Macro Markets Podcast Episode 43 Transcript: Post-FOMC/Jobs Report Update
Adam Bloch, Portfolio Manager on our Total Return team, and Matt Bush, Guggenheim Investments U.S. Economist, update our economic and market outlook.
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. We are recording this episode on November 3rd, 2023. We come to you during one of those quirks in the annual calendar when the Federal Open Market Committee meeting and the release of the monthly jobs data happened in the same week and both events were market moving. market participants can be excused for feeling like they've been on a roller coaster. This fall, bond yields have been up and down, stocks briefly entered correction territory, and adding fuel to the volatility, of course, is a new war breaking out in the Middle East and budget and refunding drama playing out in Washington. In short, it's been the kind of week that prompts a check of our outlook and here to provide us an update on that is Adam Bloch, a senior portfolio manager on our Total Return team, and Matt Bush, Guggenheim Investments U.S. Economist. Welcome back, Adam and Matt, and thanks for taking the time to chat with us today.
Adam Bloch: Thanks for having us, Jay. Glad to be here.
Matt Bush: Thanks Jay. Great to be back on.
Jay Diamond: Well, Matt, let's start with you and the domestic headline events from this week. First, tell us about this week's FOMC decision, what you saw in it, and what you heard in the press conference afterwards.
Matt Bush: Let’s start with the post-meeting statement, where there weren't many changes and they were pretty small, but I think notable on the margin. So first, they acknowledge the strong third quarter GDP growth numbers, saying that economic activity expanded at a strong pace in the third quarter. That phrasing is interesting because it puts the strong expansion in the past tense, which I think it's a subtle way to show they don't expect strong growth to continue. Really the only other change in the statement was that they added that tight financial conditions will weigh on economic activity, which is a nod to the rise in long term interest rates over the past few months. I think overall, based on Powell's press conference, it's clear this is a Fed that doesn't want to hike again, as they're increasingly focused on downside risk to the economy. Powell really backed away from the September dot plot that implied one more hike for this year, and he acknowledged the risks of doing too much are more balanced with doing too little. It was also notable that he was much more emphatic that policy is now restrictive and is having an impact on the economy. So I think going forward, the key dynamic to watch is going to be upside surprises in the economic data, which if they continue, would make a hike more likely versus the impact of tighter financial conditions, which, if sustained, would take hikes off the table. In our view, the data is going to come in soft enough to prevent any more hikes. And we think by the second quarter of next year, the conversation will be shifting toward rate cuts.
Jay Diamond: Now Matt, I don't know if Chair Powell had a preview of the jobs report today, but it certainly supported his view that the economy might be slowing down. What were the main takeaway is that you saw in this morning's release?
Matt Bush: Well, for the first time in a while, all the signals in the report pointed in one direction. So it's a fairly straightforward one to analyze, and it shows that the economy is pretty unambiguously slowing down. There is a slight caveat that the auto sector strikes did depress the jobs numbers a bit by around 30,000, but what stood out to me was not only that job growth is slowing, it's increasingly reliant on just government and health care jobs, which made up 128,000 of the 150,000 payroll gains. I think it's also notable that the August and September numbers, which look so strong last month, were revised down by over 100,000, which continues a pattern that we've seen all year where job growth is ultimately revised weaker than what it's initially reported. Looking beyond just the payroll figures, the report looks even weaker if you consider that average hours worked actually fell, which is just another sign that labor demand is cooling off. And then we saw a rise in the unemployment rate, which is driven by an increase in people losing their jobs. The unemployment rate is almost 50 basis points off its recent lows. Historically, anything above that 50 basis point threshold is consistent with a near-term recession. So markets are interpreting this report as kind of Goldilocks: soft enough to prevent further rate hikes, but not soft enough to really stoke recession fears. Really, the question going forward is can we stabilize at around 3.9% unemployment and 150,000 job growth, or is there still more slowing ahead as the lags of monetary tightening kick in which would push us toward recession territory?
