
So come back to portfolio implementation, I think when you construct the portfolios in thinking about that four corner outcome, we prepare for some type of slowdown and the soft landing, but really try to protect against that really deep recession without a lot of central bank support-type of scenario. That requires really risk budgeting in thinking about those tail risks and how much we are willing to lose in those tail outcomes.
Also, I think the global business cycles are different, right? Like the ECB and the BOJ might tighten their financial liquidity, but there are other countries that might be able to introduce some more liquidity. So I think from the portfolio construction perspective and really thinking about in the tail scenario, whether there are potential diversifiers or cheaper protections to buy to protect those scenarios. And that's one of the reason I move into this portfolio implementation type of role.
I think in the cyclical and the secular period we're going into, the bottom-up construction of the portfolios, because of the different asset correlation changes and also because of this struggle between the real economy liquidity and the financial liquidity, I think the bottom-up construction angle is becoming more and more important in the investment process.
Jenna Dagenhart: I'm glad you bring up the importance of those tail risks, Qi. Laird, you're known to say that the biggest investment setbacks often come from a failure of imagination. I think that's great. So let your imagination run wild for us.
And could you cite some tail risks that possibly loom on the horizon?
Laird Landmann: Well, I think there's a lot of secular tail risks on the horizon. I think that the degree of change that's gone on in the paradigm that we've lived in for the last 40 years and how far we've departed from that, has not fully been factored in or priced into the market.
So I think one of the tail risks we have is that we'll see something like the '70s and the '80s where we had an inflationary spike, we thought it was over, and then another inflationary spike happens again. And that could be driven by de-globalization, redoing of supply chains, just competition for resource hoarding amongst countries. We're already hearing about talk of rare earth and things like that. So that's one potential tail risk that's out.
There are others. Obviously, an escalation of the Ukrainian situation. I don't even want to use the words of what that escalation could look like, but obviously, that would be terrifying for the markets.
You just have the fact that there's been a secular trend towards the financialization of the US economy. So we've seen bonds and stocks as a percent of GDP rise by about 50%, from about 300% of the GDP to about 450% of the GDP. So just a reversal of that certainly would be a very difficult risk for the markets to deal with. It's the markets doing this to themselves.
You have further deterioration in the crypto world that's out there.
Then you have technology that could play a role in some tail risk shock. You have quantum computing that's out there. So if someone who was unfriendly was to win the war in quantum computing and begin to break encryption around the world, that could exacerbate some of the de-globalization trends that are going on.
We just heard from Lawrence Livermore Laboratories out here that they seem to have been the first to crack the nuclear fusion situation, so that could lead to various disruptions in the energy sector.
So there's a tremendous amount of tail risk out there and I think more than have been there in the last 40 years because we are changing the secular environment. That's the thing I'd really emphasize. We've been in an environment where US consumers have been buying cheap goods for China and China has been financing them for them. And we're moving into an environment where the US is going to be more insular, it's going to be focused on redoing supply chains, we're going to be in severe competition with China. And at the same time, China is going to be going through a slowdown in growth, driven by their population and the fact that their population is going to start declining if it hasn't already started declining.
And that to me looks a lot like Japan, circa 1990. You have elevated asset prices in China like you did in Japan, and we've hit the point where, basically, their population is beginning to decline and that could lead to, basically, the big growth engine of the last 20 years being turned off. So until the world finds another growth engine, that could be also another risk for stocks out there in the marketplace. It might be actually favorable for bonds because you'll have slower growth.
Jenna Dagenhart: George, what do you think is the biggest threat to a fixed income market recovery in 2023?
George Bory: Yeah, Jenna, thanks.
As my colleagues mentioned, the economic backdrop's highly uncertain. But the key linchpin in this entire discussion has to do with inflation. And as Larry just mentioned, there are some meaningful, exogenous factors that are secular in nature that have put tremendous amount of pressure on supply chains, on the price of goods, and importantly on the distribution of labor.
So as we go into '23 and beyond and think about how does that manifest itself in prices and the momentum that we're seeing in prices and the pace at which prices are expected to change that, that really becomes the key linchpin.
Right now you've seen bonds rally pretty meaningfully at the end of 2022 on the hopes that we've seen a peak in inflation, that it's going to be coming down over the course of '23, and that it's going to be coming down both consistently and persistently. It looks like PCE topped out at around 7%, looks to be around 6% now but coming down.
When we look at market-implied both expectations and estimates, there's this built-in assumption that inflation's going to just gradually, well, even more than gradually, persistently come down over the course of the year with very little interruption.
Now any question regarding that trajectory, it's going to have meaningful policy implications. The Fed is its doing its best to hold the line here and say we need to remain tight, we're still battling inflation, and yes we're going to decelerate the rate of rate hikes but we're still tightening mode. The market's already pricing in rate cuts by the end of 2023. And as we heard earlier from Chris and from Qi, that growth expectations are for a moderating growth backdrop, Not really hard landings per se as in deep recessions, but a stalling out.
