When Will Inflation Peak?
Strategy
As threats from the pandemic subside, the focus has moved to the Fed and how aggressively it will fight inflation. Having raised rates three times already, with many more hikes this year expected, it seems to us the Fed is willing to risk a recession to tame inflation. This is usually very negative for the market returns. Both equity and fixed income markets have already seen some of the worst performance ever for the start of this year. Long treasuries posted a -24% return, the S&P 500 declined 17%, intermediate Treasuries are 7% to 8% lower, and the U.S. Aggregate Bond Index is 11% lower thru late June. Chairman Powell has been amping up the rhetoric regarding inflation and the markets have reacted in a predictable manner.
We expect inflation will peak sometime between now and the end of the year. Rates will have increased significantly on everything from mortgages to car loans and the increased cost to live will have taken a toll on consumers’ finances resulting in lower aggregate demand. As demand falls, so should inflation. Another reason why inflation will peak soon is the improvement in the supply chain. We don’t require a “healed” supply chain. That may take years. We only need an improvement leading to additional supply in certain areas that takes some of the stress off the pricing of certain goods. Consumers have already modified their behavior to reduce expenses, and we believe they will continue to do so. The combination of reduced demand and improving supply will result in inflation peaking within the next six months. If inflation doesn’t peak soon, the Fed will consider larger rate hikes which will hurt the equity markets and risk a severe recession.
We discussed CMOs last quarter and continue to find structures with yield spreads near 70 basis points, limited extension risk, and trading at a large discount. Base case average life is 6-7 years. While this may seem long, it makes sense when rates are this high. Extension risk is limited to just over one year as current prepayment speeds are very low. We ran a Yield Table on Bloomberg, and the base case yield is just under 4.0% but will increase to 5% or even 6% if prepayment speeds increase. Don’t look for this to occur soon, however. Another attractive feature is the principal window is narrower than for a 15-year pass-through. Try to find CMOs that shorten to about 3.0 years in the “down 300” scenario which means this is a well-structured bond.
Our second idea is an agency pass-through that has a 20 year maturity and a 2.5% coupon. Pools are priced near $90.25, have a 7.6-year average life, and yield 4.00%. Extension risk is minimal (0.5 year) as the current prepayment speed is so low. The yield will increase if prepayment speeds increase due to the very low purchase price and all prepayments are valued at $100. The yield jumps to 5.0% from 4.0% if the speed triples which is quite possible in a slightly lower interest rate environment. Looking at the cash flows, the investor gets nearly 50% of principal back in 5.0 years. There is no credit risk as FNMA and Freddie Mac back these borrowers. This is a little longer option, but keep in mind the extension risk is minimal if rates continue to rise.
Given the bullet-like cashflows, we compare these to bullet agency securities.
One asset class we have not mentioned recently is agency Commercial Mortgage-Backed Securities (CMBS). In certain classes/tranches, the investor receives all the principal back over a few months and they have a short stated final maturity. Typically, bonds will either have an average life of approximately three to a five years. Given the bullet-like cashflows, we compare these to bullet agency securities. The yield spread is 30 – 40 basis points wider. They are also rated AAA. Yields currently are 3.55% - 3.65%. If you are looking for a bond sector with a very narrow principal window and a decent spread over bullet agencies, this one is it.
Municipal bonds appear to be a good value. A 10-year maturity general obligation new issue rated AA+ was issued at a rate that was 91% of a like-term Treasury. This is a very high percentage. The issuer was a first ring suburb of Minneapolis. Priced to yield 3.15% the taxable equivalent yield for a C-Corp financial institution would be 4.00%. The yield spread versus the 10 -year Treasury is 55 basis points. Another positive feature is that the bond is not callable. Bonds with slightly longer maturities are a better value. If you haven’t considered municipals, you may want to take a closer look.
Our final idea is a security we have used frequently. It is a privately issued mortgage-backed security or what we call an RMBS (Residential Mortgage-Backed Security). Given rates are so attractive we prefer the issues having a five-to-seven-year average life. They are frequently priced at a large discount (5-10 points) so any increase in prepayment speeds results in a large increase in yield. Base case yields are 4.50% - 5.0% and can increase to 6% - 8% depending on the prepayment speed. The credit quality metrics are outstanding which is why the rating agencies put a AAA credit rating on these types of bonds. Issuance has risen sharply the last three years making liquidity very good.
Don’t get caught trying to pick the top.
Our ideas today are generally longer in nature than what we usually discuss. Interest rates have risen quickly these past nine months. Don’t get caught trying to pick the top. The yield on the five-year maturity Treasury note was 0.80% nine months ago and stands at 3.05% today. Many of the ideas mentioned above yield 4%, 5% and even 6%, in some scenarios. Stress call protection as you will likely be glad you did in a year or two. While the Fed is in a tightening mode it won’t be forever as a recession is a possibility in the next 6 to 12 months. Hopefully inflation peaks sooner rather than later which would provide a different outlook for Fed tightening and probably give all markets a boost.