Jay Diamond: Well, let's turn to the markets for a moment, which Matt just referenced. Adam, the market has been very volatile recently. We've seen the yield curve steepen and then flatten again as the 10-year has moved from 4 percent to 5 percent and back down again. So why is the market behaving this way? Why is it so volatile? What is the recalculation that's been going on?
Adam Bloch: There's a couple of interesting dynamics taking place and the obvious ones are the tug of war between the no landing camp and the recession camp and of course, expectations around Fed policy. But some of the more interesting developments are under the surface, too, and as long-term rates have been moving higher and the curve is steepened mortgage bonds have extended their duration, given the lower likelihood for refinancing. So when mortgages extend, their duration increases and money managers with large allocations to mortgage bonds have to sell bonds in order to keep their duration in line with their overall target. So that causes somewhat of a feedback loop that pushes rates higher as rates are moving higher. So with the dovish telling out of the Fed this week and then some of the weaker economic data we saw this week that Matt was referencing, now we've seen rates move lower over the past several days, which has had the opposite effect. So money managers needing to buy bonds to offset the shortening duration profile of the mortgage book. So the impact of convexity is a big part of what's causing these wild swings and making it both challenging, but also very interesting to manage through this environment.
Jay Diamond: So Matt, let's get back to something you said before about the outlook for jobs going forward. Up till now, we've only seen strength coming from the U.S. economy, evidenced by the strong third quarter GDP advanced estimate. How are you feeling about jobs going forward and have you reconsidered your recession outlook?
Matt Bush: Yeah, we're always reconsidering our outlook in light of incoming data, but I would like to hit on the GDP number as we've gotten a lot of questions about it, but it really didn’t move the needle for us, you know, acknowledging that it was a pretty strong report. It it's pretty backward-looking at this point. You know, what happened back in July and August isn't really too relevant for the outlook right now, particularly considering how fast is economic cycle is playing out. Historically, quarterly GDP growth numbers have almost no correlation with what happens over the subsequent quarters, and that relationship is further weakened when you consider the GDP numbers can be revised heavily. So the economic data has been pretty solid for the past few months. But in forming a forward-looking view, we're focused on the broader context of where economic and policy is. Monetary policy is very tight with the effects still to be fully felt, fiscal policies becoming less stimulative, cash buffers for all but the richest households have been spent down and so to us, these factors suggest recession risk remains elevated, and we think the first half of 2024 could be the start of the next economic downturn.
Jay Diamond: And how do you feel about the jobs outlook from here?
Matt Bush: We think we'll see a continued weakening as we really have seen over the past several months if you kind of look beyond the payroll grains driven by government jobs and health care jobs, which aren't as responsive to overall economic conditions. So if we look at leading indicators of job growth, they still show reduced demand for hiring. One of the key dynamics in the labor market has been that businesses have been reluctant to lay off workers, given how hard it was to hire workers over the past couple of years when we had pandemic related labor shortages. We think eventually that reluctance is going to have to break and we will see rising layoffs heading into 2024. So we expect to see a higher unemployment rate, lower and even negative job growth for a time with a recession underway next year.
Jay Diamond: Now, Adam, we've been fairly consistent here with our house view about the economic outlook, but the market seems to be very reactive to every bit of news. So given what Matt is saying about the recession timing, do you think the market's been behaving correctly or not?
Adam Bloch: Yeah, it's a bit of a bifurcated answer. You know, when we see some overvaluation in lower quality credits, particularly CCC-rated parts of the market at high-yield and some of the more levered capital structures in the loan market where we broadly feel lenders aren't properly accounting for the sensitivity of those businesses to economic slowdowns, particularly in a higher rate environment. The same is probably true for equities, by the way, but in higher quality parts of the credit markets that we're focused on, we think the securitizations and businesses that that we've lent to are broadly recession proof. So, the fact that we're able to invest in those bonds at historically wide levels and in many cases valuations that are in the 70th, the 80th percentile of historical cheapness creates a really compelling opportunity for long term investors like us, regardless of whether we end up in a recession or not.
