The Good, the Bad and the Opportunity
The Fed pauses, labor strikes back, and we believe opportunities abound in fixed income.Download PDF
We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to get his insights into recent market performance, accelerated economic growth, the Federal Reserve’s thinking, and opportunities in fixed income. We finished up with a speed round of questions and a personal reflection.
Market Performance: Total Return
Let’s start with market performance. What happened in October?
Equities didn’t have a great month, and I believe that’s a reflection of rates moving higher. I would say equity markets are still adjusting to tightening monetary conditions in a slowing economy. That is really what’s been happening, in my opinion. The Magnificent Seven have been driving the Russell 1000 Growth Index and the S&P 500 Index.
What about fixed income?
The general bond markets were negative, but high-coupon instruments in fixed income were positive.
What’s been the impact of rising Treasury yields on stocks and bonds?
In general, when the cost of capital increases—which happens when you have rising yields—the hurdle rate for investors does as well. The biggest inflow this year is probably into cash, which is attractive now to more investors because it’s volatility and default free—so, you’re getting a “risk-free” 5%.
Six percent used to be a decent return for folks to invest in when money markets were at 1%. Now at 5%, you probably want to get compensated in the high single digits and maybe even low double digits to justify the risk premium. That’s more difficult, and I think that’s why you’re seeing risk sentiment drop.
Performance dispersion has been a big topic in 2023, focusing on the Magnificent Seven versus the rest of the S&P 500 Index. Are bonds experiencing wide performance dispersion as well?
I’d say in the first half of the year, it was a very coupon-like market. Then rates began moving up in the second half of the year—in particular, the third quarter. So far, the second half of 2023 has certainly been more reflective of bond markets adjusting. Investment grade went negative. High yield was up to mid-to-high single digits, but that’s dropped due to rates. Bank loans are simply reflecting higher short-term rates with heavy coupons coming in, which has been the strength behind the bank-loan returns we’ve seen.
What are three surprise takeaways about market performance so far in 2023?
First, the recession nearly everyone predicted has not occurred. Two, because the recession didn’t materialize and the economy was stronger and the consumer was more resilient, the result has been higher interest rates. And third, I think the equity markets have been much narrower than people expected—again, the performance of the Magnificent Seven has had an outsized impact on the markets.
GDP Percent Change from Preceding Quarter
Now let’s move to the economy. What’s going right and what’s going wrong?
I’ll sum it up in one sentence. What’s going right is we are growing, and what’s going wrong is we are slowing. That is it in a nutshell.
Now what surprised you in October?
Remember, most investors thought we’d be in a recession by now, and that GDP in the third quarter was forecasted to be negative. Instead, GDP in the third quarter was 4.9%. That’s a massive print. When you look at GDP estimates for next year, we can see that the economy is expected to slow down in the first half of 2024 but then recover in the back half.
Keep in mind, 4.9% GDP growth in the third quarter is far different than negative numbers expected. So, it tells you the projected numbers were substantially off entering 2023 and will likely be off in 2024.
Now it seems like consumers continue to spend. What’s going on there, and do you think it’ll last?
Bank of America divides credit-card spending data into 15 subsectors, and 12 of the subsectors are currently negative year-over-year. Some examples: Online electronics was down 10 to 15%; furniture down 15%; clothing down 9%; and department stores down 12%. And then on the positive side, grocery up 1%; restaurants up 1.5%; and transit up 1.5%.
I would say this was by far the most negative year-over-year consuming spending report since the COVID recession. This data is a small proxy, and the numbers are generalizations, but I’d say this proxy has been pretty reflective of the general consumer health.
Labor Strikes 2000-2003: Annual Work Stoppages Involving 1,000 or More Workers
Let’s turn to the labor market. What are your thoughts on the plethora of major strikes in the U.S.?
First, you’re having labor come to the table and ask for more compensation in a slowing economy. That is different than previous labor disputes. Typically, when the economy starts to slow or there’s a recession forecasted, labor in general tends stay on the quiet side. Right now, we’re seeing that labor knows they have some leverage. Plus, we’re out of the pandemic and union workers are assessing what inflation has done to their wages.
Here’s what labor leaders from UAW are generally arguing. Inflation is up about 17% over the past four years, but wages are up only about 6%. We’ve seen headlines that the autoworkers are seeking a 33% raise, which sounds extremely high. Keep in mind, to just catchup with inflation they’d need an 11% increase now. If they received that, it still doesn’t cushion the previous years when wages were left behind. Thus, targeting a rate expected to be higher than inflation over the next few years can make up for it. Assuming the unions get 5% over this time and inflation is less than 5%, that’s the context for the autoworkers’ demand for a 33% raise.
