Macro Markets Podcast Episode 42 Transcript: The Active Fixed-Income Playbook for Elevated Uncertainty
Steve Brown, Chief Investment Officer for Total Return and Macro Strategies, discusses the long-term portfolio strategy implications of the evolving geopolitical, economic, and policy landscape. In this period of heightened volatility and uncertainty, he shares our active investment management approach to relative value, credit risk, and the shape of the yield curve.
Jay Diamond: Hi, everybody, and welcome to Macro Markets with Guggenheim Investments, where we invite leaders from our investment team to offer their analysis of the investment landscape and the economic outlook. I’m Jay Diamond, Head of Thought Leadership for Guggenheim Investments, and I’ll be hosting today. It’s been an eventful few weeks: We received a stronger than expected headline number from the nonfarm payrolls report, and the Consumer Price Index (CPI) report. And, of course, we have a new round of geopolitical risk to consider. With all of this going on, we are very fortunate to be joined today by Steve Brown, Chief Investment Officer for Total Return and Macro Strategies for Guggenheim. Steve, along with the rest of the investment team, is responsible for synthesizing all this information into our investment strategies. So welcome, Steve, and thanks for taking the time to chat with us today.
Steve Brown: Thank you, Jay. I really appreciate it.
Jay Diamond: Well, great. Now, Steve, it’s been an eventful few weeks in the markets, but let’s start with the economic backdrop. What’s your view right now on growth and inflation?
Steve Brown: First off, our thoughts are for all those who were affected by the regional conflict that is going to likely continue to flare up for quite some time. Setting the human impact aside, this does have the potential to be a more significant market and economic event, one that we’ll come to know more about in the days and weeks ahead, particularly if it has knock-on effects with other regional partners in the area. But setting that aside, if you will, and focusing first on the U.S. economic front, as you alluded to, the September jobs release came in hot, with a headline gain of 336,000, which was actually double the median forecast and higher than all 77 estimates. And that doesn’t even include an upward revision to the prior month’s release. So this undoubtedly shows that the labor market remains strong. However, we do think that under the hood there are some reasons to be more optimistic on the Fed’s path towards some easing of the labor market, in particular with regards to wage inflation and wage growth. So, wage growth is now running at a mid-3 percent annualized run rate over the past three months. And so this is actually right where the Fed wants it to be. And much has been made about the linkage between the structural services ex-housing component of inflation, and its ties to wage growth. Those two numbers don’t have to be the same: You don’t need wage growth in the 2 percent range to get inflation down to 2 percent. In fact, you can look back to the periods leading up to the pandemic where wage growth was in the 3 [percent range] and you saw no material structural impact on inflation. So, it’s moving in the right direction. You’re also seeing job gains being more concentrated from certain subsectors, including government and healthcare and leisure and hospitality, so undoubtedly a strong report. You saw the Treasury market in particular sell off accordingly, but this does to us just put a little bit more pressure on the Fed to keep interest rates higher for longer, which undoubtedly will then feed back into more of the eventuality of a slowing of the economy. The U.S. economic resilience of the past year can really be attributed to significant disinflation. If you think about it, inflation went from around 9 percent to around 3 percent over the span of the past year. That had a stimulative impact on spending and the consumer more broadly. But the slowing of inflation, while we still think will happen, will not happen in the same amount of magnitude. That, combined with still very elevated and massive fiscal deficits, somewhere around 8 percent of gross domestic product [GDP], out of which will also be impacted by this past weekend’s events and the events of the next month or so in trying to get Washington to come together, elect a speaker, and pass the legislation needed. All of these tailwinds are less impactful than they have been over the past six to 12 months. And so more broadly speaking, yes, the economy has been stronger than we would have expected, but we think that going forward, there’s more headwinds, if you will, than tailwinds. And so, we need to be mindful of that. When we think about portfolio strategy and investment implications.
Jay Diamond: How does this data picture play into your views on the path of monetary policy from here?
