May the Fed Be With You
Does the central bank have the force to bring down inflation but not the economy?Download PDF
We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to get his insights on recent market action; the Federal Reserve, interest-rate hikes and the economy; and opportunities in fixed income. We finished with a speed round of questions and a personal reflection. We conducted this interview on “Stars Wars” day, May 4.
In April, we saw both stocks and bonds add to gains in March. What’s the takeaway?
The markets are trying to underwrite a difficult economy. The S&P 500 Index was up about 1.5% for the month and is up 9% for the year. Big Tech is carrying the ball. The Russell 1000 Growth Index was up 5% in April and over 15% for the year. The correlation between bonds and Big Tech has been quite strong. The 10-year Treasury yield, for instance, started the year at 3.8% and has dropped to 3.3%. So, it’s down about 50 basis points and Big Tech’s up 15%. When you think about interest rates, rates are supporting that rally.
How about fixed income?
The Bloomberg US Aggregate Bond Index (Agg) was up 60 basis points in April and up 3.5% for the year. On the credit side, high yield and bank loans were up about 1%. And year-to-date, high yield’s up 4.6%, and loans are up about 4%. So, a 60-40 (equities to fixed income) portfolio is up about 6% this year.
“May the Fed Be With You” might be an appropriate investment mantra as the Fed appears to be shifting gears. What are the broad implications from May’s FOMC meeting?
The market is digesting and expecting a Fed pause. The Fed hiked rates by 25 basis points this month. That takes the fed funds rate to a target range of 5% to 5.25%. From a language standpoint, the Fed ditched the quote, “Hikes may be appropriate,” and added that hikes may happen to “the extent to which additional firming may be appropriate.” In previous meetings, the Fed was looking for a reason to pause. Now, the Fed is really looking for reason to hike.
The biggest change this week was in expectations. Before the Fed’s meeting, expectations were for a pause in June, one cut in December. A day after the meeting, expectations are for a pause in June and now three to four cuts in 2023. We now have significantly more dovish market expectations for the Fed, with the burden of proof to justify another hike. Given the economic numbers, I don’t think that’s going to happen. It’s a matter of how long the Fed will keep rates here.
Inflation has remained sticky. What are we seeing in the numbers and how is that pushing the Fed?
We’re seeing inflation numbers roll over. I know wage inflation has been sticky, and it’s sustained a little longer than expected, but that’s due to lagging effects of the Fed’s actions, in my opinion. Remember, you still have quantitative tightening happening, and the Fed raised rates after a minor banking crisis. That’s a significant departure from previous cycles.
I think bank stress is going to lead to tightening credit conditions, regulatory pressure is going to increase intermediate term credit pressures, and, as a result, even though inflation has remained sticky, there’s enough indication that it’s rolling over, which I hope prevents the Fed from hiking. What I don’t know is if the inflation numbers will give them enough ammo to cut.
How does the latest job report impact the Fed’s choices moving forward?
The labor markets have been resilient, but they’re leaking. Wage and salary growth year-over-year is around 2%, according to Bank of America. In labor markets, you’re seeing layoffs increase and wage growth decline. So, the general numbers are soft. For months, a strong job market has been what’s given the Fed a high degree of confidence to hike. I think with that softening, that might take out the final leg and hopefully push the Fed to cut or not keep elevated interest rates or tight monetary policy longer than they should.
Regional banks especially are in investor crosshairs today. What do these difficulties signal about the economy and broader issues facing the Fed?
It’s interesting because I don’t know if the regional bank situation signals anything because a lot of this has to do with what’s on their books and their marks relative to a couple years ago. In other words, if they’re forced into a liquidity situation and a forced seller of some of the assets, that’s where problems compound.
Given that, I think the real issue that’s going to impact the economy is tightening lending standards. When you look through the stack from major money centers, super regionals, regionals, community banks, and credit unions, they’re either tightening or not loosening. Thus, access to capital will become harder. When that’s harder, risk premiums are typically wider as uncertainty grows and demand weakens.
The market’s just trying to get their hands around it. I would categorize this as price discovery right now for some of the assets on regionals.
Are the banking issues pushing the Fed toward cutting rates sooner?
While the banking issues may not be core to this question, I believe there’s a disconnect, in my opinion. Markets are thinking the Fed’s going to cut rates multiple times this year, yet the Fed is holding firm to its rhetoric. I mean, the Fed raised rates this month after the second and third-largest bank failures in our country’s history. If these problems persist, is the Fed going to view this as not important to the economy? Or is the Fed going to view this as structurally important to lending and capital growth and then compel them to cut rates? That’s where the markets are having trouble—or at least I’m having trouble—underwriting which way that goes.
As the debt ceiling votes approaches, how concerned are you?