Jay Diamond: Well, it's gotten a lot of play the last couple of weeks, certainly when the 10-year was at or near 5 percent. This concept of term premium for bonds. Just briefly, could one of you explain what this is and how is that, for example, the rally today reflecting into what's happening at the long end of the curve and the term premium?
Matt Bush: So if you think of a longer-term bond as the expected path of short term interest rates, the term premium is the added compensation or added yield needed for the risk that the path of short term rates may turn out differently. Ultimately, this term premium is not observable directly. You have to model it or measure it to come up with an estimate. Most estimates agree that it was very low for much of the past decade and that over the past several months it started to rise. There's various factors beyond that rise, but they all boil down to increased uncertainty. The most likely reasons for higher uncertainty probably have to do with investors reassessing the long-term neutral rate for the economy, given how resilient the economy has been to the impact of rate hikes. And there's probably a supply-demand component as well. brought about by the Fed reducing the size of its balance sheet while large fiscal deficits caused a deluge of Treasury supply.
Jay Diamond: So Adam, do you think about term premium when you're looking at yields in the market or is that factor into your thinking from a practitioner's point of view?
Adam Bloch: Yeah, no, it absolutely does. And our team worked very closely with Matt's team on kind of trying to analyze some of the effects and really where we see it most pronounced in the market is the spill over into volatility. A different way of thinking about term premium is, as Matt described as, investors are demanding that higher return to lock in that yield without having the option of rolling kind of short-dated treasuries over the next ten years, for example. That's a sign of higher expectations for volatility. And higher volatility is a technical dislocation that creates opportunities for fundamental long-term investors like ourselves. So, we keep a close eye on all these things and really try to think about how it interplays with evolving the opportunity set in credit.
Jay Diamond: It doesn't sound like it's a good thing or a bad thing. It's just a state of play that everyone has to factor into their thinking.
Adam Bloch: Yeah, I think that's right. I mean, it's another thing to consider. But listen, we joke that we all went from epidemiologists by practice a few years ago when COVID onset, to geopolitics experts, with Russia, Ukraine, to inflation experts over the past couple of years. And now we're all becoming closet term premium experts. And each one of these really wild developments that we've had over the past four years now at this point just points to how dynamic that business is and how complicated it can be to manage money. And so, you know, we're fortunate to have Matt and his team be able to help us pass through some of the more wonky corners of fixed income like term premium and help digest it and make it ultimately actionable for the strategies.
Jay Diamond: So speaking of wonky corners of the bond market, as part of our investment philosophy here at Guggenheim, we take a broad view of the investment universe and often look for opportunities in sectors and securities that are not included in the benchmark indexes for one reason or another. So with everything that's going on, what have you been seeing in yields and spreads in all the sectors that we follow?
Adam Bloch: So we've broadly seen spreads in investment grade corporates remain pretty consistent over the course of the year, almost shockingly so. And so accordingly there we are generally actively reducing market beta, so any credit that looks like broad market exposure without any particular upgrade story or secular industry type story or issuer specific quality story to it, we're generally shedding that exposure and focusing on the unique credit specific stories or industry specific stories that that we feel most confident in. Within agency mortgages, I alluded to it earlier in the duration discussion, but spreads have widened materially to GFC-era levels and we've broadly been adding after being very underweight that sector most of the year. The market disruption amid higher rates and a steeper yield curve, particularly over the past couple of months, has created a really special opportunity there to lock in 6-6.5 percent-type yields on government guaranteed paper. In non-agency structured credit, that continues to remain, in our view, the best opportunity for investors who have the ability to understand those more complicated securitizations. We're pretty consistently able to find alpha opportunities, whether that's being a liquidity provider to motivated sellers or digging deep to understand a credit story that's overlooked. And so with the backup and yields that we've seen this year and even with spreads remaining relatively consistent, we're getting, call it, 8.5 to 9 percent yields on that portion of our investments, and that's what a A average rating for whatever that's worth. But the conclusion is very high single digit yields on high credit quality assets in most situations, we think that's going to work out pretty well.
Jay Diamond: So, Adam, as a follow up, we've seen third quarter results coming out. Are you seeing any signs of credit weakness and the structures and issuers that you follow?
