"I skate to where the puck is going to be, not where it has been." Wayne Gretzky
The puck has certainly moved since our last market commentary. This month, we argue that the needle on portfolio construction should move with it. Equities have been the driver of returns for much of the last few years. While they will continue to serve their purpose in portfolios, the backdrop of a global easing cycle, a historic election, and slowing (but not plummeting) growth means it’s time for fixed income to drop the gloves. Both the fundamental and technical setup point to an evolution of the traditional 60-40 (or 60-30-10, with a 10% allocation to private/bespoke opportunities) toward a 40-50-10, where an income-focused fixed income allocation is the backbone of portfolios.
What is normally a quiet period for markets began with a roughing of crowded positions in early August. Stretched valuations in tech stocks, a five standard deviation move in the Japanese Yen, and a slightly weaker July payrolls report, culminated in the largest intraday volatility event outside of Covid and the Global Financial Crisis. The fact that such a marginal series of events created such market turmoil underscores the immense crowding and leverage that exist in today’s markets and warrants some forward-portfolio caution. While the August 5th scramble was overexaggerated, there is legitimate weakness in the labor market as evidenced by the 1.6 million jobs that have been ‘revised away’ by the BLS since February 2022. The good news is that the increase in the unemployment rate has disproportionately been a function of new entrants (as opposed to job losers), which is different from past cycles. Although the labor market is certainly softening, it’s softening from overly tight to a more normal place. That has finally pushed the Federal Reserve to start cutting rates, and by cutting 50 basis points (bps) they have rightly recognized that this half of their mandate is waving, not drowning.
The other half of the dual mandate is firmly back in normal territory with August’s CPI printing the lowest year-over-year reading in more than three years. While the shelter component has seen a small bump from the lows, a healthy downward trajectory is intact and leading indicators suggest further moderation in the coming months. Market expectations for inflation, as measured by 2-year breakevens, have almost halved since April. There has been a tremendous amount of progress made on this front, all while growth has remained astonishingly resilient. As we’ve been highlighting for much of this year, however, there is clear bifurcation taking place under the hood.
The older and wealthier cohorts are net beneficiaries of higher rates, and are driving the robust consumption data, while the less wealthy and younger groups are bearing the brunt of tighter financial conditions. Both sides of the dual mandate screen as normal; even with the first cut in the books, the Fed Funds rate still looks abnormal. The rate descent should happen faster, and it appears that this is happening now. The question is whether pricing in the market is now too aggressive for a Fed which is recalibrating the rate in an economy that is still operating at a very solid level. There is no indication of the significant deterioration in growth or labor data needed to realize the magnitude of easing that the market has priced over the next year. We view some of the valuations in the front-end as overzealous, relative to the Fed’s ultimate disposition here, but the real yields on offer in the belly of the curve still look attractive.
We wrote about the known unknowns blurring the forward picture in our last insight, which remain the elephants in the room for investing over virtually every horizon. The election, and its policy implications, are increasingly dominating the market zeitgeist. The effects of tax, trade, and immigration policy can only begin to be analyzed in earnest once we have more details. A related point in the near-term is the seasonal headwinds typical of this part of the year, which is accentuated in election years. Since 1952, large-cap U.S. equities have averaged a 1.7% cumulative drop in September and October, with that increasing to 2.3% in Presidential election years. The U.S. Aggregate has posted a negative return in these two months for each of the last five years, which can partly be explained by the post-Labor Day pickup in issuance. This year appears to be bucking the trend, with the Agg up 159 bps in September at the time of writing. The high expectations the market has penciled in for the Fed has been an overwhelming force, we see potential for volatility to continue as those expectations take on a more realistic shape.
Within fixed income, we have been calling for an income-driven approach for most of this year and still see it as a once-in-a-generation opportunity to lock in abnormally high yields. The rise of securitization and the shrinking of bank balance sheets has expanded the precision and sophistication of debt investing to be almost unrecognizable from a few decades ago. Fixed income no longer just means duration. Which is just as well, because we don’t see a whole lot to be excited about in the Treasury market. The final elephant (or mammoth) in the room is the massive government debt requirements of the coming years.