Steve Brown: There’s been a lot more reference to both voting and nonvoting members and their reference to broader financial conditions and to an acknowledgment of the steepening of the yield curve that we’ve seen over the past month to six weeks, and how high the level of interest rates are, and that they are likely sufficiently restrictive. So most of the commentary of late is really pushing back on the idea that the Fed could raise again. So again, not to sound like a broken record, but we think that short-term interest rates have peaked or [are] very close to their peak. The Fed is unlikely to, moving forward here with the policy rate and as they showed in their September meeting and the release of the Summary of Economic Projections [SEP], they are increasingly relying on forward guidance, if you will, and the talk of higher for longer and had really taken out a number of the rate cuts that they themselves had projected for next year. And the Fed now sees 50 basis points or so of rate cuts next year versus 100 that they previously expected. So, our thought there is that the quantitative tightening is the big unknown variable. We’re keeping a very close eye on bank reserves and the balance of the Reverse Repurchase Agreement (RRP) there are significant, and coming with a lagged impact of the reduction of the balance sheet, which is somewhat unprecedented. And so, the combination of the Fed trying to jawbone the market into not pricing in too many cuts, yet also acknowledging that they’re likely done hiking with the fact that quantitative tightening (QT), will kind of run in the background until it doesn’t mean that we can’t expect in a base case scenario a significant shift in Fed policy to easing. However, the next big move in interest rates and the big move on the policy front will likely be to the direction of easing. It’s just a matter of when and to what degree in scale.
Jay Diamond: Sounds like the transition from hiking to pausing to easing requires a lot of communication and digestion from the markets.
Steve Brown: Absolutely. And you’re seeing this indigestion play out really for the better part of this year. When you think about what the Fed has actually done this year on the policy change front, they haven’t done a lot. The majority of the rate hikes that have been put into the market were put in in the last calendar year of 2022. So they’ve really significantly slowed the speed of rate hikes, quantitative tightening. It has been the more dominant factor this year, but it’s the market indigestion, if you will, on the direction of policy and the magnitude of the next stage of policy, which is leading to increased levels of continued volatility in our view, a continued positive correlation between bonds and stocks rather than the normal inverse or negative correlation, and that’s having disparate effects on different parts of the credit markets and high-grade fixed income in particular as we’ll get to later in this conversation.
Jay Diamond: Speaking of volatility, we’ve seen the 10-year yield rise from about 4 percent in the late summer, and went over 4.8 percent. Where do you think we’re going from here?
Steve Brown: The technical set up has admittedly been very poor. A lot of the rationale for the significant steepening of the yield curve and the higher rates at the longer end of the curve [has] been blamed on supply and the continued structural need for a significant fiscal deficit and the unlikelihood that the path forward, regardless of which party is or isn’t in power, is leading to much fiscal reform. So that, combined with some stepping back of more traditional buyers ex-U.S., has led to much of the blame being ascribed to the couple of trillion dollars in coupon issuance we’re likely to see over the next 12 months. Now, that’s definitely part of the story. Another part, frankly, is that volatility can introduce positioning uncertainty. Clearly, you have a lot of cash on the sidelines. You have anywhere from $1.5–2 trillion of excess amount of capital in money market funds than prior to COVID. And frankly, the inverted yield curve is having an effect on capital allocators and where they’re going to put their capital. Clearly, the flows have spoken, and you have a lot of capital sitting in short-term funds happy to earn 5 percent. And that puts pressure on the whole system to absorb the supply of duration that’s come from the Treasury, but less so from the credit markets. So our highest conviction view right now is on the shape of the yield curve over the next year or two. We continue to think that the curve will steepen and could steepen meaningfully. It could do so under either of the baseline scenarios. One on the higher for longer, soft landing, miraculous disinflation positive narrative. Higher for longer should mean more term premium. It will likely allow and facilitate for continued issuance and supply. All of that should make long-term rates rise more than short-term rates, and with the Fed on hold or pause, if you will, and the potential next move toward easing, that will have a disproportionate effect the further out the curve you go. So that’s the kind of bull case for the economy that leads to a steeper yield curve. In the bear case for the economy, in markets where inflation and or the economy roll over significantly, that would likely call for a steeper yield curve driven by shorter rates coming down and then the curve starting to price in more and more cuts. Now, while in that scenario, interest rates are likely broadly to decline across the curve, again, it would lead to a more steepening scenario. And so that expression and that that view is of the highest conviction, less so on the direction of rates, but on the direction of rates, we look out over a year. We continue to think the long and variable lags of this very significant tightening we’ve gone through will have the desired impact on inflation. It does increase the risk of the economy rolling over significantly, both of which point to lower yields across the curve.