Economic Observations and Interest Rate Outlook – Look Out Below
This job environment will very likely turn out to be a paper tiger. According to the Bureau of Labor Statistics, in April, the largest contributor to inflation was made up of services. Services can often be substituted (by doing it yourself) or they can be delayed. If the cost of dining out increases too much, or the quality of the experience declines, a person can choose to make their gourmet hamburgers at home. Most of the recent wage inflation has been focused on lower-quartile earners, largely in the service sector of the economy. If economic sentiment softens and consumers change behaviors, the recent job market “winners” could quickly become the hardest hit casualties. In the paragraphs to follow, we lay out the case for why that is our forecast.
Even though the layoff rate in May was near a historical low of 0.9% (Source: US Labor Department), industries most closely impacted by higher borrowing costs are starting to announce plans to cut staffing. Among the early sectors to feel the pinch are mortgage lenders, home builders, financial institutions, and some commodity-centered companies. A few recently released data points exhibit how the nearly two jobs per job seeker could quickly become one job (or half a job) per job seeker. Job placement firm Challenger, Gray, & Christmas indicated that as of June, planned layoffs increased to 32,517, a 57% jump from the month prior, and the highest number since February of 2021. Manufacturing overtime hours have declined the past three months, the longest downward streak since 2015. Perhaps more telling of what lurks just beneath the surface of this job market is the sentiment of both workers and employers. In June, a survey of more than 1,000 workers performed by staffing company Insight Global, found that nearly 80 percent of US employees fear losing their job during a potential upcoming recession. Perhaps the “concerned employed” are wise as the same survey found that 90% of the managers surveyed said they would likely have to layoff employees during a recession. Firms like Netflix, Tesla, and Meta have announced plans to trim their workforce, and these announcements are happening before the official declaration that the U.S. (and even more likely Europe) is in a recession.
In concert with the first quarter of 2022 contraction of 1.6%, the current GDPNow measure suggests that we are currently in a recession...
Away from the employment environment, there are many influences that are building which can push the economy into a stall. Corporate and consumer sentiment has collapsed. The “sticky” sources of painful inflation we have been calling for all year, especially in the context of a possibly more challenging corporate growth and related negative real wage gains, has brought a sense of “falling behind” on the psyche of the economy. The June University of Michigan Conference Board survey of consumer sentiment fell to a record low, and their gauge of expected business conditions is at one of the lowest readings of that metric going back to 1978. A Dartmouth College economics professor and former Bank of England policy maker co-authored a 2021 paper that showed declines of 10 percentage points or more in either of the University of Michigan Conference Board surveys are predictors of recessions going back to the 1980s. The headline number is down by 30 percentage points this year. Near the end of the quarter, Goldman Sachs economists put the probability of a recession in the next year at 30%. A Bloomberg Economics model placed the probability at 38%. We think the number that may matter the most in the near term is the Atlanta Fed’s GDPNow indicator, which is a volatile yet accurate predictor of GDP growth during a current quarter. Currently GDPNow sees the second quarter running at a contraction of 2.1%. As a quarter gets closer to a close, the accuracy increases, according to Nicholas Colas of DataTrek Research. Since the Atlanta Fed first started running the model in 2011, its average error has been just 0.3%. In concert with the first quarter of 2022 contraction of 1.6%, the current GDPNow measure suggests that we are currently in a recession (typically defined as two consecutive quarters of GDP contraction).
Sentiment is down, workers are not confident about the employment environment; it appears that we are in a recession, but the headwinds don’t stop there. Although elevated fuel costs are weighing down both consumers and corporations alike, some current operating challenges may start to impact corporate profitability (which we expect has a strong chance of pulling the “E” down in the widely observed P/E Ratio followed by stock investors). Specifically, the strong US Dollar is being mentioned by companies including Costco, Microsoft, Salesforce, and Hewlett-Packard as a reason for reduced profitability. For companies with overseas sales, a strong dollar reduces the value of their foreign revenue and at the same time it makes their products less competitive as prices rise in local currency terms (in the foreign currency, more money is required to buy US goods). Beyond currency dynamics, other areas of difficulty for corporate profits include rising wage costs, volatile yet generally higher input costs and nagging supply chain hiccups. When the demand picture sours, look for abrupt production, cost containment, and investment changes on the part of corporations.
Expect turmoil in most sectors that are exposed to rising borrowing costs as a risk. It appears that the housing market is set for a meaningful pause in activity. According to Redfin, in June nearly 60,000 home sales fell through, which was roughly 15% of the transactions for the month. The primary factors impacting affordability and transaction trends has to do with the fact that mortgage rates are nearly double what they were at the start of the year, and according to an S&P CoreLogic Case-Shiller housing price index, prices are up approximately 20% as compared to last year. Sales of new homes fell in April by the most in nine years, decreasing by 16.6%. A lot of economic activity is generated by the buying and building of homes, so marginally this will act as a weight on domestic GDP growth.
