PARTICIPANTS
Mark Brisley
Managing Director and Head of Dynamic Funds
Erinn King CFA®
Managing Director & Client Portfolio Manager, Payden & Rygel
PRESENTATION
Mark Brisley: You are tuning in to On the Money with Dynamic Funds, a podcast series that delivers access to some of the industry's most experienced active managers and thought leaders. We're sitting down to ask them the pertinent questions to find out their insights on the market environment and navigating the investment landscape. You're listening to another edition of On the Money. I'm your host, Mark Brisley. Joining me today from Boston Massachusetts, is Erinn King, managing director at Payden & Rygel, one of the largest privately owned global investment advisors in North America.
For the past 40 years, they have established their position as a leader in the active management of fixed income through domestic and international solutions. We're recording this podcast on the eve of the midpoint of 2022, and uncertainty and concern over the growth prospects for global economies and aggressive interest rate hikes from central bankers continue to dominate market sentiment. We've had a front row seat for the highest inflation in decades, and economists, market pundits and investors continue to grapple with the impact of aggressive moves in monetary policy in response to this inflation, which has been far less transient than originally expected.
Spiking yields have also stoked the flames of fear that more than one dose of harsh medicine may be required to tame inflation, and this has rattled equity and bond investors alike. Our focus today is the outlook for bonds, and the continued importance of fixed income in a diversified portfolio, and while uncertainty remains, a couple of key questions do arise. Could the shift in focus away from a rate shock, be replaced by doubts on the outlook for growth, if economic data continues to weaken? That scenario may aid support around the narrative for bonds, if we think the current monetary tightening has been priced into investor sentiment.
Erinn, it's great to have you with us today, and as I mentioned, markets have experienced exaggerated moves in both directions as they grapple with these two opposing forces, high inflation and recessionary risks. I'm going to jump right in. Inflation, highest level in 40 years. What are your expectations for it, and are central banks responding aggressively enough?
Erinn King: Thank you Mark for having me and it’s a great pleasure to be here. As you point out, inflation is persisting at the highest level since the '70s, and it's really pervasive around the globe. The Consumer Price Index or CPI in the U.S. came in at 8.6% earlier this month, which was above even already heightened expectations. Core PCE or Personal Consumption Expenditures, that's the federal reserve's preferred inflation measure, is double its targeted level. We're seeing similar elevated inflation prints in Europe at 8.1%, Canada at 7.7% and beyond. As you point out, this idea that inflation was transitory and tied only to COVID related supply chain disruptions has really been disproven.
What we're experiencing and seeing is an inflation boom that reflects a long period of easy policy combined with an extraordinary amount of stimulus and transfer of wealth to consumers. Unsurprisingly, consumers have spent this windfall and notably, they've spent it on goods in light of the pandemic. We find ourselves in a period of higher-than-normal demand and lower supply with prices adjusting accordingly, and further fueling inflation is the conflict in Ukraine which shows little sign of abating and will likely keep energy prices elevated.
Where does inflation go from here? As we continue to emerge from the pandemic, we anticipate that the supply chain bottlenecks will clear, and that spending will shift from goods to services. Now, while that should be a good result for goods prices and that they should recede as that shift occurs, we are already seeing evidence of services inflation, namely rents, which are accelerating. Energy prices for the reasons mentioned are also likely to hold in the higher range. As a result, inflation prints near term, and our view will remain elevated. What all of this means for central banks is that they're needing to move much more aggressively to combat inflation and inflation fears.
The reserve bank of New Zealand, the bank of Canada, and the bank of England were all first movers followed by the Fed which pivoted and initiated its lift-off at its March meeting with 25 basis points. However, that 25 basis point hike was not nearly enough, and policymakers have followed with another 50 basis points in May, and their hand was forced to do 75 basis points in June. Chairman Powell in fact, had to address markets twice after the meeting to reassure them that the Fed would do everything it takes to fight inflation, even at the expense of the labor market.
Fighting inflation is clearly the priority now, even if it causes economic pain. We anticipate another 75 basis points in July followed by 50 basis point hikes in September and November and another 25 basis points in December, ultimately bringing that overnight policy rate in the U.S. to %3.5 to %3.75 by year-end, and this will further be coupled with additional quantitative tightening with the roll-off of its balance sheet. Now, the story is the same across most of the developed world with the ECB, perhaps the latest to the party but also set to hike rates in July and tighten financial conditions further.
Mark Brisley: Is there a risk of going too far, tightening too much, and what will ultimately even higher rates mean for the outlooks for growth?
Erinn King: Well, Mark, this is really the conundrum that central bankers find themselves in. Tightening conditions means slowing growth, and the U.S. economy has already contracted in Q1, and data for Q2 shows flat growth, not to mention the fact that consumer sentiment around the world is at a low. In Europe, the Purchasing Managers Index or PMIs in June fell sharply, in fact consistent in magnitude with the 2008 and 2020 type of adjustment. What we're really watching are the interest rate-sensitive sectors like durable goods, so think homes and autos, as they are especially at risk due to the rapid and material tightening of financial conditions. We also expect good spending to contract.
