June 22, 2022 | Cameron Parkhurst
School is out and we are getting into the midst of summer activities for those of us with children! My kids told me about their last days, after tests were completed. It was a festive mood prior to school ending and, apparently, some students took it to extremes. A few kids found a large package of unopened rubber bands and were having a battle of sorts in the classroom. The shooting match didn’t end all too well, with one child slightly injured and many others getting sent to the principal’s office for a pre-summer talking to!
This rubber band story got me thinking about the analogy that we commonly discuss in our IC meetings about things being stretched. The markets and economy right now are tense, with inflation continuing to be problematic (and the resulting “tax” weighing heavily on household budgets). The Fed is seemingly again behind the curve and has some tough upcoming decisions to be made regarding the path of rates, even after this latest 75 basis point bump last week. With this, fixed income markets are seemingly caught in the middle for the time being. As all these pieces interact through feedback loops, we will take a few minutes to unpack them and to help provide some important clarity as to where we see value in positioning bond portfolios today.
I think all would agree that we were very early and correct regarding inflation. We were ringing alarm bells well in advance of upward price momentum, and frankly did a very good job in positioning most Advisor portfolios for this eventuality.
A month ago, we made a rotation and began discussing the attractiveness of many fixed income sub-asset classes, especially munis. We were making that call, as our market radar has slowly, but surely, moved in the direction of a slowdown at best, and likely a recessionary environment coming in 2023 (and possibly even beginning later this year). For example, on Friday, the Atlanta Fed changed their most recent GDPNow forecast to effectively 0%, this coming after a negative first quarter report. This is very close to recession territory by the historical definition of two quarters of negative GDP.
Former Treasury Secretary, Lawrence Summers had some good insight a little over a week ago during a CNN interview, by stating “when inflation is as high as it is right now and unemployment is as low as it is right now, it’s almost always followed within two years by recession”. Furthermore, he stated “the Fed’s forecasts have tended to be much too optimistic there, and I hope they’ll realize fully the gravity of the problem.”
The CPI chart above is certainly problematic, as we have not seen inflation this stretched since the 1970’s and 80’s, and only a couple of times historically looking all the way back to the World War II era. Importantly, inflation has been widespread, encompassing everything from food, energy, fuel, rents, housing prices, cars, and many other goods.
Although many market participants expect inflation to subside, with its widespread effects, it may take longer than expected and may fall less steeply than many believe. Lingering widespread inflation is indeed problematic and is a significant tax to families and their budgets, as seen below:
So where does this really leave the Fed? In our opinion, between a rock and a hard place. They have a very difficult job in front of them to stabilize the stretched rubber band without breaking the markets and driving the economy into significant recession. With this persistent inflation, the Fed is poised for at least 50-basis point rate increases in July and September…and another “shock” 75-bp increase is not off the table at this point.
With the latest CPI release coming in at 8.6% in May, a 40-year high, we have started to see a significant development in the bond market. While we had seen positive sloping steepness to the yield curve, we began to see slight inversion at the end of last week. 5-Year vs. 30 Year Treasuries inverted, and we saw moments of even the 2-Year Treasury above the long bond. This is historically significant when prognosticating a recession.
This inversion was fear driven, with bond market participants thinking that we could see an overly aggressive Fed attempt to contain inflation, and thus the potential rising for a hard landing for the economy. A hard landing would have impacts for all markets, both fixed income and equity.
Using the feedback loop thinking, this brings us to the stretched fixed income rubber band. The band has been tensioning, with a painful ride of negative returns since the beginning of 2022.Treasury rates rose significantly, corporate spreads blew out to wide levels, and munis, both taxable and tax free sold off. There was an ebb in asset flows out of most fixed income sub-asset classes.
While the ride was painful for existing bond holders, it has set things up opportunistically. As the June CPI report came out a couple weeks prior, we saw a retest of highs. Just after the Fed’s not so surprising 75 basis point hike, and their language in the report, we saw another tick up in rates. Yields certainly could temporarily go higher, but we think a situation of major league runaway rates is unlikely here. Each time we hit levels where intermediate term munis are trading in the mid-3% level we have seen some buying pressure step in. Combining this with the increasing potential for recession, we don’t expect rates to stay here over a multi-year period. At the end of this cycle, we expect inflation and rates to subside, and there to be higher unemployment than we are staring at today.
Looking at Treasury and Muni market movement last week, we saw a couple of interesting phenomena. First, it is instructive in highlighting that last week, post Fed, munis were still selling off (by a factor of 8-21 basis points depending on yield curve positioning) while Treasuries ultimately rallied by 5-15 basis points. This creates a dynamic where munis are getting back to cheap levels relative to Treasuries.
In mid-May, in our missive titled Muni Bond Attractiveness, we highlighted what we thought to be an important development in the muni market (with some bonds approaching an important 4% level). This thesis turned out spot on and we saw a subsequent muni rally, in addition to many Advisors taking advantage of a situation to capitalize on tax loss selling and portfolio duration adjustment. With the last CPI print, the Fed raising 75 bps, and fears of a possible hard landing growing, we are beginning to get a second bite at this apple for those who missed it the first time around. Thus, for those that may have missed the first opportunity in May, we should re-initiate some of those conversations now.
With the recent sell off, the high grade muni markets seem opportunistic here from both a yield and credit perspective. The quality component may become more and more compelling here as we have not seen major moves in high yield yet. History has shown that, traditionally, high yield has had significant underperformance vs. higher investment grade during these hard landing periods:
Also, when looking at taxable munis versus high grade corporates, taxable munis seem to offer both greater yield spread and historically higher overall credit quality in general. This combination of spread and quality is important to us here:
So where do we go from here with new portfolio cash or with existing positions? The objective is fourfold: 1) maintain quality. This is of the upmost importance. 2) Find sub-asset classes based on relative value and on a client’s tax situation. Currently this favors tax exempt munis for medium to high Federal brackets, and then taxable munis, some select corporates and MBS primarily for lower tax bracket clients and those inside of qualified plans. 3) Continue to evaluate tax loss selling opportunities and to use those proceeds to reposition for duration and quality. 4) Evaluate individual bonds as a substitute for core bond funds. To us, individual bonds provide more value from many perspectives, which we are happy to discuss.
With the potential for a recession soon, our bias would be to see volatility and some possible upside to yields here over the short term. Ultimately, we see falling rates with a slowdown. Thus, positioning for quality, but having some duration seems prudent. We would not be making a large bet towards the far end of the curve, but rather would advocate that having some exposure could make sense to accompany our traditional short-intermediate term duration (perhaps a barbell in some fashion to play both sides of the curve).
Most importantly, this is a great time to be having conversations with current clients and those prospective clients who have fixed income exposure. It is at these times when rubber bands could be flying across the room that we can be most valuable to you as your Advisor to fixed income. Thus, please don’t hesitate to leverage us in your efforts with clients. We are always just a short phone call or email away.
Thanks,
Your PeachCap Fixed Income Team
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