Retailers are also feeling the pinch of higher fuel prices, elevated staffing costs, and changing consumer behavior. In May, both Walmart and Target guided earnings estimates lower. Walmart said that rising food prices were forcing consumers to spend more on essentials than expected. Walmart’s inventories of $61.2 billion at the end of the first quarter were about a third higher than a year prior and as of April 30, Target was carrying $15.1 billion of inventory, about 43% more than a year earlier. It seems retail is poised to be a sector that could add to the economic drag from both the perspective of profitability and contribution to the job market.
Mid-term elections are coming up, and a natural solution to our recession would be another round of stimulus programs to help working families shoulder the burden of higher food and fuel costs during this challenging time.
Ignoring the geopolitical risks waiting in the shadows, our wildcard event is what we call the dire “feel good” scenario. In this scenario, Q2 GDP growth comes in negative, officially placing the US economy in a recession. Mid-term elections are coming up, and a natural solution to our recession would be another round of stimulus programs to help working families shoulder the burden of higher food and fuel costs during this challenging time. Unfortunately, it was supply bottlenecks, extreme central bank accommodation and stimulus dollars (both superfluous corporate and individual payments) that heavily contributed to getting us to inflation not seen in 40 years. If the Fed were to be using its nearly $9 trillion balance sheet at cross-purposes with a Congress and White House that is likely willing to throw trillions of dollars of stimulus at voters, the unintended consequences could be immense. The recently broadened goals of the Fed seemed to be a danger to their ability to fulfill their dual mandate of price stability and full employment, but if the Fed were to be acting counter to the actions of Congress, we think there would be calls for the end of the Fed in its current state. At a minimum the efficacy of the Fed would be undermined, but it would also face a credibility crisis. We mentioned a potential scenario of recession and stimulus benefits (both for the politicians and the recipients/voters) last quarter and it seems like in small ways it may already be playing out. Starting in October in California, a relief package totaling $9.5 billion will involve sending checks of between $200 and $1,050 to approximately 17 million families. States including Colorado, Maine, Indiana, and Delaware are implementing similar programs to help people cope with high prices. At the margin, such efforts are counter to the Fed’s goals. This whole inflation issue is a vicious cycle, especially if pain is required to stop the inflation. It very well may be the case that solutions born out of compassion are the very acts that risk an inflation mindset persisting and exacting more pain on working families. Although the pain of recessions tends to not be equal, it seems as though the only way to get through this episode more unified is if the sacrifices are as wide-spread as possible (and our hope for that mindset among the “problem-solvers” is probably misplaced).
Fits and starts of inflation will be our reality until the 80% of workers who fear losing their job in a recession start convincingly changing their consumption behaviors. We find ourselves getting trapped in the regime-switching mindset we have discussed many times in the past (the idea/market behavior that says you are always moving from position A to position B, or vice versa). Our expectation is that a recession is in the cards, but the same nimble Fed that ended Quantitative Easing and then tightened and announced Quantitative Tightening (QT) in a matter of weeks has the ability to cease aspects of the tightening programs if market liquidity, risk spreads, capital market access, or elements of the Fed’s dual mandate dictate. Following the mid-term elections, a form of gridlock will be the political operating environment for the next couple of years, so broadly needed spending plans may succeed, but more partisan goals will be slow to progress.
As the Fed continues to raise short-term rates, the yield curve should be flat, and depending on the degree of fear about the recession, we may see significant inversions. The world continues to be awash with significant monetary supply. That leads us to expect that term premium (the yield compensation for holding longer-maturity bonds) and general interest rates will have a longer-term bias toward being modest. Productivity also seems to have a generational pull toward being not supportive of rapid growth. Against that backdrop, we believe meaningful dislocations from long-term relationships are buying opportunities. The recent municipal market liquidity crunch, dramatically wider than average spreads (for quality borrowers), or certain odd sector relationship deviations may present opportunities to buy quality issuers of sectors during the “throw the baby out with the bathwater” moments.
As expected, QT has impacted market liquidity, so bouts of volatility will persist. Europe is moving toward recession and the US seems to be moving in lock step. The regime-switching mindset probably means that bond market investors will continue to be knocked around by market moves, but as the probability of recession and the magnitude are thought to be understood by the market, we expect a downward trend in the less manipulated segments of the bond market will ensue. 10-year Treasury yields should continue to flutter around 3.0% before drifting lower at the end of the year. Municipal investors may see 10-year yields circle back toward 2.50%. Longer-term, we think there is more force that will likely push yields closer to 2%.
The Fed’s fear of not breaking inflation is palpable.
Fiscal spending seems to be shrinking and gridlock will make that the base case. Business and consumer sentiment is in collapse. Major industries are facing numerous headwinds and turning an eye toward cost savings. The Fed’s fear of not breaking inflation is palpable. How does this not translate into a recession and eventually lower bond yields? The idea of a full-employment, pain-free end of the inflation situation in which we find ourselves is fiction. The story we are about to read belongs more on coarse newsprint with the annoying ink that stains your fingers.
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