Fiscal deficits have become a bipartisan mainstay, and with non-zero rates the interest burden is on track to exceed every non-defense discretionary category of the budget by 2030. The question of who absorbs all this duration risk looms large. We would go as far as to say the risk-free rate is no longer risk-free. Many of the largest companies have enough cash on their balance sheets to pay off the entirety of their borrowing today and have reliably increasing profits (as opposed to deficits). Doesn’t a company like Apple look more credit-worthy than the government? Corporations obviously don’t have taxing authority or the ability to create money, but the supply dynamics and periodic risks of partisan-driven default should motivate a conversation about where the actual ‘risk-free’ benchmark should be. At the very least, we see this as reason for credit spreads for the highest quality issuers to be comparatively tighter than history.
Further, the U.S. Treasury market is at the highs as a share of money in circulation; meanwhile, credit markets are smaller than in the 2010s! One of the major reasons to move the needle on portfolio construction is that there is a staggering amount of cash on the sidelines today. As the funds rate comes down, this money should move into yielding assets, which are limited in supply. The entirety of the indexed U.S. fixed income market is now throwing off $2.3 trillion of annual coupon that needs to be reinvested. Compare this to the year-to-date net U.S. fixed income ex-Treasuries supply of $1.4 trillion The reinvestment requirements alone overwhelm total net supply of U.S. fixed income, ex-Treasuries! A similar dynamic can be seen on a global scale, reinvestment needs far surpass supply, and that’s without even considering the $9 trillion sitting in global money markets. This supply/demand mismatch is an incredibly powerful technical support for spread assets.
We still need to consider the possibility of the economy slowing, so as always it makes sense not to overdo it in credit, but the fundamentals and technicals have arguably never been better for yielding assets (especially in high yield). U.S. HY has seen negative net issuance for most of the past two years. While the investment-grade (IG) market has seen little growth in the past decade as a share of the money in circulation, the HY market has been outright shrinking since 2016! Net leverage has come down broadly across ratings, and the quality mix is higher rated than in the past, with 50% of the index in BBs rated credits today. The composition is even more compelling in Europe where 65% of the market is rated BB- or above. Of course, selectivity will remain key in HY but the real yields on offer in this space are a paragon of what we mean by this being a golden age. It felt attractive before, now add to that an easing Fed. Even if spreads on yielding assets widen somewhat as the “risk-free” rate comes down, the income capture with high loss-breakevens is so compelling. With current pricing a diversified, global, income-focused portfolio may be able to achieve a 6.5% yield with less than 3% volatility.
Moving the portfolio allocation needle towards fixed income definitionally reduces exposure to equities. Over the past couple of years, we have spoken about the attractiveness of the all-time high returns-on-equity (ROE) in the equity market, rendering even elevated P/E ratios reasonable. Today, however, with an economy coming off the boil alongside high valuations, it’s hard to see the same sort of price momentum that we have seen over the past few years. The S&P 500 is trading at its highest valuation of the last 30 years, outside of the tech bubble and 2021 froth. The gap between where the index would be if it was trading at its long-term average P/E and where it is actually trading has rarely been wider. Equities should still be part of a long-term investment portfolio, but some of the near-term juice may have been squeezed out already. Given what the yielding alternatives look like today, the portfolio needle should move to more stability (and income). For years, we used the free cash flow DCF model, discounted by credit yields to highlight the attractiveness of equities over credit in the 2010s - a time when yields, the cost of debt, and the discount rate for equity valuations were lower, yet valuations remained very reasonable. Today, this calculation is showing the exact opposite dynamic.
It’s true that this valuation tool made equities look rich for the past year, but artificial intelligence (AI) and outsized tech returns created historic ROE that is unlikely to be repeated. While these are still great companies with further return potential, we prefer more balance today. With the contribution of equities to a 60-40 portfolio’s yield at its lowest in nearly two decades, it’s time to move the needle. We are not talking about a massive shift but, depending on the holding period, one could re-orient portfolios appropriately to more stable, income-heavy return drivers. We are not advocating to sell equities in longer-term oriented investment portfolios, just that the marginal allocation of new investments should reduce sizing allocation to equities in favor of income. The 60-30-10 can gradually shift to a 40-50-10, where the “50” is in diversified, yielding Fixed Income assets and the “10” is in uncorrelated bespoke deals, creating a generously yielding portfolio that can produce income and still have exposure to equity upside.
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