- Elaine Stokes, Portfolio Manager, Co-head of Full Discretion Team, Loomis, Sayles & Company
- Adam Abbas, Portfolio Manager, Co-head of Fixed Income, Harris Associates, advisor of Oakmark Funds
- Garrett Melson, Portfolio Strategist, member of Investment Committee, Natixis Investment Managers Solutions
Garrett Melson: Coming out of November’s Fed meeting, Chair Powell appeared to be still leaning into that hawkish rhetoric. It's very clear that the Fed is trying to open up the door to that downshift to a slower pace of hikes. I think it's important that, from our perspective, we retire the word “pivot.” It has gone in a bad place like “transitory.” I think we can be a little bit more nuanced in terms of what you actually expect to play out here. And from our perspective, a downshift does not equate to necessarily a pause. And a pause doesn't necessarily equate to an end to the hiking cycle. And that opens up the idea of higher for longer and slower but higher.
Adam Abbas: We don't see a lot of systemic risk built up in the system like we did in 2008. We have a consumer that's okay. We have interest coverage ratios that are fine in credit. We have cash flow runways that are okay in credit. And we have a Fed that is probably close to a pause to look around. And I don't like “pivot” language either. I think what the Fed will do is use the spring quarter to take a pause. We'll probably be 4.75% or 5% on the fed funds rate. Look around, look at some of the indicators like global PMIs (Purchasing Managers’ Index). How is unemployment eventually reacting? These things take time.
Elaine Stokes: What the market is pricing in is rate cuts in the third quarter of next year. And that's what I think the market is getting wrong. I think that's what Powell was trying to say in his remarks at the November meeting. He brought up how long we have, and to remain calm. I think he was trying to signal this is going to take a while and there's some big possible events that can happen that could force us to stay tight for a longer period of time.
We've been talking about retiring Fed pivot and when we're going to retire peak inflation. What I think we need to pay more attention to is what and how long is it going to take to fix all the structural issues that are causing inflation. They're the headline things that you think about all the time: labor, housing, energy. Because of Covid and the war in Ukraine, and because of a lot of things going on in the world today, they all have a structural piece, as well. There was underinvestment in energy as we were trying to switch from fossil fuels to more sustainable fuels. Major transitions like these are complicated. Remember the telecom industry when we went from landlines to wireless? It’s rarely a smooth process. On housing, we stopped building after the financial crisis. And now that we want to build, we have no labor or materials. The labor market, just the absolute lack of people, the mismatch in jobs, that's structural. So we're not going to be able to solve these structural issues overnight. And there are more big picture structural issues like deglobalization, cyber security, and supply chain redundancies.
We need to think more about dealing with inflation for the longer term. In my mind, the inflation problem is a multi-cycle problem, and this is not going to just go away.
Can We Avoid a Recession? What's Your Economic Outlook?
Abbas: I'll start with just thinking in a more nuanced way about how we define recession. I think it's clear that we are going to contract next year. What the markets are trying to calibrate for is what that path looks like. Is it a deflationary bust? Or are we stuck in an inflationary recession? The latter can be good for stocks and fairly good for credit defaults. The former, a deflationary bust, would be bad for both credit and earnings and potentially multiples. Our view is that it will be a nominal inflationary recession where we still can see 2% growth next year with real GDP around -1% to -2%.
Melson: Downside scenario, from our perspective, is a mild recession. And one where I think inflation remains somewhat elevated but decelerating. That could support a positive nominal growth environment. That helps earnings, it helps to limit some of the downside risks for the credit side of the spectrum, and certainly for equity earnings. I do think there's reason to be optimistic. But certainly, the uncertainty is still with us in terms of where that Fed rate cap is. And I think that's going to continue to be the key driving markets moving forward from here.
Will Market Volatility Be the Same, Higher or Lower in 2023?
Stokes: One of the biggest issues right now is market volatility – the lack of liquidity in markets. And the only thing that's going to take that down a notch is if we get to what I'm calling “peak uncertainty.” I feel like we're pretty much there now. We worked through the pandemic. We're now calling it an endemic everywhere except in China. To me, the Fed is being crystal clear. We have more clarity on China: Xi has cemented his long-term power, and ideology will have an edge over economics. We have an answer in the biggest European question we were grappling with, which was the natural gas cutoff. We also have to prepare for any other commodities, like oil, to become weaponized. We might not like these outcomes that we're coming to, but we're starting to get a little bit more information and certainty. We're starting to get some answers so that we can start to think about how we invest long term.