Jay Diamond: So, given your view on the economic slowdown and where you think rates are going to be going, what’s your view on credit right now and taking credit risk?
Steve Brown: So it depends on the sector, in short. Fortunately, right now you get paid to be defensive. Some of the widest spreads and some of the best opportunities we’re seeing are in some of the highest quality subsectors within the credit markets. When we think about credit market fundamentals more broadly, they look relatively strong. Of course, these fundamental views are largely lagging indicators, if you will, but we don’t see major systemic imbalances, particularly within the corporate credit market. I mean, you could really kind of think about the long and variable lags into three very basic scenarios: You could think about the impact on a consumer, you could think about the impact on a large investment grade corporate issuer, and then you could think about the impact on a levered company or a middle market loan issuer, for example. So, isolating those three, the significant change in interest rates, in fact, could impact consumers disproportionately. If you have consumer debt and credit cards or auto loans, more shorter-dated debt, that rate has been going up pretty markedly. If your debt is more concentrated in a 30-year fixed-rate mortgage loan, for example, you haven’t really felt the impact at all to your capital structure given you have long dated, fixed-interest service needs. An investment-grade corporate issuer is very similar to that consumer with just a single fixed-rate loan. Investment-grade issuers largely issue fixed rate. The market rolls over anywhere from 7–10 percent every year. And so interest expense coming down has been a very long-term tailwind to earnings and has left investment-grade issuers looking very strong, relatively speaking, relative to their own history. And the increase in debt service needs will take a significant amount of time because not all of their debt rolls over at the same time or is equally felt across the index. The last example would be, say, a company that has more leverage or short-dated leverage or floating-rate leverage. That company is feeling the impacts of monetary tightening much quicker than the others, but those industries are not all created equal. And so really it’s a time for credit selection when you’re going to be taking credit risk. The returns from a beta allocation are likely to be disproportionately impacted by higher default rates, higher levels of credit stress, particularly in an environment where interest rates are staying higher for longer, or even if they start to come down, as we would expect, because you’ve still had a significant move in rates relative to the 15 years post the [Great] Financial Crisis compared to the last couple of years. So, you’re going to expect a lot more dispersion around lower-grade credit and then, fortunately for us, particularly in our multisector strategies, there’s a lot of opportunity in high-grade credit categories where you’re getting paid an undue amount to take what relatively limited credit risk we think there is within those sectors.
Jay Diamond: So I am going to ask you a minute or two about how this all translates into positioning, but in general, what kinds of spreads and yields are available in the market today across the fixed-income spectrum?
Steve Brown: So the widest spreads are really in the highest quality sectors, in our opinion, and they’re in a lot of diversified sectors. One of the lessons on the year or the last couple of years is the value of diversification, not just in how you’re thinking about market returns or the variables that will drive returns, but within credit categories and across issuers. And so we have focused a lot on commercial ABS, commercial asset-backed securities, things that securitize anything from whole business royalty streams, container leases, triple net leases, broad diversified streams of cash flows, are assets that are used to service the liabilities of the issuer. So we like these particularly in an uncertain environment and so the benefit too right now is that when you compare the spreads of these more off-the-run credit sectors that we focus on versus the more on-the-run corporate credit sectors, the spread relationship is very wide. You can even take that relationship in a more vanilla category, if you will, within the agency residential mortgage-backed securities (RMBS). The spreads in this asset class, which has been impacted by QT in particular, and then highly elevated rate volatility and the broader stress in the banking system, in regionals in particular. You look at agency RMBS spreads compared to corporate credit spreads, the relationship is in the 99th percentile. So it’s really hard to map out a scenario or that doesn’t normalize, or at the very least doesn’t outperform, more vanilla corporate credit. So the spreads are anywhere from the mid-100s to the mid-300s [in terms of basis points]. And so when you bolt that on to a baseline level of interest rates of around 5 percent, you can get diversified exposure to high-grade credit that we think is cycle resilient and generate yields in the 6, 7, 8 percent [range], which are some investment opportunities that we haven’t seen since the financial crisis, frankly.
