Still Waiting…for the Recession
Strategy
Interest rates have been rising steadily since May. The yield on the 2-year maturity Treasury note has increased from 3.80% to nearly 5.0%. Similar changes have occurred all along the yield curve but at a slightly lower magnitude. The movement in the 2-year Treasury reflects the steady increase in the fed funds rate as well as expectations of additional rate hikes. We have been somewhat puzzled by the movement in the longer end because inflation has been falling steadily. The longer end of the yield curve tends to have a strong correlation to inflation. Recall headline CPI has fallen from 9% to 3% as of June. The large monthly CPI data releases should come to an end this month. Future declines will be harder to produce. The market likely got ahead of itself when rates fell sharply in March and the start of April. It’s taken most of this back as unified Fed rhetoric voiced concerns over core inflation.
One interesting segment of the fixed income markets that is very attractive is the mortgage-backed securities (MBS) sector. Yield spreads are extremely wide versus historical norms. MBS with a 20-year final maturity trade at yield spreads of 100 – 140 basis points depending on the coupon. Lower coupon pools tend to trade at lower yield spreads than higher coupon pools because lower coupon pools have less prepayment risk. Pools with a 15-year original maturity provide yield spreads of 50 – 115 basis points. The yields for both 20 and 15-year pools range from 4.80% - 5.60%. The lower coupon pools trade at a significant discount making prepayments at par very attractive. Since these investments are backed by the government, there isn’t any credit risk. This could be very valuable if there is a recession next year.
Many people have commented that the peak in yields is around the 6-month maturity. Many don’t understand why an investor may benefit from investing their money longer and receiving a lower yield, which typically isn’t the case. The reason is that yields are expected to be lower next year. Why take reinvestment risk in 6 months when you can purchase fixed income securities with attractive yields for a much longer timeframe? Yields are the highest in many years and logic dictates taking advantage of the current yield environment.
"...bond portfolio management in our view is about portfolio construction and 'tilting' toward safety or risk."
Near-term we expect base effects to produce a market sentiment that suggests inflation is behaving, followed by a reversal that head-fakes the market into thinking that the Fed is fighting inflation with insufficient tools. Fiscal policy has the ability to muddy the waters. Even if the student loan jubilee efforts turn into a forbearance extension of roughly a year, that is a stimulus of between $144 billion (assuming the average student loan payment is $300/month and there are 40 million loans) and $400 billion of debt is forgiven. The third or fourth quarter of this year seems to be shaping up to be the moment when liquidity and financing become scarce, risk spreads widen, and broad risk appetites are recalibrated. Leading up to the stress, we have a bias toward quality and liquidity, but as we’ve said many times in the past, bond portfolio management in our view is about portfolio construction and “tilting” toward safety or risk. It seems like 2023 will be the year of planning, adjusting, and constructing the portfolio in the current “higher” yielding environment, along with formulating the plan to participate in the dynamic environment we expect for the balance of 2023.
ACG’s research suggests that owning quality bonds with longer duration near the conclusion of a Fed tightening cycle historically has produced some of the more compelling forward returns of most of the return factors we track. Offsetting this opportunity is the fact that risk spreads are currently tight (risk spreads are the incremental yield investors earn for holding a non-Treasury bond as compared to a like-maturity Treasury). We think spreads will “adjust” higher from the current state which is approximately a full standard deviation “tight” as compared to the relationship for the past decade (using “A” rated corporates with a 10-year maturity). If this correction occurs, we will likely be enthusiastic about fully expressing our bias for high-quality long-duration assets. In the meantime, a barbell strategy of some short and liquid holdings and longer duration should position appropriate investors with a portfolio that has strong earning horsepower and the ability to be opportunistically nimble over the remainder of 2023, to set portfolios up for a potentially exciting 2024.
Observations and Outlook – Here Comes the Head Fake
Many things that usually signal a pending recession have been in place for quite a while, yet no GDP data points to negative growth. Examples of these signals include an inverted yield curve, restrictive monetary policy, leading indicators that have been falling for numerous months, and a decline in year-over-year Gross Domestic Income (GDI). This last point is notable because there has never been a year-over-year decline in GDI without a preceding or coincident recession. GDP data tends to track GDI data and GDP revisions tend to follow GDI. It would seem the slowing inflationary dynamic has momentum to continue, and a “soft landing” may be difficult to achieve.