How do you square this with slowing job growth?
Again, we’re growing, but slowing. Jobs are not increasing as quickly as they were before. And I think that’s consistent with the economy. I would be surprised if it deviated from that narrative anytime soon.
Let’s turn to the Federal Reserve. What are your thoughts on the Fed’s decision to continue to pause rate hikes?
I think that’s the right decision. I don’t think rates need to be this high, but the Fed has been anchoring to its goal of 2% inflation. This month, the Fed’s narrative has been balanced. We are seeing the Treasury curve come down. Treasuries have rallied a ton, and rates dropped 20 basis points yesterday (Nov. 1) after Fed’s announced it would pause rate hikes for at least another month coupled with the results of the auction. We’ve seen the curve get more inverted over the past 24 hours. What I like is the Fed appears to be marginally coming off of the 2% inflation goal or at least giving themselves room to cut rates even if inflation remains above 2% if financial conditions dictate it.
Now how will the GDP and PCE prints affect the Fed going forward?
The forecast on GDP is that we are going to slow. And if we slow to 1% and lower, you’re talking about a real fed funds rate that’s highly restrictive. Couple that with long-term rates where they are and quantitative tightening, I think financial conditions are leaning overly tight. But the narrative around GDP and PCE will factor into the Fed’s decisions on rates. I think the Fed is also going to factor in the strength of the economy and the job market. All of this is part of the mosaic.
Do you see a hike in December?
I haven’t been good at predicting what the Fed will do, but I’m going to say no.
Fed Futures: Implied Fed Funds Rate
All right, now what is the base case for hikes and/or cuts in 2024?
Let’s take a look at fed funds futures. In January 2025, the fed funds rate is expected to be about a point lower than today. That translates into three to four cuts next year with the first cut expected around the end of the second quarter of 2024. In theory, the first cut would be in the second quarter, the second cut in the third quarter, and the third cut in the fourth quarter. But a lot can change. There’s an economic eternity between now and then.
Let’s move to bonds. Where do you see opportunities in fixed income today?
Honestly, opportunities abound in fixed income. Rates have gotten to the point where investment grade is sitting at over 6%, short term is at 6%, and leverage finance—which is high yield and bank loans—is in the high single or low double digits. Since July of 2022, I’ve been very constructive on credit. I think risk-reward is a no brainer.
High yield has outperformed the S&P 500 Equal Weight Index this year. Bank loans are up twice as much as the S&P 500 Equal Weight Index. The S&P 500 Index is up 10.7%, but bank loans are up 10% and they’ve been substantially less volatile than the S&P. When you look at the risk premium when compared to equities, you’re getting coupons of 6 to 9%, equities for me would need to return double digits to justify the risk. What you do have here is a truckload of coupon. I still think the bank-loan trade has a meaningful place given the protection against longer-term rate volatility coupled with the high coupon. Investment grade has gotten a lot more compelling. At 5 to 6% yields and coming off back-to-back negative years, there is value.
A Closer Look at High Yield
Another area that has gotten compelling is the BB portion of high yield, which, for lack of betterment, is the highest quality of junk bonds. We got to a point a little over two years ago where BB rated high yield was trading at 2.86%. It’s now over 8%—that’s up 500-plus percent. High yield has been very much a shorter-duration-based asset class where the move on the short end of the curve has been substantially impacted. Now, you have a situation where higher quality high yield is over 8%. Again, that’s compelling. I’ve been constructive on the bank-loan trade versus high yield for a while now. However, I’d say for high yield, the relative value is really setting up well.
And I think relative valve is there across credit, and this is something we have now within high yield. I wouldn’t want to go heavy into lower quality at this time, but I think you stay with upper quality high yield.
Do you think credit spreads are signaling recession?
They’re leaking but not quite signaling a full recession. Let’s suppose we have a recession. That’s where the coupon is giving you protection. You have that buffer in capital protection. It’s much different than having a 3% buffer. You now have an 8, 9, 10% buffer in leverage finance to offset price movements or credit spreads widening.
Now let’s shift gears and move to the lightning round. Here we go. The federal budget deficit.
That should continue to increase—probably until you and I are much older.