And it's really unclear if that's going to be enough to create this disinflationary environment to allow prices to have this glide path that creeps gradually down and steadily down towards target.
We don't think it's going to be that easy. The first third of the move as you go from say 7 to 5%, that's very achievable, you can do it in a pretty quick period of time. But as you need to get from, say, 5 down to say 3.5% inflation, it's going to require some meaningful effort. Then that final third, if you will, getting all the way back down to target, that may not be achievable. And if that's the case, that would suggest that the Fed has to stay in tightening mode for an extended period of time and that's not priced in.
So I think the risk as we go into next year is that we get reminded that inflation isn't dead yet and that there will be waves of this and maybe it's trending in the right direction, but this steady, straight line path down to 2% is unlikely and it's going to be a more jagged line. It means you're going to have to be a little bit more patient. Yields will actually end up staying higher than perhaps people expect and that the front end of the curve remains pretty steeply or deeply inverted for a pretty long period of time. I think that's some hope that's been built up towards the end of 2022, and the risk is that some of that hope gets sucked out of the market as we go through 2023.
Jenna Dagenhart: We'll talk much more about inflation in just a moment. But first, Qi, I want to get your thoughts on credit risks. Yields are much higher today, so there's optimism with bonds.
But what vulnerabilities do you see within credit markets and does anything give you cause for concern?
Qi Wang: Yeah, I want to echo what the George said. If the inflation doesn't come down fast enough, if you look at the easing price in the fixed income market by the end of next year and the corporate credit spreads or high yield spreads and more importantly look at equity PE, we're really pricing in that very painless soft landing scenario, which I think the asset market is probably a little bit too optimistic.
So if you think that this inflationary process is not going to be as smooth or as painless as the market is imagining right now, then let's look at the trade.
I think in the fixed income market, the lower quality part of the credit spectrum is going to have a hard time because if the Fed is not going to ease as quickly as the market imagines it's going to be with short rates maybe somewhere between 4.5 and 5.25%, I think the levered loan part of the fixed income universe, the floating debt, the reset of the interest rate part, is becoming challenging.
Also, I think in the economic recession, the lower quality credit and eventually you'll go into some type of default cycle, may not be as high as in the last recession. But in every recession, the default rate picks up.
So in the part of the fixed income market I would be worried about would be the levered loan part of the market and also lower quality part of the high yield market.
Also generally from the portfolio construction perspective, I think we're talking about really the monetary liquidity, both from central bank tightening and from all the QTs everywhere, financial liquidity is tightening up. So even without the fundamental deterioration, I think the liquidity feature, the market really has to pay attention to. So the less liquid the product is, the more problem you potentially can have.
Jenna Dagenhart: Chris, what are your expectations for inflation and what's the impact on portfolio diversification going forward?
Christian Pariseault: So George made some really good points and we tend to agree. Everybody's going to be focused and continually focused on the CPI print. So we saw that in December. And if we see that falling, I think the market's going to get a little bit more comfortable and I think the Fed will, as well.
So the December 12th inflation report brought quite a bit of good news and that the disinflation phases in motion, if you will. So headline core CPI came in softer than expected, bringing us just over 7% year-over-year on headline and 6% on core. So this should bring some relief to the Fed. But we think that the labor markets and wage growth are going to be key in determining the stickiness of inflation once the dust settles. So is it possible to get to 4% next year? It's possible, but as George mentioned, it's hard to see a straight line to get to there.
What we have seen this year, in terms of correlation, and if you look at the 60/40 portfolio, it's been a very painful ride for the 60/40 portfolio. Back in the fall it was down 30% that approached lows that hasn't been seen since the 1920s, so a really rough year for 60/40 portfolio. That was because of increased correlation between stocks and bonds. In a rising interest rate environment, the stock market, of course, gets affected by the prospect of lower economic growth, so that affects earnings. So the denominator in the PE, so multiples go down. You have competing returns from other investments.
So around the hallways of Fidelity when fixed income used to have to follow other asset classes in the asset allocation pecking order, we would usually be last in terms of expected returns. That conversation is definitely turning around.
Then when you think about the regimes that we've been in. So if you go back to year-over-year inflation, we went from the 1960s, where in the 1970s we started to see year-over-year inflation tick up. It got to a high point of just shy of 14% in 1980s. Then, we've been on this secular run of inflation getting attacked first by the vocal administration bringing it way down and then it's been at this 2% run rate for a very long time. So we've had this higher inflation regime. Then, ever since 2001 we've been in this lower inflation regime. Actually, since the mid-1990s, candidly.
So then you've got a situation where correlations between equities and fixed income were pretty high all during that higher inflation period, all the way back from 1968 all the way down to 2001. Then we had negative correlations between equity and fixed income all throughout the 2000s, 2010 and into 2020s. Now we're seeing a tick back up again.