Based on the third revision to 1Q GDP, growth was 2.0% in the first quarter. The 2nd quarter looks to be somewhere between 2.0% and 2.4%. The Bloomberg Economic Surprise Index hit a 2-year high. A strong labor market continues to provide fuel for consumers to spend. Consumer spending is nearly 70% of GDP. Real incomes are now growing. As consumer spending goes, so goes economic growth. There remain over 9 million unfilled jobs leading one to assign a very low probability to an imminent slowdown in the labor markets. The most recent nonfarm payroll report showed a slight slowdown in job creation with a moderate gain in wages. GDP will likely be negatively impacted by the resumption of student loan payments later this summer, but the Administration is working on ways to delay it further.
Even though the Fed has indicated it will raise rates up to two more times this year, inflation continues to fall. The Consumer Price Index (CPI) peaked at 9.1% in June of 2022. The June 2023 CPI YOY reading was 3.0%. The money supply has also declined, which tends to foretell a decline in inflation by 13 months. Most agree inflation is falling. The Fed is focused on “supercore” inflation. This measure removes food, energy, and housing. The issue is that isn’t falling fast enough.
As the third quarter of 2023 is underway, it seems the Fed can nearly abandon half of their dual mandate, price stability and full employment, for the near-term. Although a slowing in some of the job metrics has materialized, unemployment is currently 3.6% and wages are growing at an annualized rate of 4.4%. The decelerating aspect of the job market comes from recent downward revisions to the April and May job growth and the slowest pace of nonfarm payroll growth since late 2020. The quarter should play out as a whirlpool of tight monetary policy, colliding with loose fiscal policy, mixed with nonuniform economic results and waves of vacillating market sentiment.
"A two-year pandemic will turn into a four-year debt forbearance in a strong job environment."
Monetary policy will be restrictive. Even if the Fed doesn’t raise the Fed Funds rate 25 – 50 basis points more this year as is anticipated, current Quantitative Tightening (QT) balance sheet reduction efforts are expected to result in roughly a $1 trillion shrinkage of the Fed’s balance sheet. The Fed Funds Rate is in restrictive territory so borrowing costs are starting to weigh on some consumers and corporations. Although unemployment is very low and wages are climbing, there are efforts to continue the series of stimulative fiscal policies, not-too dissimilar to the stimulus programs that topped off the end of the pandemic and likely contributed to this bout of inflation. Student loan debt forgiveness is said to help more than 40 million Americans. Following the debt ceiling negotiations, where student loan payments were to resume in October, the Supreme Court struck down the Biden Administration’s student loan forgiveness policy. In response, the Administration has a “no consequences” solution. Borrowers who miss payments will be spared many of the usual consequences of non-payment until October of 2024, which is somewhat close to the November elections. Loans will not go into default and delinquencies will not be reported to the credit reporting agencies. A two-year pandemic will turn into a four-year debt forbearance in a strong job environment. It is relevant to the collision between monetary policy and offsetting fiscal policy because the debt forgiveness jubilee would represent nearly half a trillion dollars of stimulus. It feels like a future recession of character may be born out of our current solutions to problems of many non-needy people. On a short-term basis, the “no consequences” solution improves student loan borrower’s cashflow by approximately $300 per month (Source: US News & World Report, as of March 2023). That has been and will continue to be a lot of additional dollars circulating around in the economy.
Away from stimulative fiscal efforts, economic releases and persistent strength will likely make the third quarter the one where the crescendo of calls that the Fed is behind the curve and, that they may not have the tools to fight this brand of inflation, rises to the top of the headlines. Despite recently elevated mortgage rates, the consequences of 2022’s second and fourth quarter’s decline in residential investment has contributed to a shortage of existing homes for sale. What has been a drag on GDP growth may contribute to the sticky inflation that we anticipate will present itself in the 3rd quarter of 2023. Institutional buyers of residential homes have been on the sidelines for much of this year as price increases and financing costs have resulted in institutional buyers acquiring 90% fewer homes in the first couple months of 2023 as compared to the same period in 2022. If rates or prices fall, look for institutional buyers to jump back into the market, which should create a natural price floor. Without the institutional buyers housing demand has exceeded supply and as of April, new listings of existing homes remain 20% below the levels of a year ago. Past underinvestment, limited supply and robust demand suggest that housing could be a contributor to stubborn signs of inflation.
Base effects, the result of comparing a growth statistic to a particularly outsized number experienced during the preceding year, made the June 2023 headline CPI number look like inflation is subsiding. In late July, the Fed is expected to hike the Fed Funds Rate one more time (by 25 basis points). We expect the same base effects that make the market think inflation is significantly slowing, will reverse in July and August. The combination of a Fed rate hike that the market may interpret to be ineffective, with base effects that show inflation is not steadily in decline should precipitate a market reaction that the Fed is behind the curve and that the inflation genie can’t be put back in the bottle (because this brand of inflation is different). Stocks, which are fully valued by historical measures will likely send a temporary signal of strength as short positions have diminished and recent “high” levels and valuations may be carried even higher due to the regret of not being along for the ride up the “wall of worry” and the age-old “FOMO” (Fear of Missing Out).
