Total Return Outlook: We Have Liftoff!
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Beyond the physical toll, the pandemic continued to roil global economies for a second year. In 2021, it was disruption of the supply chain, which dealt the most difficult blow, as inflation began to surge – especially in the United States. In a sense, the Fed got what it sought in 2020 – inflation above target for some period, but never did they expect to see headline CPI more than triple their long-term target of 2%.
Most of 2021 was spent debating the persistence of inflation – transitory was a word that was bandied about for many months, until late in the year when higher and higher inflation readings quelled the notion that inflation was purely a passing concern.
It leaves the Fed in a very precarious position as we enter 2022. On the one hand, easy monetary policy has spurred economic growth with a recovery in the labor market and risk assets at lofty valuations. On the other, the more persistent forms of inflation – specifically wage and rent inflation – are less likely to abate with a simple flip of the QE-switch. This has become a clear case of “be careful what you wish for” for Chairman Powell and team.
However, the dual-pronged approach to quantitative easing leaves the Fed a fairly elegant solution for removing accommodation beyond the crude “fed funds target rate” lever. That the Fed has openly discussed a timeline for reducing its balance sheet – and discussed this while still purchasing assets (albeit at a slower rate) shows at least an awareness of the need to act quickly and forcefully should inflation remain well beyond their comfort zone.
To recap the last two years, quantitative easing has successfully bolstered risk assets while artificially depressing yields. In particular, QE depressed yields on longer maturity Treasuries that were purchased by the Fed. Quantitative tightening will unavoidably have the opposite, if not equal, effect. But how and when it is implemented is key, and bringing balance sheet reduction into the equation makes for better outcomes. We see three potential scenarios:
- To counteract an overheating economy, the Fed can raise the target fed funds rate, as usual.
- To counteract inflation, the Fed can reduce its balance sheet more aggressively – which would effectively raise longer maturity rates while maintaining some “dry powder” for raising shorter rates more slowly.
- To counteract both an overheating economy and inflation, they can begin with hikes to lift the target rate off the zero bound, but ultimately use both levers to effect the outcome that provides the softest landing for the economy.
Since we’ve highlighted the options the Fed has to guide the landing, the question as to whether they succeed is less about having the right “tools” to implement the change and more about whether they are following the right gauges and using some finesse in steering their rather unwieldy ship. In our view, they should be monitoring both macroeconomic and inflation data:
- Macroeconomic data – specifically employment, durable goods, and surveys of economic activity – to guide the trajectory of rate hikes.
- Inflation data – specifically wages, rent, and surveys, as well as traditional inflation measures – to guide the pace and composition of the balance sheet reduction.
- The interaction between macro and inflation data – to provide the big picture. The two types of data are correlated and interdependent – neither is absolute (just as the debate about inflation being transitory or persistent was never absolute either).
On the topic of persistent inflation, we continue to believe the best guide is the Underlying Inflation Gauge, published by the Federal Reserve Bank of New York. At year-end 2021, this gauge flashed its highest reading going back to 1995 (the first year for which data is available) – snugly in the mid-4% range. The Federal Reserve Bank of New York defines this gauge as the persistent component of common inflation, and although they never comment about it in their policy statements, we feel investors should take this number at face value. In this circumstance, we should follow the Fed’s numbers, not their words.
How does this impact fixed income investors? In their latest Strategic Income Outlook, Carl Kaufman and team explain the major shift (longer) in duration of the investment grade market, and we agree this is a critical issue. The Bloomberg Aggregate index currently has over 50% more interest rate risk than the index of a dozen years ago. With interest rates near zero and rising, there is very little carry (in the form of coupon) to cushion a rise in rates – we witnessed this in 2021 with a negative return for the index, and we may very well see the same in 2022. The index has never experienced two years of negative return since its inception in 1976, though we also have not endured a protracted liftoff from zero rates that featured longer maturity Treasury yields below 1%. During the prior quantitative tightening period (2014-2018), interest rates (especially in longer maturities) were substantially higher than we find them currently.
Sectors within investment grade have benefited from QE, and we may see a pause in any material spread tightening. This is especially true for the MBS sector, which experienced direct investment as part of QE and is often considered the first asset for which accommodation should be removed due to strength in the housing market and low mortgage rates. TIPS are likely to struggle as direct purchases will end, though this depends on which tack the Fed takes to curb inflation. In our mind, it is very likely that realized inflation may persist substantially north of 2%, although it is not clear that there is value in investing in this sector of the market with breakeven inflation levels implied by the TIPS market of near 3% for the 5-year point or north of 2.5% for the 10-year given the technical backdrop. We feel there is a strong chance that inflation will subside over a longer time period, but not as quickly as the Fed would like.