So the good news, I think, for fixed income and equity portfolios is we've only seen... If you look at the Agg for example, the Bloomberg Barclays Aggregate Index, we've only had four negative return prints in 50 years. So that's not a bad track record.
This is only the third year, by the way, where bonds and stocks were down together in the past 100 years. So those are meaningful correlation benefits for fixed income relative to equities.
The good news is income is returning to fixed income. We've spent nine out of the past 14 years with Fed funds at a zero rate. And today the yield is five times on the index, what it was two years ago.
So to wrap, we've got stronger nominal and hopefully positive real returns with inflation, hopefully not as much of a factor and then bonds hopefully will keep their expected diversification benefits over the longterm, going forward.
Qi Wang: Can I jump in just with one comment on that? See, when people talk about the 60/40 portfolio, when you think about it this year, the beating is taken. Actually, the only repricing it has done because the real rates across the curve repriced by 300 to 400 basis points. So you will say in cash balance, equities and commodities, the only reprice that has happened in the financial sense is that the real rate structure. So you have the whole real interest rate in the US priced somewhere around the 1.5%, give and take. For sure, if you buy inflation-linked bonds, you are going to get a positive, real yield if you think the inflation is measured correctly.
And I would say, yeah, the inflation, we may still have some tailwind, the inflation not coming down enough and then the fixed income may still get repriced a little bit. But from this point on, at least from the real rate perspective, I think most of the beating has been taken by real interest rates in the fixed income. From this point on, if you want to have the slowdown expectation, that 60/40 portfolio to get any return, most of the heavy lifting has to be done by the 40 part. So from that perspective, I'm actually very positive on fixed income returns, both from real and the relative space, relative to equities.
Christian Pariseault: Yeah, I totally agree with that, totally agree with that. And hopefully, yes, the worst is over the 60/40 portfolio and you get that bond portion to work harder for you.
Jenna Dagenhart: Yeah, those are great points. Thank you.
Laird, turning to you. Do you think inflation is peaked and is there a wild card of a surprise out there? What's the secular case for persistently higher levels than the disinflationary era of the 1980s through 2020 that we were just discussing? And how about a possibility of a return to those muted days of price pressure?
Laird Landmann: Well, it's interesting to see how wrong economists can get things. I mean, the last 30 years, it's just been paper after paper about how the Phillips Curve is dead, there's no trade-off between inflation and employment anymore.
Really, what we were probably seeing is the fact that we had this huge, overriding secular trend of disinflation being brought on by globalization. And that is, as I mentioned, probably going to be at least slowing down, if not going in reverse. The outlet that China was in terms of labor cost pressures is probably going away.
Locally, have we peaked on inflation? Yeah, I think we've had a local peak on inflation. Inflation will come down. It may come down more than people expect, given the direction the discussion was just in. But it may be very quick to go back up again once we get through commodity priced disinflation that's baked into the market at this point.
But the real question is, do we get wage inflation down? That's what will keep inflation sticky over the longterm. And if you look at... It's called the Beverage Curve, if you look at job openings versus unemployment, there's still many, many more too many job openings. It's come down a little bit. But it doesn't seem likely that wage inflation is coming under control anytime in the very near term.
Because of that, we would expect that inflation will run above the Fed's targets for a little while. It might crash through the Fed's targets for a moment, but it'll quickly rebound. And the struggle to keep inflation under control on the part of the Fed will go back, surprisingly, most likely to being a Phillips Curve type of argument going forward. Unless there's some sort of exogenous shock and you find that there's a new labor outlet, whether it's Africa or India, where we're able to basically continue this globalization that created the disinflation we saw over the last 40 years.
I mean, there's a couple other secular trends that I think for active managers are really interesting. I think all of this is going to create more volatility, which is whether you're a tops-down manager, a bottoms-up manager, this is going to be good for active managers. The volatility suppression that we saw from central bank policy over the last 10 years obviously has made for a pretty difficult environment for active managers.
And there's another secular trend that overlays this, which is that the amount of balance sheet that the market makers are contributing versus the growth of the financial markets, it's just been going down steadily. So the individual volatility we would expect you're going to see in corporate bonds, in structured products, et cetera, for those who are willing to provide liquidity in difficult times, there's going to be a lot of opportunity out there. So basically, TCW sees a tremendous amount of opportunity in fixed income, not just in the next year, but going forward because there'll be more volatility and more opportunities.
Jenna Dagenhart: George, do you think that the Fed can actually control inflation?
George Bory: Well, indirectly, yes. They have a big challenge ahead of them. And what seems to be clear is that if we look back through time, going back several decades, longterm inflation rates tend to be closer to 3% than to 2%. So getting all the way down to target's going to be a real challenge, we think.
But one thing that does stand out to us is, in past cycles the Fed has typically gotten policy rates, either Fed funds or T-bills depending on how you want to measure it, but the very front end of the curve, usually has to get above the spot inflation rate and then stay there for a persistent period of time. As we've just discussed, we've seen a material repricing in real terms across the curve and Powell has been pretty explicit that having positive, real yields is an objective of his.
