- Fixed Income Portfolio Manager
United Kingdom, Institutional
Change
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Key points:
- Distracted by US Federal Reserve (Fed) tightening, investors missed the fiscal impulse that boosted earnings and asset prices. Furthermore, real rates are below their long-term average and are not restrictive, even though they are above recent artificially suppressed levels.
- At current levels, it’s hard to see value in US Treasuries, especially when the federal government is printing ~US$2 trillion of fresh issuance per year to fund an unsustainable 8% budget deficit.
- The economy and inflation could reaccelerate later in 2024; the Fed’s job does not appear finished. However, the Fed appears amenable to cutting rates, making it difficult to justify being underweight risk.
- Conservative financial policies at individual companies have left credit fundamentals in good shape, unlike past Fed tightening cycles. I have a constructive outlook for credit, especially banks, one of the biggest beneficiaries of a soft-landing scenario.
Distracted by Fed tightening, investors missed the fiscal boost
Fixed income market participants were laser-focused on the Fed during its tightening campaign, pushing US Treasury yields sharply higher across the curve. However, I think not enough emphasis was placed on the strong fiscal impulse and its impact on the economy and markets. I would argue that fiscal stimulus buoyed earnings the same way that quantitative easing inflated valuations. Having cut my teeth during the QE era I do worry about markets going back to the old regime and having the Fed and QE being their primary driver, but I think it would be wiser to focus on the impact that fiscal stimulus has on the economy and what that means for earnings and asset prices.
I believe we are in a new regime in the US but also in many spots globally where fiscal policy is doing the heavy lifting and monetary policy is a distant second. The implications for economies and markets are profound. While the fiscal impulse this year is set to be a bit weaker than last year depending on how you look at it, we are still likely to run a historic deficit that has only truly been eclipsed in crisis times like 2009 and the pandemic in the post-WWII era. I find it difficult to imagine that the US would have a nasty recession in 2024 when the government is running a 7% – 8% deficit while the Federal Open Market Committee (FOMC) appears keen to cut rates before we even see any trouble. I don’t think the US government is pursuing a wise or sustainable policy, but I believe the day of reckoning for that view is (a) outside of our investable time horizon, and (b) would necessitate a MUCH higher rate structure than we have today.
Real rates are not very restrictive
The market is pricing roughly 150 basis points of rate cuts over the next 12 months on the thesis that as inflation continues to fall, the spot real rate is moving higher, and the Fed would be effectively tightening policy. While real policy rates appear elevated versus recent history, 10-year real rates are below their longer-term average (Figure 1). And the recent history was held artificially low by Fed purchases during QE and the pandemic. In an environment where the federal government is printing ~US$2 trillion of fresh issuance per year to fund an 8% budget deficit, it is hard for me to believe US Treasuries have much value. Economic textbooks would say that massive deficits require higher-than-average real rates to attract capital. To me, sub 2% real rates just aren’t attractive given the fiscal state of the US government. I don’t think US households are going to be excited to buy 5- and 10-year Treasuries yielding around 4%, and this is the group that will need to fund the growing deficit in the years to come.
Figure 1
Financial conditions and the real economy
My colleague, US Macro Strategist Mike Medeiros, estimates that the lag with which changes to financial conditions flow through to the real economy is much shorter than it has been in the past, contracting from roughly 18 months pre-pandemic to closer to three months today. While the growth and inflation data has slowed a bit in the past three months, given the financial condition easing experienced since the end of October 2023 (lower interest/mortgage rates, higher stock prices, strong housing market, etc.), I think we need to be incredibly open to the idea that the economy could start to reaccelerate in the 2nd or 3rd quarter this year. Inflation could go with it. This is the circular issue whereby every time the Fed says it is done tightening, the market jumps two steps ahead to a full-blown easing cycle, effectively undoing the tightening. I believe this circular nature of markets will be with us for quite some time, and we should feel emboldened to trade it.
If this sequence does in fact unfold in the coming months, this will put the Fed in a tough spot were it to cut rates in March, only to get whipsawed by the data and need to mention the possibility of tightening again in 2Q. I simply don’t understand why the Fed would be in a rush to cut until it was certain it had won the battle against inflation. The job doesn’t seem finished to me with inflation still well above target, a tight labor market, and the equity and housing markets near record highs.
Conservative financial policies strengthened corporate balance sheets
Companies got the message in early 2022 that the Fed was trying to slow the economy and managements reacted by paying down debt and/or building cash. They were able to do this despite slowing revenues because the starting point for balance sheets was healthy heading into 2022 and because the economy didn’t slow fast enough to adversely impact cash flow. This phenomenon is supported by data from economy-wide financial accounts as well as a bottom-up aggregation of individual companies. We think market participants over-indexed to the Fed hiking cycle and to what that has portended in the past for credit spreads and the economy. They should have focused more on the financial policies coming out of most of the companies that we follow. (In short, “it’s less attractive to borrow at higher yields into a slowing economy.”) These policies have left credit fundamentals in a particularly good spot to start 2024 (Figure 2).
Figure 2
Banking sector poised to outperform
In my view, the most attractive opportunity in credit markets is in banks, which trade at historically wide levels versus other sectors, despite being one of the biggest beneficiaries of a soft-landing scenario. I think the worst of the bank issues experienced last March is behind us — like industrials they have had time to rebuild some capital in the past few quarters. The prospect of punitive losses on account of a credit default cycle also seems to have abated significantly. Finally, I think there must be a prospect for banks to make loans at attractive rates in the coming years if the economy stays decently strong and rates stay higher for longer. I’m not sure if this is a great equity story because of the regulatory angle, but I suspect profitability will be better in the coming years than it was in the past two.
Constructive outlook for credit
A strong economy that is underpinned by fiscal support, strong employment, and strong household balance sheets should benefit corporate cash flow. At the same time, the current prevailing level of yields leaves most corporates less than enthused about adding leverage to their balance sheets. This makes me constructive on credit spreads, but I acknowledge the opportunity is less compelling following the sharp rally to close out 2023. I am focused on maintaining income but holding liquidity to allow me to buy dips (which I expect to be shallow). Credit-spread volatility should be substantially lower than interest-rate volatility. Yet, record-high money market assets indicate many market participants are betting on a recession. To me, the worst of the economic concerns appears to be further in the rearview mirror, and with the Fed now looking for excuses to cut rates it’s difficult to justify being underweight risk. I suspect holders of cash will be looking to reinvest on dips, which will support risk for quite some time. It is difficult for me to envision a credit meltdown until investors reposition long and some leverage gets built up on the balance sheets of companies. I think we are a long way out from that occurring, which makes me want to lean overweight risk.
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