Fed Up With Rate Hikes?
Is the latest raise enough to bring the economy in for a soft landing?Download PDF
We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to get his insights into recent market action, the Fed’s next move, the state of the economy, and opportunities in fixed income. We finished up with a speed round of questions and a personal reflection.
In July, U.S. equities had a strong month, while fixed-income performance was mixed. What can we take away as we head into August?
When looking at the equity side, for the first time in a while, the S&P 500 Equal Weight Index, and the Russell 2000 Value Index outperformed the S&P 500.
But for this year so far, the tech-heavy Russell 1000 has led the way—up 33%. That’s a staggering year. We are seeing more breadth in the marketplace with small caps and the equal weight index outperforming.
Total Return for July and Year-to-Date
What about fixed income?
The 10-year U.S. Treasury is above 4%—the highest for the year from a yield standpoint. Credit performing well, primarily due to coupon. Bank loans and high yield were up 6 to 7% through July and on track for high single digits, low double digit returns for the year. Meanwhile, the Bloomberg US Aggregate Bond Index (Agg) has been impacted by rates moving higher, so it’s sitting at a lackluster 2% for the year. With the strong performance of equities, balanced portfolios should be having a nice year.
Let’s move on to the Fed. What does the central bank’s 25-basis-point raise in July mean?
I hope it means it’s the last hike. Right now, the fed funds rate is at 5.25-5.50%. That’s much higher than people expected going into the year. The Fed is leaving the possibility of up to two 25-basis-point hikes by the end of the year, but the current odds for a rate hike in November are 38% with expectations to skip a hike in December. For 2024, the market is predicting four to five cuts, which would take the overnight rate down to the low fours.
Federal Open Market Committee Dot Plot
Performance After a Fed Pause in Interest-Rate Hikes
If July was the last hike in this rate-hiking cycle, what should investors keep in mind?
When you look at the last rate-hike cycle, the Fed paused in late 2018 at about a 2.5% overnight rate. Over the next year, risk assets did quite well. Agg was up 10%, investment-grade bonds were up 16%, high yield was up about 10%, and the S&P 500 was up 17%. I think the difference back then was we were uncertain when Fed was going pause. Today, the market is expecting a Fed pause.
What curve ball could derail the Fed’s current narrative?
One curve ball is if inflations drops substantially and/or unemployment rises faster than expected. In that scenario, all of a sudden you have a significant real rate of return on the Fed or weak job market, enticing the central bank to cut sooner or more aggressively than they may be thinking.
Do you think the economy’s coming in for a soft landing?
The economy is expected to soften in the next few quarters, which is why you’re seeing both the Fed and the market forecast rate cuts for 2024. There’s hope right now for a soft landing. It seems to be going that way, but we’re still flushing the excess money that came in during the early stages of COVID. We’ll see.
What grade would you give the Fed based on their actions over the last two years?
Three or four months ago, the Fed was more hawkish than the market, and since then, it appears the Fed has been on the right side of that trade. For that, I’d give them a high grade. However, I still believe they were very late on the inflation side. Overall, I’d probably give them a B at this time.
Consumer Spending Year-Over-Year
Let’s talk about the economy. How’s it going and where’s it heading?
Let’s start with second-quarter earnings. About 60% of the S&P 500 have reported. That’s a little over 300 companies, and 65% have beat on sales estimates. Eighty-one percent of the companies that have reported have beat on earnings, according to Evercore ISI. Market expectations were expecting a down quarter from an absolute standpoint, and sales were up marginally, about 30 basis points. Earnings growth was actually down 7.5%, even though 81% of the companies reporting beat estimates.
When looking through to specific sectors, second quarter earnings of energy companies were down about 50%, healthcare was down about 33%, and materials were down about 30%. Conversely, consumer discretionary was up over 33%, and industrials were up 17%.
In general, the market beat expectations. A soft second quarter was expected, but the companies performed better than predicted.
How’s the consumer spending holding up?
Let’s compare the last week of July this year with the same period in 2022. From the standpoint of general consumer spending, it’s up marginally over the past year, according to Bank of America credit-card spending data. So that is an indicator that things are not as robust as people may feel. Behaviorally, consumers are still spending on experiences. For example, entertainment and restaurants are up double digits year-over-year.
What’s the most optimistic view and the most pessimistic view of the economy?
First, I’ll take the optimistic view. The Fed narrative changes to a slightly dovish tone, which means July was their last hike. Inflation rolls over. Then you have a situation where the S&P 500 still has their pricing power, but margins improve and you have a shot to 5,000. Add to this, consumer spending remains resilient. Here’s why I think you can make that case: Today, there’s approximately $11 trillion in home mortgages, 90% of them are fixed rate. And of those, about 60% are below 4%. So, most homeowners are not paying a high financing rate, and more importantly, their payments are fixed.
Yet the “owner’s equivalent rent,” which makes up about a quarter of the Consumer Price Index (CPI), is showing year-over-year growth of 8%. But if you’re on a fixed-rate mortgage, you don’t get hit with that element of the CPI. I think that prints an artificially high CPI number for owners, which means the consumer has more purchasing power than we think. That is an optimistic view.
Okay, what about the pessimistic view?
That would be the economy slows quickly, layoffs start, and inflation rolls over, but the Fed stays hawkish because inflation still sits above their 2% range. Then velocity slows further, financial conditions tighten, and the negative feedback loop starts.