But first and foremost, they need to get policy rates above the inflationary rate and that we're clearly not there yet. Inflation's, let's say, around 6% and coming down. Fed funds is at 4.5% and going up. Those two numbers should cross at some point in the first half of next year or of 2023. And when it does, then the whole discussion changes. Because the Fed can be perceived as being effectively ahead of the curve.
And what Larry just mentioned, about the Fed being able to be a little bit more, I think, responsive to the cyclical pressures rather than one-dimensional and focusing as we've seen over the last, call it, 15 months exclusively focused on inflation, they become much more balanced in their approach of which segment of the market, of the economy are they trying to control.
But we know they don't directly control inflation and it's only through growth and the labor market and ultimately, around earnings and demand that they can actually control. So these lags are significant and is one of the reasons that we think you're going to face a much more choppy year.
And the point that Larry just made around volatility can't be stressed enough. Really, there's a combination of macro-exogenous shocks that create volatility, but it's further compounded by the major shift in central bank policy, both from a rate perspective but also from a balance sheet management perspective. Globally, you have this massive suppression of volatility that has been released and is being released into the market and that is going to continue. So that's a more typical, pre-credit crisis environment and during that environment, yields are higher, positive real yields are more achievable, income is a much bigger driver of your portfolio because of that predictability of yield, and then the ongoing compounding at much higher rates becomes a much stronger ballast in the portfolio.
So the short answer to the question is, does the Fed control inflation? And I think the answer is sort of and not directly. But they do have to manage around it and they need to just get ahead of it. That's been what all of 2022 has been, is them trying to catch up to where the market is. In 2023 they should get ahead of the curve and then we're going to see a much more, we think, tactical and finessed strategy that might be up, it might be down, but it's going to be a lot more tactical than this one-directional trend that we've seen for the last 15 months.
Jenna Dagenhart: All eyes are clearly still on the Fed entering 2023. Qi, although though it seems like we're close to the end of the hiking cycle, what's PIMCO's view on the Federal Reserve's future path?
Qi Wang: And I think there is, at least for the time being, it seems they can go another once or twice and probably going on hold. I think the Fed has communicated that way and they are moving the focus from how fast and how high interest rate has to go to how long they're going to hold at that level and give the market some time and to see how the inflation process works.
But I think the debate is moving to inflation is going to come down but at the higher rate level, as Fed funds goes to 4.75 or 5%, how fast the inflation is going to come down to their target? And I think that's really where the big contention is. How fast it's going to come back and the whether the 50 basis point priced cut for later 2023 is going to come through. And that, I think, market probably has a little bit too much optimism or confidence that the Fed is going to turn around and cut interest rate. We don't have that much confidence in the inflation really going to come down to target that soon for the Fed to reverse course and cut interest rate.
Jenna Dagenhart: Laird, where do you think the Fed goes from here? How long can they hold out until a necessary reversal?
Laird Landmann: Well, I think we don't give them enough credit for being sophisticated when they speak and we give them too much credit for being sophisticated when they put out a forecast. I think when they go to a conference, like Powell did, and speaks fairly dovishly, he knows exactly what he's doing. He's looking, he's seeing the fact that financial conditions have tightened much faster in this cycle than any other cycle in modern history. And he's saying, "Well, I want to slow this down a little bit."
Now just the other day in December, we were released basically their forecast and the market got very pessimistic about it because they were suggesting that they were going to hold rates high for a while as was just suggested. And I'm sure that that is their objective, they'd like to do that. But they don't have any more clear view into what's going to happen in the future than any of us do or for that matter, anybody. So they have an objective they'd like to hold, get rates higher. I agree that it's probably one or two more hikes and then they're going to wait and see.
Chris mentioned that monetary policy works with long and unexpected lags. So I think at some point you have to wait and see those lags, how they're going to affect the economy and they know that. Whether they get to hold rates for the rest of 2023 in the 5s somewhere, that will be determined by basically how the economy responds and how this financial tightening comes through the economy and how much the labor market weakens, which are very hard things to forecast at this point. We would suggest that they probably won't be able to do what they want to do. But all those forecasts mean is they're just telling us what they like to happen. They're not telling us what will happen.
Jenna Dagenhart: Given where rates sit on the front end of the curve today, George, how should investors think about short duration bonds in their portfolio mix? I mean, these yields are very attractive.
George Bory: Yeah, they are very attractive. And when you look at the front end of the curve, just going back to what we were talking about before, in terms of where rates were just 12 to 15 months ag, relative to where they are now and thinking about the amount of volatility that is in the market today, you think about the two-year yield at, call it 25 basis points or so, maybe a little bit higher about a year ago. Your break-even, your ability to absorb volatility, is de minimis. There's really not much in a bond, even a two-year bond, with that low level of yield to be able to absorb any price volatility. So bond yields only needed to go up 15, 20 basis points before you were actually losing money over a one-year holding period.
