With investors wondering whether we are finally through the worst of the selloff, our latest Strategic Income outlook tries to answer the question, “Are we there yet?”
Are We There Yet?
Anyone who has been on a long road trip has no doubt heard the above refrain, especially those traveling with young children. It seems to be an apt metaphor given the current economic and market uncertainty. The question can be asked about many important topics today, including inflation, the Fed tightening cycle, and the stock market. All three have taken investors on a wild ride so far this year, and understandably, investors are anxiously awaiting better news – some tangible evidence we have “arrived” at the bottom of whatever this is. The stakes are high, as the specter of recession looms over the economy while we try to figure out where we are, but sadly, the answers are not a simple yes or no.
Given market returns so far this year, one certainly hopes the answer is, “Almost.” As concerns over inflation, Fed tightening, and a possible “hard landing” weighed on investors’ minds, the S&P 500 delivered its worst first half performance since 1962 (and nearly its worst since 1932!), losing 19.96% – almost 20% – a level commonly referred to as a bear market. While bear markets do not cause recessions, declines in equity prices (and 401(k) balances) can have negative psychological effects on consumers. On the other hand, given the stretched valuations that many stocks reached after more than a decade of “free” money, it is somewhat reassuring (yet painful) to see valuations come back to earth. It is worth noting that the market recovered nicely in both ’32 and ‘62. The 5-year annualized return following the 1932 first half was 30.0%, and the 10-year annualized return was 10.5%. Likewise, the 5-year annualized return following the 1962 first half was 14.2% and the 10-year annualized return was 10.5%. We hope history rhymes.
Bonds have not been spared either. The Bloomberg U.S. Aggregate Bond Index is down 10.35% for the first half of 2022, and according to Deutsche Bank the performance of the 10-year U.S. Treasury over the same period is the worst since 1788! This may have more to do with the simple math of starting with the lowest coupon rate in 200+ years. However, the good news for bonds is that as prices fall yields rise. As of 6/30, the yield on the 10-year Treasury was 3.0% and the yield on the ICE BofA High Yield Index was 9.0%, so if investors can weather market volatility, base loading a portfolio with higher yields should generate better future returns. As a sign that we may be closer to a bottom, we have seen more non-traditional buyers bottom fishing in the high yield market to take advantage of these more generous yields. Are we there yet? Getting closer?
The Fed has raised its fed funds rate by 150 basis points since the beginning of the current tightening cycle, which started in March. As Chairman Powell has already said, the next raise (in July) will be 50 or 75 basis points, and there are several meetings to follow in the fall. The Fed has been emphatic that containing inflation is their number one goal right now. The concern of strategists, which is amplified by the media, is that everyday citizens believe there is runaway inflation. If one believes that the Fed is stomping on the proverbial brakes too hard and will cause a severe recession, it certainly can change corporate spending plans, which would have a chilling effect on economic growth. After all, CEOs watch the news like everyone else.
The reality, however, may be more nuanced. As they say, the best cure for high prices is high prices. We have seen inflationary pressures in many sectors, particularly the price of gasoline, which surpassed $7 a gallon in some regions of the country. Driven in part by a rise in global oil prices due to the war in Ukraine, it is also self-induced as Americans had a pent-up desire to travel post-pandemic, so demand is currently outstripping supply. But is this a longer-term problem? If consumers decide that a long road trip (cue the refrain) is too expensive, they will stay closer to home, cutting demand for fuel. Additionally, Congress, along with some states, is considering a gas tax holiday to ease the burden on consumers, although we doubt this will make much of a dent. Of course, if prices stay high the industry may produce additional supply.
Similarly, actions by consumers in one area can also blunt inflationary headwinds in others. The result of spending more on gasoline may limit how much one can spend on other goods and services, thereby limiting demand in other sectors of the economy. Additionally, consumers may begin to balk at higher prices. For at least the last 12 months, companies have been discussing rising raw material and input costs on their earnings calls. So, it should not be a surprise that for the last few quarters we have seen those costs passed along to consumers. Eventually, there will be pushback, but it takes time for behavior to change - what economists call the substitution effect. As we have talked about before, individuals’ experience with inflation also depends on their respective purchasing baskets. If you are not in the market for a new house or car, higher prices and rising borrowing costs are not going to affect you, and your overall basket will likely be cheaper than the headline CPI would suggest. Yet, seeing price increases and inflation discussed on the news nightly may affect your mindset.
This is evident in the Michigan Consumer Confidence survey, which has steadily declined over the last six months. While not great news, it is a sentiment index which can be swayed by stock market moves and media headlines. Catch people on a positive day and you may get a different reading. The Wall Street Journal recently wrote an article discussing the issues with the Consumer Confidence index. What the author found was that most people have no real sense of how much prices will rise and when queried typically respond with large round numbers. In addition, political affiliation seems to influence a respondent’s outlook based on whose party is in office. The author found that whoever’s favored party is in power has the rosier outlook. Clearly it is difficult in our polarized political environment to give the opposition any credit for a decent economy. Surveys like the Consumer Confidence index are soft measures of the economy. While we prefer more hard data indicators, it is still helpful to understand what consumers are feeling but we advise taking it with a large grain of salt.