AI and the 2024 elections.
I think it’s too early to understand the role AI will play in the elections. I feel the same way about the elections themselves. I remember about a half-year before the 2016 presidential election, Donald Trump was at the back of the pack with something like a 2% probability of being nominated. So, a heck of a lot can change between now and the 2024 election.
To me, the Magnificent Seven are just eating the world. And they will continue to eat the world.
Even with higher interest rates?
Again, on the margin. But they also don’t have a ton of debt, and that may impact their valuation. But from a business model perspective, they’re still going to continue eating the world.
It feels like the Saudis won’t let prices drop below $60 a barrel for very long.
Advice to new homebuyers.
You want to be patient. Buyers are getting discouraged, but pricing is the last thing that typically breaks in the housing market
All right. Thanksgiving special: Turkey or ham?
Stuffing or dressing?
I don’t know the difference.
Stuffing is when it’s inside the turkey. Dressing is when it’s outside.
Canned cranberry log or fresh?
Last question. Is November too early for holiday songs on the radio?
With that, we’ll close with a personal reflection.
This one has been weighing on me for a while. Over the past two years, two hot spots have developed in the world: Ukraine and Gaza. There’s been—and continues to be—so much human tragedy in both places. It got me to thinking about our privileges. We, meaning Americans, have the privilege of taking our national security for granted, which is really amazing when I reflect on it. It is truly a privilege that we can take it for granted because there are those watching, working, and defending our country around the clock so that we can. While I love that national safety can largely be taken for granted, I don’t want to forget that it can be. For all of this, I wish our military heroes, past and present, a wonderful Veterans Day.
One basis point equals 0.01%.
A bill auction is a public auction, held weekly by the U.S. Treasury, of federal debt obligations—specifically, Treasury bills (T-bills), whose maturities range from one month to one year.
Bank loans (or 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.
A bond with a BB rating is considered as non-investment grade, which is commonly referred to as high-yield or junk bond. This means that the issuer of the bond has an elevated risk of defaulting on their debt obligations and therefore the bond carries a higher risk, yet also pays higher yields.
A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity.
The credit market is where investors buy bonds and other credit-related securities. It is also where governments and corporations raise funds.
In bond trading, a credit spread, also known as a yield spread, is the difference in yield between two debt securities of the same maturity but different credit quality.
Dispersion refers to a statistical measure of the range of potential outcomes for an investment based on its historical volatility or returns.
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.
Fed funds futures are financial futures contracts based on the federal funds rate and traded on the Chicago Mercantile Exchange (CME) operated by CME Group Inc. (CME).
The federal funds rate is the interest rate that banks charge each other to borrow or lend excess reserves overnight.
The Gross Domestic Product (GDP) growth rate compares the year-over-year (or quarterly) change in a country’s economic output to measure how fast an economy is growing.
High-yield bonds (or junk bonds) are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds.
A hurdle rate is the minimum rate of return required for a company or investor to move forward on a project.
An inverted Treasury yield curve is an unusual state in which longer-term bonds have a lower yield than short-term debt instruments.
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.
Magnificent Seven stocks are Apple, Microsoft, Nvidia, Amazon, Meta, Tesla and Alphabet.
Maturity is the date on which the life of a transaction or financial instrument ends, after which it must either be renewed or it will cease to exist.
Monetary policy is a set of tools used by a nation’s central bank to control the overall money supply and promote economic growth and employ strategies.
Personal consumption expenditures (PCE), also known as consumer spending, is a measure of the spending on goods and services by people of the United States.
Quantitative tightening (QT) (or quantitative hiking) is a contractionary monetary policy applied by a central bank to decrease the amount of liquidity within the economy.
Relative value assesses an investment's value by considering how it compares to valuations in other, similar investments.
Risk premium is the excess return above the risk-free rate that investors require as compensation for the higher uncertainty associated with risky assets.
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.
S&P 500 Index is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.
The S&P 500 Equal Weight Index is the equal-weight version of the widely used S&P 500 Index, which is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.
The short end of the yield curve refers to the part of the curve that ranges from 0 to 1 year.
Treasury rates or yield is the effective annual interest rate that the U.S. government pays on one of its debt obligations, expressed as a percentage.
Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security.
Yield is the income returned on an investment, such as the interest received from holding a security.
A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity.
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The views expressed are as of the publication date and are presented for informational purposes only. These views should not be considered as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment or market. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant.
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