But you fast forward to today and that break-even is now tenfold what it was a year ago and that, to us, looks very attractive. And we can talk about these different scenarios. But as Laird just mentioned, we're all talking about what's going to happen in the future. It's very difficult to predict. We can come up with scenarios and ways to manage around it and the active management aspect of our job allows us to do that and hopefully allows you to position yourself to beat some of these challenges. But in reality, your biggest buffer is having a lot of cushion in the trade.
So when the two years at 4.25, 4.5%, well, bond yields could go all the way up to 6.5% before I'm actually going to lose money over a one-year holding period. That gives us a lot of confidence that this is actually a relatively attractive entry point. We can also talk about real yields. We can go down in the rating spectrum.
But we can look at the factors that drive fixed income portfolios and the risks that tend to detract from performance as we go through time: it's inflation, it's credit migration, it's defaults, and it's liquidity. When we look at today's market and we start to dissect those segments of the market, you're being paid fairly well for medium-term inflation expectations. You're being paid fairly well for the extra risk premium to take credit migration risks, so more like investment-grade risk. You're even being paid well to go all the way down into high yield. And this all harbors in the front end of the curve. You don't have to take a lot of duration risk today. Now you can and there's reasons to do it.
But from a very pure yield capture and volatility-adjusted yield opportunity that three to five-year part of the curve to us it looks fantastic right now, quite honestly. Because you are being compensated for every one of those factors and then some. And that's very different from the type of market we've been dealing with for the last, let's call it, 15 years.
To just go back to what I think Qi mentioned earlier is there's been no alternative, the whole TINA notion. There's been no alternative. You had to buy either private credit or private equity or real estate or very illiquid securities to be able to capture any incremental income and/or try and set up your return targets.
But now with the full repricing of the bond market, the short message is, "There is an alternative." We're in a TIA environment. There is an alternative to just pure illiquidity or to pure private strategies. Publicly-traded bond markets now provide you with positive real yields, a generous credit buffer, and even a liquidity premium that we haven't seen in 15 years.
So the shore message is, the front end of the curve looks pretty attractive right now and we're trying to exploit it as much as possible in all of our portfolios.
Qi Wang: Right. Or even, I would say, in a very negative environment for fixed income, I know a few panelists to worry about we go back to late 1960s and '70s or '80s in the high inflation era. And if you look at historical returns, I mean, even those period, with the exception of commodities in the financial universe, cash and the really short term fixed income was the only one that gave you some positive return. Because you get the income, you wrote to cash, and then we invest short.
So I think anyway you look at it, when you think about your different quadrants, we're still repricing cash plus a credit spread in the shorthand of the US fixed income in the financial space is really the most attractive thing there is. I mean, certainly, if you think we go to a deflation scenario, you can go out the curve and get long duration or real rates, you think you go negative again. But shorthand, is really something gave you a lot of protection, low volatility, and a lot of income. And short duration, you can also roll some to cash, gave you a lot of flexibility, as well. So I totally agree with that.
Laird Landmann: I would just add that there's a risk that we haven't taken into account, which is that all these developed economies are running more than 300% debt to GDP. So the likelihood that we stay at high rates for a very long time, I think, is exceedingly low.
The Federal Reserve and the federal authorities can enact financial repression in one of two ways. They can keep inflation higher than interest rates. That has been rejected soundly because it taxes the average person just as much as it taxes savers. The other way to do it is the way we've been doing it, which is to keep real rates of return extremely low. So I do think that when we're sitting here in a 1.5%, potentially, real rate environment, it's extremely attractive. It won't last for a long time. So yes, you want to own short maturity securities.
But I worked at a firm in the beginning of my career and a very famous portfolio manager said to me, "Laird, go down to the copy machine and make me as many copies of the two-year note as you can." It took me a moment to figure out what he was talking about, but what he meant was, "Go get me leverage to the two, three, and five year area of the curve because I want to own a lot of duration but I want to own it just in that area of the curve." And I think that's what you're supposed to be doing right now and people are going to make a lot of money when this yield curve normalizes, if they're able to do that.
Jenna Dagenhart: Laird, sticking with you, while the rate environment being so much higher than a year ago has been a design to slow demand and curb inflation, this could also hurt the financials of debt issuers. What debtor entities, governments, businesses, anything else, do you think we'll fare better or worse throughout this upcoming period and why?
Laird Landmann: It's an interesting moment for that because when you look at consumer debt burdens, you can go back 30, 40 years and the consumer's in as good a shape as they've ever been. When you look at the delinquencies that are coming through in bank statements, they're going to go up, but they're still relatively low. When you look at corporations, corporate credit seems to be, for the most part, you can find zombie companies always, but it's really going to be about selection within that. Companies that are most hurt by the higher interest rates, those that didn't hedge loans, were mentioned as a potential problem area. So those companies that have a lot of exposure to floating rate instruments and didn't put swaps on the other side of it will be extremely vulnerable.