Adam Bloch: So not anything pervasive or broad market, but definitely an uptick in idiosyncratic issues. And so that comes to fruition in restructurings, distressed situations, distressed exchanges. We've been fortunate to largely avoid those situations, but we certainly see it evolving in the market. A couple of those popping up every few weeks, when 6-12 months ago there were showing no sign of distress in the corporate market in particular. The impact of higher rates is definitely squeezing some of these higher levered companies and particularly floating rate borrowers, who are now left with really very little wiggle room for execution of strategy. They almost have to be perfect in some of these more higher levered companies. So marrying that with our recession view that Matt walked through, we expect the default rate to tick up over the next year, which will certainly introduce some stress, but probably nothing like what we saw in 2008 or 2020, but something that'll still create an opportunity set for investors like ourselves that are able to see through the carnage and find good opportunities.
Jay Diamond: So Matt, is some of the weaknesses that Adam's alluding to start to play out and the economy slides into recession or something that looks a lot like it. Where do you think the Fed goes from here?
Matt Bush: In our view, the Fed will be content to leave rates unchanged for the next several meetings and really just talk tough about rate cuts being a long way off. I think if we're right about recession in the first half of next year, we think they'll be pivoting quickly to rate cuts, ultimately cutting rates by around 150 basis points next year and more into 2025. We have them taking the Fed funds rate down a bit below 3 percent and pausing balance sheet runoff and what we think will be a recession, albeit a mild one. But even if we do get the fabled soft landing for the economy, I think rate cuts are still pretty likely next year and probably more than the 50 basis points projected in the dot plot.If we are in the soft landing scenario, we should see inflation pretty close to target and growth right where they want it to be, so there's no reason to keep policies so restrictive in that environment. So if you think about the balance of risks, maybe if the data continues to come in strong for the next few months, they hike one or two more times in an upside scenario, but it's much more likely we see a couple hundred basis points of cuts going forward, and so clearly the balance of risk is tilted toward Fed cuts over the next year.
Jay Diamond: So, Adam, where the rubber meets the road is how you're positioning in portfolios, given the backdrop that we've been discussing, what are you and your team doing in portfolios right now?
Adam Bloch: We're really focused on low-risk ways to generate income. So I mentioned earlier, but when we can get 6 percent on agency guaranteed mortgages, 8 to 9 percent on a A-rated structured credit, 9 percent on BB high-yield, so the highest quality parts of the high-yield market, we think those profiles generally achieve most of our investors’ long term goals, and we're frankly not getting paid enough to reach further down the capital structure or for much more at this time. At the same time, we're keeping ample dry powder, 20 to 30 percent across most strategies, so we can be opportunistic over the coming quarters if the recession view does come to fruition and or we see stress evolve in markets. But with where risk free rates are right now, to some extent you're getting paid a decent amount to be able to be patient, but we're cognizant of the importance of locking in current yields and spreads at these levels.
Jay Diamond: Adam Bloch: So we've shifted a lot of duration from the long end of the yield curve where we were very overweight relative to indices and peers at the beginning of the year. That overweight obviously worked well as the yield curve is flattening, but now that we believe the Fed is likely done raising rates and as Matt talked through, the next move is likely to be rate cuts coming over the course of the next year, we shifted more and more duration towards the front end of the yield curve. So everywhere from two years, three year and five years where we're focusing the overweight now. Ultimately, we see that as consistent with the next move in rates being lower at the front end of the yield curve and ultimately that being a relatively stable part of the yield curve and insulated from the kind of whipsawing of inflation expectations that's more likely to move the long end of the curve one way or the other. So moving more duration towards the front end and of course with a very flat yield curve, then inverted in some parts of the curve, you're not giving up any yield in order to move duration towards the front end of the curve. But importantly, that's coming at a time when we're doing that without taking down overall duration. So we're o still either kind of market level to slightly overweight duration across most of our strategies. We're just reconstituting the composition of that duration towards the front end of the yield curve to position for a steepener over the next couple of years.