Jay Diamond: What kinds of decisions are you making in terms of allocations and how are you positioning for the next turn in the markets?
Steve Brown: In the broadest sense, were relatively defensively positioned. So our sector overweights are two sectors that we think are cycle resilient, as I said, given the uncertainty on the macro backdrop and the policy response, and then those that we think are cheap, or are paying you a disproportionate amount to take whatever that risk is, whether it’s credit risk, volatility risk, prepayment risk, etc. So that skews us towards those higher quality securitized products categories. Within more generic credit exposure, we have a lower-than-normal allocation. So if you want to just think about investment-grade corporate credit, we’re actually in many cases underweight the benchmark in lieu of more Agency mortgage exposure because frankly, the decisions we’re trying to make are how do we want our returns to be driven and what scenarios are we trying to prepare ourselves for. So we’re trying to prepare ourselves for a very wide range of scenarios, up to and including a soft landing or severe economic stress and kind of everything in between, and then the uncertain policy response to any of those scenarios. So again, trying to take as little risk as possible, frankly. So high carry, low-duration instruments that we think have wide spreads and low likelihood of credit impairment are the places where we’re allocating most of our capital and then leaving more dry powder to take more credit beta if the environment justifies it or the pricing justifies it.
Jay Diamond: And how do you quantify this liquidity bucket or dry powder bucket relative to where you’ve been in history?
Steve Brown: It’s definitely on the higher range. It’s not quite at the maximum level, but depending on the portfolio or strategy, it’s anywhere from 10–30 percent of the available capital to put to work.
Jay Diamond: Spreads are typically widening in an economic slowdown, so is that kind of what you’re waiting for to deploy all that?
Steve Brown: It is, or it’s looking to take some of the more extreme valuation differences and the relationships that we’re taking advantage of now and rotate if you were to see spread curves normalize. So frankly, because we’re able to make a lot of relatively short duration, high quality investments, that reduces the overall spread risk of the portfolios, and we’re able to do that with kind of no give on the income front. What we’re going to do is probably extend out that spread duration or spread risk if spreads were too materially widen.
Jay Diamond: As a fixed-income manager, you’re always looking for things that could go wrong, so right now do you see any black swans lurking that you’re worried about?
Steve Brown: The most topical for us and more obvious across the broader ecosystem is in commercial real estate. The sheer size of the commercial real estate market and the debt that has to rollover or be modified in the next couple of years is in the trillions. And obviously, its association with the banking sector in the regional banking sector in particular is an acute risk were highly focused on. We don’t have a lot of active exposure to the market, but are certainly cognizant of the risks and, eventually, potential opportunities there, and that is a very disparate market and one where, of course, region, sector, vintage, or even within the same block, you can have two very different outcomes on something that looks quite similar to its neighbor. So that’s the sector that’s front and center, and then of course, there are any number of more obvious risks with policy, with geopolitics and unintended consequences that are both hard to predict. The level of uncertainty is quite high relative to history. The category of worries is quite long.
Jay Diamond: Steve, I’m sure you’ve getting this question a bunch over the last couple of months, but with short-term rates so high, and for example, you can get 5 percent or more on a one- or two-year CD, why should an investor choose an actively managed fixed income structure as opposed to just buying CD?
Steve Brown: It’s a very relevant question and one, as you said, that we’ve been getting quite often. I mean, one, the main theme of the environment right now is uncertainty. If you go back over the past couple of years and plot out the chart for how we got to where we are, 5 percent on interest rates, an equity market that entered a bear market and then a new bull market, and then very significant shifts in fiscal policy and geopolitics and the surrounding world, I think it’s easy to look back and look forward and say that the future is uncertain based on what we’ve just been through. So when we think about the tradeoff of CDs and less volatile higher income, short-term investments versus more diversified and higher income, intermediate or longer-term investments, you have to acknowledge that the future is uncertain. So while CDs introduce very low volatility, as do money market funds, they introduce a lot of pin risk, or diversification risk, or reinvestment risk. So what we’re trying to do is within our portfolios is, as I’ve gone through, work in defense of higher yielding, short-dated instruments that are generating 6, 7, 8 percent yields rather than the 5 percent in a money market fund or a CD. We’re also trying to position the strategies for optionality to benefit from capital appreciation. A CD generates income; our strategies are trying to generate income and capital appreciation. And when you zoom out and see that investable yields across all of these relatively higher quality sectors are generated anywhere from 6, 7, 8 to even 9 percent yields, and you look back at any recent history, that’s always proven to be a very attractive entry point. And I think what we would say is be diversified in your exposure: Don’t put all of your capital in one bucket, just as we aren’t within our underlying funds and strategies, because you don’t want to have all of your investment capital pinned on one decision or one variable that in this environment in particular is hard to forecast.