But where you're really worried in this environment is about government debt. That's, really, in most places where we have a debt overhang.
One of the off the wall black swans that we didn't talk about in the first question was, what if there's some a debt crisis?
We saw one briefly occur in the UK. But if rates stay high and the US keeps rolling their debt here and debt interest costs go up dramatically, you could see basically fears around that begin to materialize.
So I would mainly be worried about the self-feeding nature of higher interest rates, they lead to higher debt costs. You look for issuers who will be exposed to that.
Certainly, housing collateral and commercial real estate collateral is going to suffer here. You're going to have to have a normalization between cap rates in commercial real estate and actual funding rates, particularly for newer projects that are out there.
But if you're buying residential real estate that's several years seasoned with low LTVs, that is the place we would most want to focus portfolio right now. Whether it's agency mortgages at low dollar prices, high spreads, whether it's legacy, non-agency mortgages from before the great financial crisis that have 45, 50% LTVs. These will survive a minor housing downturn, which is almost certainly coming and will be the place to really focus.
Because the consumer, the debtor, is in good shape. The collateral is very much above water, as we would say. So you're probably investing in some of the securest things there and you're getting paid for the illiquidity very, very handsomely right now.
Jenna Dagenhart: Chris, what are your thoughts on credit spreads?
Christian Pariseault: I'll agree with Qi and the fact that we want to own good paper in this environment. Because as you've seen the market back up as much as it has, it's all been a rate story. So yields are very attractive. But in high yield, the average going back 35 years for high yield spreads is about 540. Right now we're at about 437. Investment grade is about average. Emerging market, that is about average.
So there isn't really anything necessarily from a spread perspective to get too excited about. Corporations still maintain solid financials, for the most part. Revenue, EBITDA well above pre-COVID levels. Leverage has been reduced, as Laird was talking about. Liquidity is solid. I think a healthy US banking system adds a critical layer to robustness. So having banks have solid balance sheets is really critical.
But the pressure going forward is going to be on forward-looking earnings and those are experiencing a deceleration from what we've been used to, which has been double digit earnings growth. So you get a strong dollar, you got weak global growth that are also going to weigh on profit.
From a valuation perspective, spreads are wide in financials. There's year to date supply that's been pretty hefty, spread pressure in the Yankee bank sector, so US bank sector more specifically. Manufacturing, auto REITs, pharma have outperformed more recently. So it depends. It's almost like with spreads being in the 30 to the 40th percentile, it's almost like being in the middle of a field of the World Cup. Nothing really happens there.
So I think it's really getting the bonds in your portfolio from a credit perspective that you feel really comfortable with and just holding those for now. The long end of the curve feels a little risky in terms of taking on spread duration out the curve right now until we've got a little bit more clarity on what the Fed is likely to do. But that's our feeling. I mean, I think having that higher quality carry, not trafficking down the credit curve, and just holding bonds that you know and you like, make good sense in here. And that really applies not only to investment-grade credit but certainly high-yield leverage loans as well.
George Bory: Yeah. So just picking up from what Chris said about credit spreads and the fact that credit spreads look to be very mid-cycle level. They look effectively fair value from our perspective and it has to do with what the construct of the corporate sector looks like today and what's unique about this cycle.
Many companies borrowed money, a relatively large amount of money, at a very low borrowing cost. That gives them tremendous financial flexibility as we move through time. Now it doesn't last forever. As rates go up, they will start to experience some degree of credit deterioration and funding pressure. But further time being, and we think well into 2023 and even to 2024, that default pressure from funding costs and from acute borrowing needs is actually going to be fairly limited.
So while credit spreads look on the tight end of the range, they can stay pretty tight. And we think that the publicly-traded part of the corporate bond market is actually in pretty good shape in this cycle and it's very different than prior cycles.
The most acute pressure is in the loan market where companies have either borrowed, levered up meaningfully. They might be private type credits that have levered up and are now having to absorb that rapid increase in borrowing costs with not a lot of ways to finance their way out of it. So that distinction in financial flexibility, it's going to be a really powerful force over the course of this year and next.
Jenna Dagenhart: Now with this new value proposition for bonds, how should investors think about their bond allocation today, Qi? And for 2023, what parts of the fixed income market do you feel are primed for success?
Qi Wang: I think I'm pretty optimistic about, actually, the whole spectrum. George just talked about the lower quality part and also floating rate part might run into a big some type of a problem, depends on how severe the slowdown is going to be and how long the Fed is going to hold interest rate at this point.
