Jeff Klingelhofer, Co-Head of Investments & Managing Director, looks to a period when the Fed’s mandates of low inflation and high employment may not peacefully coexist.
Observations in Fixed Income: Central Banks Dominate the Year
I’m Jeff Klingelhofer, cohead of investments and portfolio manager at Thornburg Investment Management. We finished the first half of the year with risk assets broadly off their highs. As I pointed out before, the top story of the year has been and will continue to be central bank actions around the world. On one hand, take the Fed, which is raising rates and continuing the paradigm shift from a free cost of money to a very significant and real cost of money.
On the other, we’ve witnessed over 200 rate increases around the globe, notably the first from the ECB, which exited its negative interest rate policy. Turning to emerging markets, many developed nations are in a relatively precarious position. They’ve been forced to hike preemptively to preserve their own currencies, forcing down the strength of their economies. Emerging markets also face the additional headwind of a stronger US dollar.
Countries that issue US dollar denominated debt must now pay more to service that debt when they convert the local currency to the US dollars. Thankfully, emerging markets are entering the second half from a position of strength, but the rally in the US dollar, along with commodity import pressures, paint a challenging backdrop for this cohort.
Let’s turn to inflation. Central banks have the habit of portraying or even downplaying inflation by calling a transitory central bank ceded to market pressure by eradicating the word transitory from the rhetoric. I continue to believe that most inflationary pressures are not structural in nature, with the one caveat being potential ongoing wage inflation. As we’ve seen in the past three CPI releases, goods inflation has declined while wage pressures have been bleeding into stronger services inflation.
I still think it’s too early to hang the “Mission Accomplished” banner and shift to an environment where the Fed stops hiking rates. Low rates across the board have had profound effects on the global economy. The low interest rate environment, expanded equity multiples, increased home price appreciation, and allowed cheap financing for companies, some of which had relatively poor business prospects.
But what happened on the flip side? I worry about the effects as we emerge from an environment of extremely low rates into one that we believe is much more sustainable. Our team believes that rates have already peaked at roughly three and a half percent on the ten-year US Treasury earlier this year. We’re exiting in a period where the Fed’s dual mandates of maximum employment and price stability can peacefully coexist.
The current period of price instability, a.k.a. high inflation, is forcing the Fed to raise rates in a hurry. At the same time, businesses have reported high inventories, which suggest retail prices should decline to clear this excess supply. For me, what’s perhaps most important is that inflation expectations themselves have stayed within a relatively contained band for some time and only now have begun to edge lower in recent periods.
On the flip side, headlines announcing hiring freezes and layoffs are ratcheting up across industries. Initial jobless claims are trending upwards, so the Fed’s dual mandate of price stability and maximum employment shows signs of a not so peaceful coexistence.
High rates and the rhetoric from central banks have prompted markets to turn from a question of what do we have to do to begin to bring inflation down to what most central banks around the world do to prevent us from moving into an outright recession?
Our belief is that despite relatively weak GDP, albeit this is just one measurement, the world today doesn’t feel like it’s in a recession. But are we moving towards one? Probably. We do believe that inflation has peaked, but it won’t fall fast enough to give the Fed comfort. We expect the Fed to hike rates above neutral in September. This means that the Fed will shift from a neutral monetary policy to a restrictive monetary policy, which significantly raises the likelihood of a recession.
Historical precedent shows few periods in which central banks around the world have hiked above neutral that they managed to avoid a recession. In fact, the Fed has seldom been in restrictive monetary mode without triggering an outright recession. So, we are mindful about heading into what will be a moderate contraction in growth. Let’s consider how all this is playing out in credit and ultimately our portfolios.
The notable increase in underlying interest rates is causing a broad-based slowdown. Spreads are moving wider and prompting funding pressures to corporations and consumers around the world. Although wider credit spreads are apparent, they’re not fully pricing a recession yet. For now, we remain cautious and still uncover pockets of value. The best thing about the move higher in interest rates is that today the role of fixed income is notably more critical to provide steady incomes as well as potential return. We find high quality companies and credits that are well positioned for almost any eventuality in underlying economies at four to 6% today and slightly less good companies in the seven to 8% range.
We believe municipal bonds are a bright spot for investors, too. They look undervalued today versus taxable fixed income broadly. The underlying issuers and municipals remain very well capitalized, and we believe defaults are likely to stay low well into the future. Relative to other high-quality areas in the market, munis broadly represent a terrific pocket of value.
On the other end of the spectrum, credits exposed to the low end of the consumer give us pause, both in the corporate space as well as within securitized structures. We’re starting to see the early signs of rising delinquencies and defaults. The low end, low wage consumer has been squeezed the most by inflationary pressures. Additionally, we’ve seen low wage income earners on a grab for credit. On a recent call with a consumer finance company, they reported a 50% increase in applications over recent months. That’s a staggering figure. Additionally, we’ve seen debt relief companies suggest that they’re having some of the busiest months in their company’s histories.
Overall, our stance is cautious. We are weighing the Fed inflation and a likely brief recession and our day-to-day analysis. We focus on credits that we believe are well protected from inflation and have durable pricing power. Within emerging markets, we like companies and countries that are exporters of commodities. Within the securities space, we focus on the higher quality consumer and up the capital stack. We’re aiming to keep credit duration notably shorter because we don’t believe we’re well compensated to step into significant forms of potential volatility.
Thanks, and see you next quarter.
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