What did everyone pretty much get wrong at the start of the year when expectations were nearly 100% for recession in 2023?
I thought that we’d have lower rates. We’ve seen the S&P up 20% in the first seven months of the year, the 10-year Treasury is now over 4%, and the Fed has been raising rates more aggressively than many expected. So, I’d say on the rate side, most Wall Street forecasts and pundits have been incorrect.
I’m pleasantly surprised with the 10-year Treasury above 4%—I think it makes bond yields very attractive. But certainly, many people, including myself, have been incorrect about the strength of markets.
Opportunities in Fixed Income
Where do you see opportunities in fixed income today?
In general, I’ve been constructive on credit now for over a year, and I remain constructive on credit because I believe an investor is getting compensated for the risk they’re taking. So far this year, high-yield bonds are up 6 to 7%. Floating rate is up 7 to 8% in total return, and you’re still getting compensated with a 10 to 11% yield. You’re not taking very much interest-rate risk, but you’re getting compensated quite heavily for credit risk.
In the meantime, with the 10-year Treasury moving to over 4%, I think the investment-grade side now has yields above 5%. If you believe that the economy will slow down and that rates will be lower in the next year or two, taking on some duration also helps. I’m still a proponent of the barbell, which I think gives you quite a bit of compensation on the credit side in floating-rate loans and you’re also getting compensated to take a position in duration-based assets. A core assumption is the 10-year Treasury has a better chance to go from 4 to 3%, than it does to 5%. Overall, I think credit has compensated investors nicely.
Do you have growing concerns around defaults?
My concerns are on the margin right now. The economy is performing better than expected. Companies have done a better job managing their balance sheets. We haven’t seen as many leverage takeouts as when private equity was extremely active back in 2018-19. It is expected that defaults will rise, but not to a level that’s unmanageable. I also think what’s going to be telling over the next six to 12 months is the access companies have to the markets. In other words, if they need to refinance or they need to raise more capital, how open will the markets be? Right now, for corporate credit, they’re pretty open, but as maturity walls come in, will that remain the same? We’ll see, but currently, rising defaults are priced in. We’re sitting at a 2 to 3% default rate, and expectations are in the 4% range. If I think they get above 5%, then you might start to have softening credit performance.
Let’s go to the lightning round. First phrase: the AI opportunity.
I believe a large portion may be amazing, but there may be a smaller portion that could be very dangerous for the flawed species we are.
Big tech earnings.
Our tech companies are eating the world, and they haven’t lost their appetite.
Sticky. This can be painful given the Fed’s goal of bringing down inflation, but in general, stronger wages mean a stronger economy over the long-term.
The drop in EV prices.
Thank you, Elon.
Surprisingly stable. And some of that to me has to do with the low fixed-rate mortgages we talked about earlier. If you have a 3%, 4%, or 5% mortgage, the bar for you to move is that much higher because financing rates are so high. As a result, inventory remains low, supporting prices.
Threads versus Twitter.
I recently downloaded the Threads app and was unimpressed. But it’s early.
Oh, this one’s interesting. I think it’s the first time both actors and writers are striking at the same time. This is about the business model going forward. There are new mediums for entertainment, so who has the leverage? It’s tough to get a handle of it right now because all the leverage points are changing with streaming, consumer behavior, and technology.
Absolutely. World Cup winner.
There’s only one answer I can give. It has to be Team USA.
Let’s close with a personal reflection.
I have found myself wanting to focus more on reading. But to read, I need peace. Generally, peace is very helpful for my life in general. Finding at least five minutes—preferably 10 or 15 minutes—in your day for peace is helpful and can result in equanimity. And over time, that equanimity can produce positive ripple effects throughout your life. I know it has mine.
Bank loans, also known as floating-rate loans, are financial instruments that pay a variable or floating interest rate. A floating rate fund invests in bonds and debt instruments whose interest payments fluctuate with an underlying interest-rate level. The barbell is an investment strategy applicable primarily to a fixed income portfolio that invests half in long-term bonds and half in short-term bonds.
One basis point is equal to 0.01%.
The Bloomberg US Aggregate Bond Index (Agg) is composed of investment-grade U.S. government bonds, investment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds.
The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living.
A dove is an economic policy advisor who promotes monetary policies that involve low-interest rates. This viewpoint is called dovish.
Duration is often used to measure a bond’s or fund’s sensitivity to interest rates. The longer a fund’s duration, the more sensitive it is to interest-rate risk. The shorter a fund’s duration, the less sensitive it is to interest-rate risk.
The federal funds rate is the interest rate that banks charge each other to borrow or lend excess reserves overnight.
An inflation hawk, also known in economic jargon as a hawk, is a policymaker or advisor who is predominantly concerned with the potential impact of interest rates as they relate to monetary policy. This viewpoint is called hawkish.
High-yield bonds (or junk bonds) are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds.
Investment grade refers to the quality of a company's credit. To be considered an investment grade issue, the company must be rated at 'BBB' or higher by Standard and Poor's or Moody's.
The maturity date or wall is when a debt comes due and all principal and/or interest must be repaid to creditors.
The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-value ratios and higher forecasted growth values.
The Russell 2000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell1000 companies with lower price-to-book ratios and lower expected growth values.
S&P 500 Equal Weight Index is a stock market index gives the same importance/weight to each stock in the index.
S&P 500 Index is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.
Yield is defined as the income return on investment.
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