But I think the fixed income right now at these yield levels, both in terms the shorthand nominal yield and in terms of the long and the real yield, I think it really gives one both the income opportunity and also capital appreciation opportunity. For the past 12 years, I think people invest in fixed income as a diversifier of the portfolio. But right now, I think fixed income really has a lot of merit on his own feet from the portfolio diversification perspective, from the income perspective, and from just really the capital appreciation perspective. So I actually quite optimistic.
Jenna Dagenhart: Chris, turning to you. With the significant negative returns that we experienced in 2022, do you think the worst is over for fixed income? And what parts of the fixed income market look most attractive to you?
Christian Pariseault: Well, I'll speak for Qi and George and Laird and say I certainly hope so.
We have had returns on the Agg... Agg's been down about 12%. 30-year Treasuries down over 30%. High yield down 10%. Stocks down 15%. So, ugly, no matter where you look.
But as I think all of our speakers have said today, yields are attractive again. So you've got a yield on the Agg of about 4.5%. Credits about 5.2%. Then you've got high yield at 8.5%. So that gives you a lot of room for forgiveness.
And if you think about it just from a client perspective, a lot of our corporate pension plans, for example, have their rates of return at about 7%. So if you've got fixed income eating up most of that return target, that's a pretty good thing. We haven't had that in quite some time.
And I also agree with the defensive nature of carry in a portfolio and you can afford some price instability if you've got positive carry in your portfolio, which we have not had in this low for long environment. So it feels good to have that again.
I do think that the worst is probably over for fixed income. It's highly likely that we're finally nearing the end of the fastest tightening cycle that we've seen in over three decades.
Volatility remains elevated though. The pace of global monetary tightening has accelerated, albeit in the December meeting with the Fed, we've seen it notched down a little bit, but it has been accelerating, but at a little bit of a decreasing pace now. You've still got the Russia- Ukraine crisis, the unwind of zero-COVID in China, the dollar continues to accelerate by and large, and you've got Euro weakness. So the US continues to be in late cycle. You could say the Euro economy is already on in recession.
But in the US, you've got consumer spending, the labor market being the bright spots, business spending is a bit weak. And in the labor market, you've got strong but higher mortgage rates, tighter financial conditions, negative real income growth and moderating economic activity. Those things are going to send, in all likelihood, a negative pulse over the coming quarters.
But for active asset allocators, bonds are pretty attractive right now to get some yield. And if you are a bit bearish on equities, bonds are not a bad place to be to wait for more drawdown on stocks.
But I do want to reemphasize that when it comes to credit, you've got to buy what you like and there's no real need at this point in time to go aggressive and lower quality. Having said that, if high yield backs up a couple of hundred basis points from here, I think we get really excited about that, but not until then. And when that happens, you're probably looking at another 15% draw on the stock market. So bonds will have been a good place to be. Then stocks at that point in time are probably a 15 to 17 PE and then you're competing for cheaper valuations across most asset classes.
So in our view, I think the bond market could probably do some mid to high single digits over the next couple years, maybe even higher.
Then in terms of picking our spots and where we'd like to be, again, I would emphasize being more along the lines of a bit underweight in nominal US Treasuries. We don't have any exposure to TIPS right now. But having a slight overweight in high yield bonds and leverage loans and even a little bit in international credit, we feel pretty good about, given some of the spread that we're getting there.
Even though agency mortgages have backed up a little bit, relative to everything else, we don't get too excited about agency mortgages in here. But having said that, reflecting some of the things that Laird had talked about, the US homeowner, if you own a home and you've refinanced, there are very few 15 and 30-year mortgages that are going to reset higher, that aren't locked down already. That is not the same picture in Europe, that is not the same picture in the UK.
And so the US consumer is in pretty decent shape and that's why we think that we're probably going to be in somewhat of a shallow recession, if and when we do get one next year. So it's going to have some slight pressure on spreads. But owning corporates in the right part of the curve, where you can get some roll down and some good price appreciation from the steeper part of the credit curve, makes sense for us. We think seven to 10 years makes good sense in here. Then remain tactical, have some dry powder in the portfolio to take advantage of potentially a better spread environment.
But like I said, when the asset allocation team is calling for an overweight in fixed income, we're in a good spot because those types of calls haven't really been happening to us in a few years now.
Jenna Dagenhart: Laird, you raised some important points around housing earlier. Turning to commercial real estate, the landscape there has really changed a lot in recent years as well: brick and mortar retail, pandemic effects on hospitality, work from home arrangements. How can these avoid a massive devaluation?
Laird Landmann: Yeah, I think we very much like the structured product side of the trade. We take the other side, the government guaranteed side of mortgages that are affected by volatility, extremely cheap volatility is very high, but we know volatility comes off.
When we get to the credit side of it, we're very much with the homeowner at this point. We're buying things that we're trading at 60 over in December of last year that are now trading 280 over, that are AAA-level investments with seasoned collateral.
But when we get to that CMBS sector, yeah, we're concerned. Basically, we see that the work from home trend, the retailing on the internet trend, all of these things are basically knocking bits of the demand curve out from underneath the commercial real estate market. And when you analyze a business or any sector... I think I'll date myself. It was Cheech & Chong who said in their five-minute university, "Economics, all you need to know is supply and demand."