Right now, U.S. Treasury Secretary Janet Yellen is signaling June will be problematic. I think that’s posturing, but I also believe it’s appropriate posturing because the urgency will probably be very problematic in July and August. Hopefully, they get to resolution in June. I would say not concerned yet, but we’ll get there quickly.
With the economy appearing to be slowing, how are companies doing in this environment?
A little more than two-thirds of the S&P 500 companies have reported their earnings for Q1. In general, sales are up about 4%, so in line with nominal GDP. Earnings are up a little over 1%. When you look through to estimated earnings for this year, S&P is coming in around $220 per share. Next year, S&P earnings are projected to be around $250 per share. That puts you at a 16 to 18 multiple on forward earnings. I would categorize S&P 500 earnings as fine to slightly better than expected.
When you think about the broad picture today, the economy is most likely going to worsen over the next six to nine months. Things are slowing, confidence is waning, jobs are weakening, and access to capital could be a potential problem. Thus, assuming we have a recession, the real trick is how deep the recession will be and the response of the Fed to loosen conditions. And that uncertainty is what I’m focusing on with the market expectations versus Fed rhetoric. We’re in a time of flux with the economy, with markets, the Fed, with rates. Markets are trying to get their hands around it, which is why you’re not seeing conviction one way or another.
Given that information, where do you see opportunities now in fixed income?
The opportunities in fixed income are, in my opinion, still centered around credit. They continue to be protected by the coupons. If you think about this year, despite all the different headwinds the markets are going through, high yield and loans are up 4%. That’s just above coupon clipping, so you have a ton of protection as it relates to coupon and higher yields. Investment-grade bonds have returned around 4% because rates have dropped 50 basis points. In a world where you have a ton of uncertainty, the thought of rates moving higher isn’t really a probability. You have protection with the yield, so that just enables you a ton of downside cushion over the next year or two. In my opinion, the risk reward of credit is quite attractive relative to many other asset classes.
Just to give you a sense of levels, high grade is yielding about 5%, high yield is yielding about 9%, loans are still yielding about 10%, and generally most prices are below par sitting around $90. So, if you have a recovery at some point, the total return could be attractive.
We’ve seen Treasury rates dropping. If we do continue to see deterioration, is it likely that duration will be helpful?
Rates are down about 50 basis points on the Treasury curve, at least in the belly and longer end. If we have a worsening economy and the Fed is firm and holding policy tight, I would think the curve becomes more inverted, which means there’s more to go on the duration side. If, however, the Fed backs off the 2% target for inflation or feels liquidity needs to be injected, you could very well have more normalized curve, and duration would be more neutral. Again, it’s all very uncertain right now.
Time for the lightning round. I’ll say a word, phrase or quick question, and you tell me the first thing that comes to your mind. Here goes: Fed cuts by year-end. If so, how many?
I feel like I’ve been wrong in the past two years, but I will say one cut.
Chances for a U.S. default as a result of upcoming debt limit?
Technical default? 25%.
Any meaningful impact from the debt-limit debate?
My concern is the mindset for austerity. We’ve had a very friendly fiscal and monetary policy environment for a decade, along with expansion and growth. If you have an austerity mindset—a view that we should not spend—then all of a sudden you have spending contract. That’s going to lead us into a deeper recession, slower growth, and substantially lower yields longer term.
We had the example in Europe of that.
Yes, post-financial crisis, the Germans anchored to an austerity mindset, and Europe could not get out of a recession. Meanwhile, we were printing money, we were spending money, and our economy was moving faster than Europe. Policymaker mindset is the real risk in these debt-limit discussions.
Largest cause of sticky inflation?
The need for workers, a dynamic set up by COVID policies and the M2 that was printed. We’re still working our way through that. In addition, the Fed, markets and investors don’t really know what the long-term inflation run rates should be. I don’t believe it should be 2% given everything we printed, but should it be 3 or 4%? Unsure.
When looking at the economy, what part is currently the source of greatest uncertainty for you?
In my mind, private assets. You look through the repricing of assets, liquid assets were repriced last year. Semi-liquid assets such as real estate are currently being repriced. Private assets have yet to fully incorporate the repricing or risk premiums. You also have a business model that was heavily dependent on leverage. Given the leverage mechanism has become more difficult, does that model work and how does that impact previous investments? At a high level, that gives me a ton of concern. Also of concern is commercial real estate, in particular office and retail. And, of course, some of the regional banks are a worry.
Favorite “Star Wars” movie?
“Empire Strikes Back.”
Let’s conclude with a reflection. What do you have for us this month?
Since this interview is on "Star Wars" day, let me leave you with one of Yoda's most famous quotes: “Do or do not. There is no try.” What he’s saying is that there’s basically no middle ground when it comes to chasing a goal. If you’re going to make the effort, success should follow. Just trying isn’t enough.
The Bloomberg US Aggregate Bond Index 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.
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 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 S&P 500 index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S. stock market.
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