At This Later Stage in the Cycle, How Is High Yield Looking?
Stokes: The credit quality of high yield is strong right now. The number of CCCs is nothing like it was during some of these other downturn periods we've had. That has all taken place in the bank loan and private market. Also, upgrades to downgrades the past two years have been two-to-one upgrades. Let’s not forget the starting place. We had to shake out all that excess in this market during the pandemic. So it's a little bit different this time.
Abbas: We still like high yield. We like double Bs and certain single Bs. In fact, I like triple B long duration risk. I think that's really interesting because credit spreads are historically attractive. But also because of the dynamic. If things get bad, you have about 100 basis points of cushion. Let's say you buy the ten-year cyclical name that's trading in the 75th percentile on historical yield. If things get bad, the ten-year will be at 3%. If things get really bad, risk-free rates are going to come in and come in sharply. So long duration, triple B, high quality assets might protect you very well in both scenarios.
I think it's time to start thinking seriously about long-dated investment grade, triple B minus credit, especially the cyclicals that have built in some sort of default cycle. That doesn't require you to have a strong view on how deep or long the recession is.
Melson: What's your sense of how much the lack of new suppliers/issuance is helping support spreads? I mean, they've been so well behaved relative to how much tightening we've seen in financial conditions. How much do you think that's part of the story?
Stokes: I think in high yield it’s a huge part of the story.
Abbas: Yes. I agree.
Stokes: As a net, high yield creates income that needs to get reinvested. And if you're not even bringing enough issuance to reinvest that income — and the scale is way off balance this year — it creates natural buyers in the market. I think that's such an interesting part about what's going on today.
How Is Lack of Liquidity Hindering Bond Buying?
Stokes: For example, if I decide I want to buy stocks, I buy stocks. But if I decide I want to buy high yield bonds, it's a process. It's weeks of delay.
Abbas: Elaine, I love hearing that. It’s not only my desk that is feeling this.
Stokes: Again, it's a little bit different when buying stocks versus bonds today. I don't have to worry about being a little late in buying stocks because I know I can execute quickly. Whereas buying bonds, I think you need to be early. You need to get your money into the market and give your managers that opportunity to take advantage of the volatility.
In fact, the volatility that we're having right now is the opportunity in bonds. For example, we are looking to take advantage of the fact that high yields are having a bad day, or for other reasons, and buy the names that we really like and that might not be down the five points but are down two. That's still a good opportunity for me.
Let's take advantage of the fact that the entire securitized market is a little bit out of whack and let's engage that dealer who's trying to bring the ABS (asset-backed securities) deal and can't get it done. Well, I'll take that off your hands for 50 or 100 basis points cheaper than that. So, for us, this volatility has been really fun.
What's Your Outlook for Municipal Bonds?
Melson: I think munis had some really strong tailwinds coming out of Covid. But essentially that relative value gap is completely compressed at this point. You're seeing a little bit of widening for high yield munis over the high-quality space. That, I think, makes sense with today’s tighter financial conditions backdrop. But again, when you start to look at some of the other opportunities out there across fixed income, I don't think it's a compelling opportunity right now.
Could Leveraged Loans Be This Default Cycle's Subprime Crisis?
Stokes: Is it loans? Or is it private markets? Or is it a combination of the two? We don't know. You always have to look at where all of the excess borrowing has been. We have not seen signs of it in the high yield market. The high yield market has been running around 20% of expected issuance this year. For the bank loan market, at least we have a little bit of visibility into this area. But with privates, it will be much harder for the system to figure out where the losses are and how they’re really going to affect the overall market. I think there's going to be a lot of investors saying, “I'm stuck in these privates and I can't get out.”
We suspect that we're going to have an opportunity in leveraged loans. When I look out at what might present a buying opportunity to us next year, loans come up. 70% of the bank loan market is rated below B-plus. So it's become a single-B market. 60% of the bank loan market has no high yield debt associated with it. It's now the lowest point in the capital structure. It has basically become just a floating rate high yield market. You used to buy bank loans and you had the straight debt below you. That could give you some comfort if you were looking at the capital structure. You don't have that anymore.
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