So when you look at these demand curves getting hacked away at, particularly on the office space, there's a tremendous amount of risk here and it's happening in slow motion. There's going to be a lot of people who get caught in this debt, it's not particularly liquid.
So we believe in having a pretty stark underweight, particularly to the office sector, particularly to some of the regions that were hot prior to this. You think about San Francisco, Los Angeles. Some of these places are going to approach 30% vacancies. You have record levels of sub-tenancies up for lease, people trying to get rid of space at this point. So we're very, very concerned about that market and that's the only place really within the structured product market that we are not actively finding tremendous value. And it's not that the spreads aren't wide, the spreads are getting wider and wider, but when you look at the degree of leverage and the degree of adjustments... In San Francisco, in particular, we've seen office buildings basically getting transacted at 50% of their original appraisals and lower. That begins to wipe out BBB holders in the cap structure, A holders, AA holders, and it begins to touch AAA holders.
So a great deal of concern around it, the amount of restructuring that's going to have to go on in particularly the office space area.
Jenna Dagenhart: Finally, let's talk a little bit more about munis. George, how would you consider the opportunity set in municipal debt to be for investors, specifically tax-sensitive ones? And as we wrap up this panel discussion, what approaches do you think investors can take to global fixed income investing for finding yield enhanced strategies?
George Bory: Yeah, yeah, no. I think we've touched on a lot of topics and I think the most important one is volatility.
Volatility spiked meaningfully this year. It's likely to persist as we go into next year. So the active approach certainly should do well in here. As you think about investing tactically or at least actively, to us, it's comes down to three things.
Number one, keep your horizon realistic. It's good to have an eye on the long term. That's certainly where a lot of our clients are. It's where we need to think about where markets will get to. But we invest in this somewhat near term and having a six-month horizon that you roll through time. Good, good portfolio management.
The other really has to do with, within any cycle there are sub-cycles. Identify themes, there are sub-themes. We just heard of a few. We just talked about the real estate mix in your portfolio, critically important.
Municipals, really interesting part of the market. It's a huge part of the market and it's done very well this year in the sense that munis tend to outperform in a rising rate environment and they've done so this year. When we look at, say, tax-adjusted yields relative to the taxable universe, tax exempt still actually has some pretty good value. When you think about the muni market at call it roughly about 3.5%, you growth that up and you're talking about a 4.75, almost 5% type of yield equivalent. And that's well above Treasuries. It's in line with, say, A corporates, as we've just heard. So there's a really good value proposition to get some diversification into your portfolio.
Munis have a cycle that runs different than, say, corporates or real estate or other things. It's still going to have interest rate sensitivity, but it's a nice diversifier and we find a lot of value there.
Then the last is, as an investor and being in bonds for well over 30 years, you have to be honest with yourself. You can't be biased as we go through these markets. So that volatility manifests itself in a lot of different ways. And you want to have a fresh perspective every time you re-look at the market. Because valuations are changing, they're changing quickly, the backdrop changes very rapidly and you want to be able to respond to that.
So from our perspective right now, we have this, what we call a five-pronged approach.
Number one, you do want to be tactical with your duration trait. Yields are high. Policy's moving to your advantage. So we talked about yields, backing up, adding and having some duration and being willing to tactically hold that in your portfolio makes a lot of sense right now.
The most important thing in the portfolio, number two, it's positive real yields. Qi mentioned it earlier, we've been talking about it throughout the meeting. This is by far the most attractive value component.
Third, corporate credit. There are a lot of moving parts up there. You can move up in quality, but don't ignore the technical. So technicals are actually working to your advantage.
Structured product, we've already heard about it. It's a stable cash flow for an unstable environment and there's a lot of value there.
And as I mentioned, Munis. It's just a good place to park money. You've got the good core anchor tenant from a lot of individuals, but really you get that nice diversification.
So there's a lot to do there and by pulling that all together, you create a very nice, consistent cash flow stream that can meet the liabilities of your clients. And that's what bonds do, they create good lon-term cash flows that can meet obligations for corporations, for individuals, for pension plans, for endowments. And that's precisely what everyone on this call is doing, day in and day out.
Jenna Dagenhart: Well, I wish we had another hour here to continue the conversation, but we better leave it there. Really appreciate everyone joining us, and thank you so much to everyone watching this Fixed Income MASTERCLASS.
Once again, I was joined by Qi Wang, CIO of Portfolio Implementation at PIMCO; christian Pariseault, Head of Institutional Portfolio Managers at Fidelity Investments; Laird Landmann, Generalist Portfolio Manager and Co-Director of Fixed Income at the TCW Group; and George Bory, Chief Investment Strategist, Fixed Income at Allspring Global Investments.
And I'm Jenna Dint with Asset TV.