"Money supply shrinkage often heralds recessions, and U.S. M2 money supply is shrinking at the fastest pace since the 1930s."
As mentioned last quarter, our thesis continues to be that the weight of restrictive Fed policy, both in the form of quantitative tightening and through previous and upcoming Fed Funds Rate hikes, along with negative money growth supply and a more smoothly functioning global supply chain means fewer dollars may be chasing an adequate number of goods and services. Money supply shrinkage often heralds recessions, and U.S. M2 money supply is shrinking at the fastest pace since the 1930s. Also adding to the weight of the situation is tighter lending standards on the part of community banks, and an unknown degree of carnage that banking system exposure to commercial real estate may cause bank profits and lending capacity to diminish. Banks with less than $100 billion in total assets have 14.4% of their assets in commercial real estate, nearly twice the exposure of banks with between $100 billion and $250 billion in assets, with 8.15% in commercial real estate loans. About 15% of U.S. banks now exceed the 2006 FDIC guidance on commercial real estate loan exposure. Banking system liquidity may be further challenged by continued Fed QT efforts (moving at a pace of roughly $1 trillion per year) and banking system reserves that may be drained out of the system as the U.S. Treasury fills its coffers with approximately $1 trillion in debt issuance, following the inability to issue debt leading up to the debt ceiling crisis. It has been estimated that the banking system needs to have $2.5 trillion in deposits at the Fed and currently reserves stand at $3.2 trillion. Clearly the Fed has injected liquidity when needed (such as the Reverse Repo Liquidity Facility) but it rarely elicits market confidence in markets when the Fed must run to the rescue.
Another theme we have expressed for the past few quarters is that the zombie companies and the zombie consumers are coming for us (we have even presented the idea of zombie governments, but their pockets are so deep that we don’t think the weight of higher rates will impact them in the short run). 55% of the smallest quintile companies in the Russell 2000 (small cap index) are unprofitable. In the top quintile of the largest companies in the same index, a surprising 20% of companies are unprofitable. It makes us wonder why people are paying such high multiples for stocks when many of them are not profitable. Perhaps the plan is to lose money slowly but make it up in volume. As sources of stimulus and liquidity are drained from the economy, it feels like zombie corporate borrowers, and stocks of unprofitable companies are poised for difficult times. Currently the junk rated debt sector is pricing in a default rate of roughly 4.6%. If a recession occurs, it would be reasonable to see high yield defaults move closer to 8%. Risk markets seem priced for perfection and some disappointment seems to be more of a sure thing, rather than achieving “perfection.” Zombie consumers may be moving in step with struggling corporations. Consumers may be changing behaviors as they have whittled-down savings that were accumulated during the pandemic, they have added to their credit card balances, and now they are “trading down” on basic goods. General Mills recently issued a profit warning, saying that consumers are substituting brand names for lower-cost alternatives. General Mills’ volumes fell in the last fiscal year in all categories except for North American foodservice. When people ditch their Honey Nut Cheerios for Honey O’s, you know consumer behavior is changing, eventually their psyche will follow subconscious trades and substitutions. Other signs of a discretionary recession, meaning trading down or skipping unnecessary expenses, are upon us. In a poll released at the end of May, 83% of Americans think the economy is fair or poor, and 72% expect it to get worse. According to Citigroup, through April, U.S. credit card spend on “Luxury” was down nearly 40% from a year earlier. Black Box Intelligence says that casual dining traffic has declined by 5.4%. Consumers may be encouraged to eat at home more because according to the Bureau of Labor Statistics, May restaurant price increases were 8.3% annualized as compared to the growth in cost of retail food, which grew at 5.8% annualized. The pain of inflation may finally be overwhelming people. According to economists at the University of California at Berkley, the inflation-adjusted value of assets held by the middle class has fallen 6%, or $2.4 trillion, or $34,000 per middle-class adult. We have known that savings rates were falling, and consumer debt is at or near all-time highs, but balances on home equity lines of credit rose by $3 billion in the first quarter of 2023, the fourth continuous quarter of increases after nearly 13 years of declines. As consumers’ bad feelings turn to changed behaviors, corporate profits should sink, and a recession seems to be the most reasonable outcome.