What's often mentioned in the news as the offsetting factor, if you will, to all of this has been the labor market, which at least in the U.S. has remained noticeably strong. However, the unemployment rate does not tend to rise gently over time, it declines gradually during an expansion, but then it tends to lurch higher during a slowdown. As a result of the Fed's actions and the slowdown in economic growth, we expect unemployment to rise through year-end, and wage growth also will likely persist, albeit at a slower rate. This is what makes the current environment so tricky to navigate.
When you think about it, central banks are essentially maneuvering and attempting to pilot a massive ship. They're having to change directions very, very quickly, but in doing so they run the risk of oversteering. Arguably, they were too easy for too long, keeping rates low even in the face of unprecedented stimulus. Now they're course-correcting and the challenge is that there is no immediate feedback loop. Inflation is a lagging indicator, so it will be really difficult for them to tell if they have gone too far, or not far enough in real-time. Right now, we see them erring on the side of fighting inflation and continuing to tighten monetary conditions.
Mark Brisley: As both our countries there are headed into a long weekend, probably one of the big cocktail party questions is going to be, can a recession be avoided? I know that's a really tough question to pose, but I'll get you ahead of the weekend here. Can a recession be avoided?
Erinn King: That's really the million-dollar question. Can central bankers orchestrate this magical soft landing, whereby they raise rates enough to quell inflation, but not so much that they stall growth, so I probably would be the unpopular person at the cocktail party, but we at Payden are skeptical that they can do this. We believe inflation is forcing central banks' hands to be more aggressive in tightening policy sooner. The impact of those higher rates flows through the economy at a lag, and it will be difficult to know the true impact on employment and growth until it has already happened.
How quickly will housing turn is really a key question that we are watching. Now, that said, not all recessions are the same and in fact, each one is quite unique throughout history. Obviously fresh in our minds are the crumbling of financial institutions during the 2008 global financial crisis and the very difficult climb back from that particular recession. More recently, we have the shorter-lived, but violent COVID recession. However, a more cyclical recession can actually help shake out strong companies from weak ones.
Wash out those that lack solid business plans or are overly levered. Unfortunately, there will be collateral damage in the process, but it does not need to be a deep and prolonged recession. While a soft landing is perhaps a best-case scenario, we are planning for the greater likelihood of a downturn and a recession.
Mark Brisley: Payden & Rygel is a global manager. When you look outside of the U.S., how are conditions differing around the world in different markets?
Erinn King: Overall, the global economic growth momentum has certainly slowed, and many economies, notably those in Europe are already perched on the precipice of a recession, or fully in contractionary territory. In contrast to the U.S. where the consumer wage growth has actually helped to offset some of the inflation, in Europe wage growth has been far more muted. The global energy shock is also more intense in Europe. Interestingly, emerging market central banks were some of the first to hike starting last year, but now almost every central bank, Japan being a notable exception, is tightening.
Another exception and important economy to watch is China. China's reopening is very important to helping the supply chain log jam, but it still actually has mixed implications for near-term inflationary forces. Reopening will ease some of the supply chain challenges that has been impacting good prices. However, it will also fuel demand for commodities. Over time, we think the structural slowdown tied to the Chinese property market combined with the shift of the world consumer back to services from goods will present some obstacles for China. This will limit the growth rate going forward at a time when it politically needs stronger growth. We believe this will likely keep the PBOC in an easier mode.
Mark Brisley: Erinn, we've seen this positive correlation between developed market, government bond yields, and credit spends as being unusual. Do you think this is something that's going to persist?
Erinn King: I think what we're seeing here today, Mark, is a reversal of what we've experienced in recent years. With unprecedented government and central bank intervention, we saw markets correlate to one in a positive direction with price appreciation for nearly all assets. Of course, no one complains when that's the case. As this accommodation and intervention is removed from markets, we are seeing the exact opposite play out. In fact, over the last six months equities, government bonds, investment grade, high yield credit, and gold have exhibited the highest correlation on record since the early '90s. That said, we feel we are much closer to normalization today.
As markets begin to pass the baton from inflation concerns to growth considerations, we anticipate a return to more normal market behavior and relationships. We're already starting to see this play out in particular in the longer end of the yield curve. It's really this tug of war between the risk that central banks have to tighten even more to fight higher inflation and the growth turning over and the resulting recession. The tug of war between those two forces we're seeing play out in a more normal relationship, we believe as the economic reality becomes clear that high-quality government bonds will act as they have in the past. For example, rallying in response to evidence of slower growth in recessionary conditions.
Mark Brisley: One of the big challenges, I think for a lot of investors and I'm sure many of our listeners is we think of bonds in a portfolio or the fixed income part of a portfolio as the ballast. What protective measures can you take in a fixed income portfolio in these conditions?
