For the better part of the last decade, interest rates have been near zero and leverage has driven asset prices higher. Meanwhile, wage gains remained stubbornly low. The economy was not strong enough for the Fed to raise rates and shrink the money supply, but inflation looked to be inevitable nonetheless. Even so, banks were not increasing consumer lending. Fortunately, the stagflation scenario predicted as imminent by some economists never quite came to pass… at least not yet.
Today, after a brief dance with economic disaster, a realignment of the economy, coinciding with a variety of one-off events (supply chain disruptions, the Ukrainian war, and a labor supply shortage), has driven core inflation to levels not seen since the early 1980s. The Fed has raised rates three times already in 2022 and is signaling several more aggressive rate increases over the rest of the year. In a matter of 12 months, they seem to have gone from worrying that reducing economic stimulus might create a problem they could not control to worrying that the problem they cannot control now requires an aggressive reduction of that very same economic stimulus.
What we find interesting is that the current state of inflation, on the surface, appears to be the result of a series of seemingly one-off scenarios, and that may very well be the case. However, if one looks closer, patterns begin to emerge. For example, let us consider the war in Ukraine. There is no shortage of uncertainty facing the United States as a result of the Russian invasion. But what may not have been properly vetted yet is the broader risk to globalization that this war represents. It has been notable that the U.S. government believes that it can wage a shadow war on the Russian economy and Putin’s finances as a way to engage in the conflict for the benefit of Ukraine without engaging by sending soldiers to fight. The way they have done this is by shaming and/or sanctioning those who do business with Russia and expanding those policies slowly to those who do business with countries who align with Russia.
More and more, companies are being highlighted by people not affiliated with official U.S. policy for their willingness (or lack thereof) to withdraw from their business activities in the offending countries. A professor at Yale went so far as to publish a list of companies with Russian business interests, updated regularly to show who has or has not taken action. This list has galvanized a variety of people and organizations to take matters into their own hands and apply pressure to those companies.
To us, this is just the start of what could be something very big. We expect companies to start taking a closer look at even the smallest risk of being perceived as morally questionable. With branding in the 21st century being so closely tied to public perception, and with technology enabling such efficient citizen activism, the reality is that companies will need to imagine all sorts of unlikely scenarios to avoid risks, however small, before it is too late.
In our view, this means that the trend of globalization and the relentless focus on margins and profitability at all costs may begin to reverse. What used to be a decision focused on cost cutting may turn into a decision on how much additional cost is acceptable to avoid such risks. If companies begin to think of self-preservation in these terms, we would also expect to see a wave of onshoring, with increased manufacturing and service jobs coming back to the U.S. from a variety (though not all) locations around the globe. Labor and input costs would most likely be higher, which would force companies to aim to shore up their margins the only way they know how if cost cutting is no longer an effective arrow in the quiver: by raising prices even further.
What we are painting here is a scenario in which long-term inflation stays well above the Fed’s 2% target, maybe even 3-4% as a medium-term run rate. We wrote just at the end of 2021 about the impact of potentially unavoidable wage inflation on corporate earnings,1 but this potential scenario would require companies to continue to play catch-up on wages for years to come. This would prevent issuers from using higher prices to shore up margins and instead force companies to erode profits as they absorbed higher costs just to maintain their market shares. It is possible that we would see a widescale consolidation trend to use synergies and economies of scale as an offset to this financial impact.
What does this mean for the fixed income markets in which we invest? First, we may want to get used to a prolonged period of rising and then stubbornly high long-term interest rates with a steepening yield curve. It is no secret that such an environment favors both shorter duration and selective credit. However, this is not just due to the bond math benefit of not owning duration or beta in the face of rapidly rising interest rates. That said, it will give investors little comfort to recognize that the most likely counterpoint to this outcome is an economic recession, which may mitigate longer-term rates but at the expense of longer-term credit spreads. Either way, we prefer sticking to shorter timeframes.
In the past, we have highlighted another little-publicized differentiator of resilient fixed income portfolios. Too often, investors see market prices decline and assume that they will rebound. Today’s focus on ETFs, in which bond portfolios are traded like equities, have reinforced this misperception. However, a key characteristic of a portfolio designed for capital preservation is how it performs if prices decline (due to higher rates, for example, or a recession) but do not recover. What if, instead of getting a V-shaped bounce, one has to wait for the higher yields in the portfolio to earn back the decline over time?
In that situation, which is the most likely outcome in the environments we describe above, a portfolio with the highest ratio of yield to remaining time offers the profile most likely to deliver consistently positive performance. To achieve such a ratio involves a thoughtful approach to credit, seeking securities which offer higher yields while mitigating default risk and managing volatility. This profile cannot be achieved with indexing, as credit analysis is an inherently active effort. Managed duration combined with careful security selection, in our opinion, provide the best buffers to the storms that may be brewing. The portfolio we aim to deliver is exactly that.
1 We have seen some weakening of the labor markets which could release some of the pressure temporarily for the remainder of 2022, and beyond if the Fed is unable to (or chooses not to) avoid triggering a recession. That said, when taking a longer-term view, every time we look at these types of issues from a different angle, we end up in the same place: The days of profit as top priority and outsized executive compensation (sometimes tied to profitability and sometimes regardless of it) are numbered. Practically, with fewer and fewer cost-cutting levers available to companies, we’re not sure they have much choice if they are to stay competitive in the labor markets. As investors who watch ESG factors closely, we believe we may be approaching a tipping point for governance factors in these areas, and once they reach the citizen activist mainstream, there will be no turning back.
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Venk Reddy is the Chief Investment Officer of Sustainable Credit Strategies at Osterweis Capital Management. Established in 1983, Osterweis Capital Management is an independent asset manager with $6.6 billion under management as of June 30, 2022. The firm provides investment management services to institutions and individuals through mutual funds and separate accounts, offering both equity and fixed income investment strategies. Learn more at www.osterweis.com.
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