The corporate bond market closed 2021 with an option-adjusted spread of 92 basis points, which would be at the tighter end of the pre-pandemic experience. Again, the path the Fed chooses is key, and a relatively easy Fed with continued support for risk assets broadly would benefit corporates. Interestingly, inflation can be a positive influence on the credit metrics (e.g., leverage ratio, interest coverage ratio) of corporations with pricing power, because their top-line revenue increases while their debt remains constant. Sector selection will be critical to corporate bond performance, and security selection will also be important; the key is to identify those companies most likely to be able to pass along higher costs of production. We continue to favor reopening sectors as we push past the spread of the Omicron variant – these include aircraft lessors, travel, and hospitality. Further, inflation and higher oil prices are positives for the energy sector. We will likely avoid technology due to valuation concerns and the potential for increased merger and acquisition activity that would need to be financed.
Turning to the securitized credit markets, ABS and non-agency mortgages have also benefited from inflation. The assets securitized by these deals have seen dramatic appreciation, helping to deleverage deals and reduce credit risk to bond holders. Further, wage increases have improved borrowers’ ability to service debt, such as mortgages and auto loans, thus further enhancing the performance of these securities. We remain relatively constructive on the credit risk of these sectors, while keeping an eye on how the Fed decides to let some air out of the balloon.
In the end, the Fed holds the key. Fortunately, they have the ability to engineer a smooth landing – so long as they trust their data and maintain a steady hand on the wheel. It’s never that easy, and while we have already seen some deflation of bubbles in alternative assets, we construe these to be fairly positive developments overall. The tug-of-war between inflation and growth will create volatility in interest rates, and in this volatility exists opportunity to extract value – both in the rates market, as well as any resultant spread moves that may occur. The yield curve is expected to flatten as we continue down this course toward normalization, but having started at such a flat point for this inning of the rate cycle suggests that perhaps a lot of this move has already happened – especially if balance sheet reduction is adopted in earnest.
We would like to thank you again for your confidence in the team and welcome any questions or comments you may have.
Eddy Vataru, John Sheehan, Daniel Oh
Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. It is not possible to invest in an index. No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management. Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The Federal Funds Rate is the rate at which depository institutions (banks) lend reserve balances to other banks on an overnight basis. QE, or quantitative easing is a monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply. Maturity is the date on which the life of a transaction or financial instrument ends, after which it must either be renewed, or it will cease to exist. The Bloomberg U.S. Aggregate Bond Index (BC Agg) is an unmanaged index which is widely regarded as the standard for measuring U.S. investment grade bond market performance. This index does not incur expenses. The index includes reinvestment of dividends and/or interest income. Investment grade includes bonds with high and medium credit quality assigned by a rating agency. Spread is the difference in yield between a risk-free asset such as a U.S. Treasury bond and another security with the same maturity but of lesser quality. Option-Adjusted Spread is a spread calculation for securities with embedded options and takes into account that expected cash flows will fluctuate as interest rates change. A mortgage backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages. Treasury Inflation-Protected Security (TIPS) are a type of Treasury security issued by the U.S. government that is indexed to inflation in order to protect investors from a decline in the purchasing power of their money. As inflation rises, TIPS adjust in price to maintain its real value. Leverage ratio is a financial measurement that looks at how much capital comes in the form of debt (loans), or assesses the ability of a company to meet its financial obligations. Coverage ratio is a measure of a company's ability to service its debt and meet its financial obligations. The higher the coverage ratio, the easier it should be to make interest payments on its debt or pay dividends. The trend of coverage ratios over time is also studied by analysts and investors to ascertain the change in a company's financial position. An asset-backed security (ABS) is a type of financial investment that is collateralized by an underlying pool of assets—usually ones that generate a cash flow from debt, such as loans, leases, credit card balances, or receivables. Duration measures the sensitivity of a fixed income security's price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations. Volatility is a statistical measure of the dispersion of returns for a given security or market index. A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates. Holdings and sector allocations may change at any time due to ongoing portfolio management. References to specific investments should not be construed as a recommendation to buy or sell the securities by the Osterweis Total Return Fund or Osterweis Capital Management. Coupon is the interest rate stated on a bond when it's issued. The coupon is typically paid semiannually. A basis point is a unit that is equal to 1/100th of 1%. Credit Quality weights by rating were derived from the most recent data available as determined by Standard and Poor’s. Grades are assigned to bonds by private independent rating services such as Standard & Poor’s and these grades represent their credit quality. The issues are evaluated based on such factors as the bond issuer’s financial strength, or its ability to pay a bond’s principal and interest in a timely fashion. Ratings are expressed as letters ranging from ‘AAA’, which is the highest grade, to ‘D’, which is the lowest grade. 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It may also make investments in derivatives that may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. The Fund may invest in in debt securities that are un-rated or rated below investment grade. Lower-rated securities may present an increased possibility of default, price volatility or illiquidity compared to higher-rated securities. Investments in foreign and emerging market securities involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks may increase for emerging markets. Leverage may cause the effect of an increase or decrease in the value of the portfolio securities to be magnified and the fund to be more volatile than if leverage was not used. Investments in preferred securities have an inverse relationship with changes in the prevailing interest rate. Investments in Asset Backed and Mortgage Backed Securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. It may also make investments in derivatives that may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. The Fund may invest in municipal securities which are subject to the risk of default. Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [OSTE20220111-0415]
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