Jay Diamond: So we’ve gone over a lot of topics, and you’ve shared a lot of very important insights with us, but if I could ask you to summarize for a final takeaway for our listeners, what you as a chief investment officer [are] thinking about right now, what are the final takeaways for our listeners?
Steve Brown: We would like to thank everybody for their continued partnership and for their time today and listening with us.
Jay Diamond: Great. Well, thank you again, Steve, for your time. Please come back again and visit with us soon. Really appreciate it.
Steve Brown: Will do. Thank you, Jay.
Jay Diamond: And thanks to all of you who have joined us for our podcast today. If you like what you are hearing, please rate us five stars. And if you have any questions for Steve Brown or any of our podcast guests, please send them to firstname.lastname@example.org and we will do our best to answer them on a future episode or offline. I’m Jay Diamond and we look forward to gathering again for the next episode of Macro Markets with Guggenheim Investments. In the meantime, for more of our Thought Leadership, such as the Quarterly Macro Themes or High Yield and Bank Loan Outlook, please visit guggenheiminvestments.com/perspectives. So long.
Important Notices and Disclosures
A certificate of deposit (CD) is a bank product that holds a fixed amount of money for a fixed period of time, such as six months, one year, or five years, and in exchange, the issuing bank pays interest. When you cash in or redeem your CD, you receive the money you originally invested plus any interest. Certificates of deposit are considered to be one of the safest savings options. A CD bought through a federally insured bank is insured up to $250,000.The $250,000 insurance covers all accounts in your name at the same bank, not each CD or account you have at the bank. A bond is a debt obligation, like an IOU. Investors who buy corporate bonds are lending money to the company issuing the bond. In return, the company makes a legal commitment to pay interest on the principal and, in most cases, to return the principal when the bond comes due, or matures. Like all investments, bonds carry risks and are subject to market fluctuations. When interest rates go up, the price of the bond goes down and vice versa. One key risk to a bondholder is that the company may fail to make timely payments of interest or principal. If that happens, the company will default on its bonds. This default risk makes the creditworthiness of the company—that is, its ability to pay its debt obligations on time—an important concern to bondholders.
Investing involves risk, including the possible loss of principal.
Stock markets can be volatile. Investments in securities of small and medium capitalization companies may involve greater risk of loss and more abrupt fluctuations in market price than investments in larger companies. The market value of fixed income securities will change in response to interest rate changes and market conditions among other things. Investments in fixed-income instruments are subject to the possibility that interest rates could rise, causing their value to decline. High yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility.
Investors in asset-backed securities (“ABS”), including mortgage-backed securities (“MBS”), and collateralized loan obligations (“CLOs”), generally receive payments that are part interest and part return of principal. These payments may vary based on the rate loans are repaid. Some asset-backed securities may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity and valuation risk. CLOs bear similar risks to investing in loans directly, such as credit, interest rate, counterparty, prepayment, liquidity, and valuation risks. Loans are often below investment grade, may be unrated, and typically offer a fixed or floating interest rate.
Investments in securities of real estate companies and companies related to the real estate industry are subject to the same risks as direct investments in real estate. These risks include, among others: changes in national, state, or local real estate conditions; obsolescence of properties; changes in the availability, cost, and terms of mortgage funds; changes in the real estate values and interest rates; and the generation of sufficient income.
Dry powder refers to highly liquid assets, such as cash or money market instruments, that can be invested when more attractive investment opportunities arise.
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