Erinn King: As you point out, almost all markets have suffered in essentially this shift from dove-ish central banks to much more hawk-ish ones in a very short period of time. There's been this market-wide resetting of base expectations with literally nowhere to hide, and as markets have moved really swiftly to price in this pivot, they've been highly correlated in doing so. We've certainly witnessed this over the past few weeks with inflation being top of mind and markets reacting very strongly to new data. When we think about protecting in our global unconstrained strategies, one of the key ways that we have done this is by being short in duration, meaning having less exposure to interest rate risks.
Central banks are focused on inflation. That means higher rates. With the shift from goods-related inflation to services-related inflation, we feel there's the potential for inflation to persist longer than central banks would like, and perhaps result in additional action from them. In the current environment for us, it's all about being active and selective in exposures. For example, we favor floating rate loops that will benefit as rates move higher. This is part of our shorter duration bias, and with this short maturity profile, combined with both higher rates and wider credit spreads, we're also cognizant of the more attractive break-evens and have become more balanced in taking credit risks.
We own the energy sector as a defensive play as it offered both an inflation hedge and a geopolitical hedge. With its relative outperformance we're now rotating into less cyclical sectors, targeting areas like healthcare and technology that are more insulated from economic cycles. We also like exposure to multi-family commercial real estate securities with the rise in rental income, and to real assets like cell towers, data centers, equipment via the securitized market, where we have both floating rate characteristics and structural protections.
In the residential mortgage market, we are running a base case of zero home value appreciation and targeting more seasoned transactions that have stronger loan-to-value ratios. This is one of the unique benefits of the securitized market. The ability to be very selective with the underlying collateral characteristics and its vintage, as well as the added structural protection of the investment. As a bond investor, it's sometimes just as important what you don't own, and a key benefit of being in a strategy that's not tied to or reflecting a particular index.
For example, we are avoiding retail and office properties in light of cyclical and work-from-home trends. We have no direct exposure to China and have fully avoided exposure to Russia. Being nimble and active is critical in a volatile market. We are on the outlook for those inflection points. For example, when growth fears take over and inflation begins to abate, we're prepared to add duration as a hedge to our shorter credit exposures. Given that shorter maturity profile, combined with our confidence in our credit underwriting, we can allow our credit risks to simply mature and benefit from the pull to par.
This is the power of shorter bonds. They pull to par at maturity and absent a credit event leading to permanent impairment, we then have the opportunity to redeploy the proceeds. The average life of our global unconstrained fixed income portfolios is currently around four years. Meaning a quarter of the portfolio will roll off each year, giving us plenty of natural liquidity and maneuverability.
Mark Brisley: I guess for investors though, as you said, bond returns have been negative in 2022, so a little harder maybe to see the forest for the trees as it were. Why own bonds now?
Erinn King: Well, Mark, we believe bonds have a role to play in broader asset allocation and in diversified portfolio construction. Despite this very unusual high correlation and sharply negative start that we've had to 2022, we believe there will be a return to more normal relationships between bonds and other risk assets. Timing markets with precision is near impossible. As long-term investors, these diversification benefits ultimately serve to dampen volatility. Importantly, bonds provide current income, which can serve to pay liabilities or known expenses or be reinvested and compound over time.
As we think about value-add fixed income strategies intended to complement your core Canadian bond allocation, we find many benefits in looking at an enlarged opportunity set with global markets where we can pursue the best risk-adjusted returns. Different parts of the world are beginning to move at different paces, and in different directions, which creates opportunities for global investors who can be active and capitalize on these diverging trends. Importantly, with shorter bonds at yields of 4 to 5%, high yield at over 8%, we have both the cushion of carrying and opportunities for price appreciation.
Mark Brisley: Well, Erinn, I guess one final question, whether it be fixed income or equities, but the focus today being on fixed income. Investors have to be ready for volatility, and in the short term in particular, but at that same time, just the importance of maintaining an asset allocation suitable for their time horizon at the individual level, but not much different from what you're doing as a global bond manager yourselves, and diversification across asset classes and long-term time horizons for riskier assets to ride out these short term periods of turbulence remains important, I would imagine not only for the retail investor but for yourselves as well.
Erinn King: That's the role bonds play. We have to look through the interim volatility and really focus on the underlying credit work, ensuring that we've done our homework, that we're confident in the ability of either the corporation or the collateral to produce the attractive cash flows that we're looking for, and invest through this cycle such that we can reap the rewards of these income-producing assets.
Mark Brisley: Erinn, thank you so much for joining us today and for your insights. We look forward to having you back towards the end of the year. Hopefully, we're talking about a different narrative, but nonetheless, confident in the fact that these insights and outlooks in today's environment are very much appreciated.
Erinn King: Thank you again for having me, Mark.
Mark Brisley: To our listeners for more information on what you've heard today, please feel free to visit either of our websites at dynamic.ca or Payden & Rygel's at Payden- that's P-A-Y-D-E-N, payden.com. Thank you for joining us. You've been listening to another edition of On the Money with Dynamic Funds. For more information on Dynamic, and our complete fund lineup, contact your financial advisor or visit our website at dynamic.ca.
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