It is also important to monitor changes in people’s ingrained thinking, which can lead to changes in behavior. If consumers are concerned that the Fed will raise rates too high and cause a deep recession, as in the early 1980s or after 2008, they may alter their spending and savings plans, which could induce a steeper economic decline or accelerate the timing. The reality is that every recession is different. In the early 1980s, when Paul Volcker, Chairman of the Federal Reserve, tried to beat down inflation with large rate increases, it was already ingrained in consumers’ minds as it had been elevated for nearly a decade. Dealing with inflation had become a way of life, and to break the inflationary mindset required more drastic measures. In 2008, we faced the reckoning of overleveraging and risk-taking that culminated in a collapse of the housing bubble and sent the economy into a severe recession. In addition, it almost took down the global banking system, which was littered with bad mortgage paper. The difference today is we have an economy that has battled through the pandemic shutdown and subsequent reopening, resulting in an inflationary boom, and is slowly reverting to a more normal, moderate growth pattern, albeit with elevated inflation – potentially for some time. Additionally, banks are mostly very healthy due to heavy regulation.
John Mauldin reminds us that historically in the 1990s, a 3% annual CPI reading was common and did not cause concern. He also highlighted that “CPI approached 5% in 2005 and was briefly over 5% in 2008. But from 2012 until last year, 3% was a hard ceiling — to the point where Federal Reserve officials worried more about generating inflation than preventing it.” Current interest rates are a matter of perspective and reference. Since we have had such low inflation for a while now, it has come to be expected as the norm. That has now changed, and unfortunately breaking that thinking is what the Fed needs to do, while walking a fine line so as not to send us into a deep recession.
While the debate about whether the Fed can engineer a soft landing will persist over the next few quarters as they continue raising rates, the current tightening cycle does seem to be having the desired effect. Consumers have pulled back on spending for homes and other durable goods. As we have seen in earnings reports, some big box retailers are stuck with a significant amount of inventory as supply chain snarls have mostly been worked out (and they ordered too much). Retailers will be resorting to significant discounting to move this excess inventory, which should counter some inflationary anchoring for consumers as they see bargains emerging. Higher mortgage rates have led to slowing home sales. In turn, commodities related to housing have been coming down significantly concurrent with the decline in demand. Lumber prices have dropped 58% since March and copper prices are down 21% in the same time frame. In addition, the Purchasing Managers Index, currently at 51.2%, has been softening. As an offset though, unemployment claims continue to drop as jobs are still relatively plentiful, but this bears watching for any deterioration. While the data are mixed, it does not seem that inflation will be getting too far out of hand. Couple this with the fact that the Fed only recently began the runoff of its balance sheet (quantitative tightening), which should dampen liquidity further. Liquidity is the kindling upon which inflation depends, so this could put some upward pressure on yields making them more attractive for investors.
Typically, recessions lead to corporate stress and defaults as a slowing economy impacts fundamentals and profitability. Given the work corporate finance teams have done to improve their balance sheets over the last few years, defaults should not be a systemic problem for the markets. While we welcome some creative destruction and a metaphorical clearing of the deck, most companies were able to refinance debt with longer maturities and lower coupons, helping to insulate their balance sheets from future rate increases and slowing fundamentals. At this point, the “maturity wall” in the high yield market is very low and does not portend a significant concern. Tempering this, however, is the significant amount of not-yet-issued bridge loans and leverage buyout (LBO) debt that banks have already committed to. This overhang is something we are keeping an eye on, though we are slightly reassured that investors are finally demanding very high yields and concessions from issuers of LBO paper that carry higher leverage, which is a welcome return to more rational capital allocation. Regardless, we are not concerned that this will be a systemic banking issue, but it could cause banks to restrict some lending or be less willing to extend credit at reasonable rates, possibly creating an additional headwind.
So, we return to the question, “Are we there yet?” The Fed is determined to raise rates at least a few more times. Some commodities seem to be softening as the growth outlook slows due to consumers and companies who are changing their spending/investing habits. Whether the Fed can truly engineer a soft landing or shallow recession will be the debate over the next few quarters. Consumers have better balance sheets, states are still running surpluses, and the markets are approaching attractive levels. But given the continued headwinds, we are not ready to answer the question with a definitive “YES.” In the meantime, we are selectively adding positions at these wider market levels but also maintaining a healthy cash balance for any further market declines. And as rates continue to rise, we are once again able to add commercial paper to enhance our short-term yields.
We thank you for your continued support, and we look forward to hearing from you.
Carl Kaufman
Co-President, Co-Chief Executive Officer, Chief Investment Officer – Strategic Income & Managing Director – Fixed Income
Bradley Kane
Vice President & Portfolio Manager
Craig Manchuck
Vice President & Portfolio Manager
© Osterweis Capital Management
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