Jay Diamond: So Matt and Adam, we have stayed pretty focused on conditions and risks and opportunities here in the U.S, but let's expand our view a little bit. Matt, how do you evaluate the impact of policy and growth outside of the U.S. on our markets?
Matt Bush: Well, given most of our portfolio activity is in U.S. assets, a lot of the analysis that our international economists are doing is through the lens of how things will spill back into the U.S. economy and into U.S. markets. So, a couple of the topical issues we're focused on is as we think about slowing growth in the U.S. and rising recession risk, one thing we're asking is whether foreign growth will be enough to provide a buffer for corporate earnings for U.S. companies. And right now, that doesn't seem to be the case, with the latest data out of Europe suggesting that they've already fallen into a recession. And with China continuing to struggle with managing its overleveraged property sector. So there's really no growth boost coming from overseas. Obviously, another big focus right now is foreign central bank policy. Things are a little bit more mixed there. On the one hand, you have rate hike cycles winding down in most developed markets like the eurozone in the U.K. But then you do have the Bank of Japan getting ready to exit its yield curve control policy and possibly raise interest rates, which could pressure U.S. Treasury yields higher. So the challenge is always how do you weigh these different factors from different countries, but on balance, we think the international picture supports the view of cooling economic growth and lower inflation, both in the U.S. and at a more global level.
Jay Diamond: Adam, do you see any exogenous events on the horizon that are particularly concerning right now?
Adam Bloch: Oh, no, Jay, nothing. Nothing's out there. It's all smooth sailing right now. Look, it has felt like there's been an extreme amount of, quote unquote, events over the past several years. But realistically, there's always risks on the horizon in any market environment or any point in time. And frankly, the fact that we're all talking about these risks all the time, even though there are so many of them, means we're less likely to get caught off-guard if one of them does flare up. We take a longer-term view of risk premium, and of course, our credit underwriting focuses on ways to avoid idiosyncratic risk or exposure to any one of these major risk factors. So, it's something we're cognizant of, but by virtue of being fortunate enough to have long-term investors, we really try to push through the short-term disruptions and risks and think about the long-term evolution and how we can add value.
Jay Diamond: Well, great. So, Adam, as we wrap up here, what is a main takeaway that you'd like our listeners to have from our conversation today?
Adam Bloch: It's been obviously very painful to get to the point where we are today in fixed income markets and across the yield spectrum, but we were talking about on the desk the other day, it's kind of like the farmer who stumbles upon a burned out forest after a wildfire and all he sees is farmable land. In some sense, we have to put the carnage behind us and focus on the great opportunities we have across high quality credit sitting in front of us today. So for most investors, being able to invest in portfolios that are composed of bonds yielding 7 to 9 percent for high quality investments and in some cases government guaranteed investments, that should be more than enough return in a 3 percent inflation environment. So we're focused on, again, locking in these record high current yields and we broadly think that's what investors should be doing, too.
Jay Diamond: Thanks, Adam, Matt, is there anything else you'd like to share with our listeners.
Matt Bush: Just echoing Adam's comments. It’s been a volatile and challenging year. Huge amounts of economic and market uncertainty. And we just really appreciate the opportunity to share our viewpoints with everyone who tunes in. So please keep the feedback and questions coming.
Jay Diamond: Well, thanks again for your time, Matt and Adam. This has been great. Please come again and visit with us soon.
Matt Bush: Thanks, Jay.
Adam Bloch: Thank you, Jay.
Jay Diamond: My thanks once again to Adam Bloch and Matt Bush for joining us today. And thanks to all of you who have joined us for our podcast. If you like what you are hearing, please rate us five stars. If you have any questions for Matt, Adam, or any of our other podcast guests, please send them to macromarkets@guggenheiminvestments.com 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, visit guggenheiminvestments.com/perspectives. So long.
Important Notices and Disclosures
One basis point is equal to 0.01%.
Dry powder refers to highly liquid assets, such as cash or money market instruments, that can be invested when more attractive investment opportunities arise.
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. Structured credit, including asset backed securities or ABS mortgage backed securities and closed complex investments are not suitable for all investors.
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