2022 saw its share of challenges for advisors and investors. Between record-high inflation, an inverted yield curve and a looming global recession, advisors faced no shortage of headwinds.
Here’s a look at a few of these obstacles, along with our perspective about how to potentially turn them into opportunities in 2023 and beyond. Our clients rely on us to bring institutional-grade fixed income experience to their individual retirement planning as well as family office strategies focused on producing lifetime, sustainable income,
Inverted Yield Curve: What You Need To Know
Today’s yield curve is inverted—more so than it has since the 1980s. The U.S. Yield Curve (10-yr treasury—2yr treasury) is a bone chilling -78 basis points of inversion. History tells us this may be especially troubling: the U.S. yield curve (10yr – 1yr) has inverted before each recession since 1955, with a recession following between 6 and 24 months. An inverted yield curve offered a false signal just once during that timeframe, according to a report by the San Francisco Fed. Now the worst since Q3 1981, when it inverted by -170 bps, this is the clearest signal yet that trouble may be on the horizon for the economy.
Against this backdrop, the rate of change in interest rates is unprecedented: today’s 30-year mortgage rates have increased over 120% in just over a year. Meanwhile, the U.S. Treasury index has experienced a -18.51% drawdown from its peak in July 2021, according to the Bloomberg U.S. Treasury Total Return Index.
The Inflation And CPI Conundrum
Inflation and consumer prices present a mixed bag for investors. The recent and relatively good news is that inflation appears to have rolled over, coming down off its 40-year high, giving the Fed the ability to potentially slow the pace of increases. On the other hand, inflation remains extraordinarily hot despite the recent pullback. Here are a few additional economic indicators and trends we are watching and implications we are anticipating:
• CPI isn’t helping matters as cost pressure on household essentials has not yet eased. Prices across essential household goods and cost centers continued to accelerate. Price growth continues to run a premium to wage growth.
• As asset price deflation continues, and cost components of CPI continue to rise, we anticipate the ultimate slowdown in the economy, due to the Fed’s aggressive hiking cycle, which is what ultimately fixes inflation, will occur sometime in 2023.
• Job growth for the most part is robust; however, we are beginning to see layoffs in the tech sector, and may see layoffs in the housing sector.
• Domestic growth: We are getting mixed signals when it comes to domestic growth. Some fourth quarter estimates look relatively strong, while Q1 2023 numbers are indicating a rollback into negative growth territory. This suggests that if a strong fourth quarter plays out, it may be more of an outlier than a norm. It’s important to remember that forecasts aren’t always right, so take any domestic growth data with a grain of salt.
• Real estate: We expect residential real estate prices will continue to decline as mortgage rates rise. In fact, now you can essentially earn the same rate of rental return on a Treasury as you were getting on rental real estate six to nine months ago.
Compelling Fixed Income Opportunities For Advisors
The fixed income market has evolved alongside these industry shifts in 2022. And while deploying fixed income into investor portfolios should be well researched and done thoughtfully, we are exploring several areas that may present compelling opportunities for advisors and investors in 2023:
• Take advantage of attractive bond yields with a tactical approach. As the stock market has come down, bond yields have risen to a point that the long-term volatility in bonds makes them a very good alternative for stocks at current rates. For conservative, income-oriented investors, we may get both income and potentially price appreciation in the bond market. And within the bond landscape, there are three approaches to help maximize outcomes. 1) Shorten duration. 2) Go up in quality, from low grade credit to government backed. 3) Consider swapping to higher coupons.
• Consider laddering Treasury-Bills (T-Bills). For the last several months short T-Bills have been the best place for advisors and clients to invest hard-earned capital. Laddering from 30 days out to about four months has worked effectively as the Fed raised the federal funds target rate from under 2% to almost 4%, which allows investors to reinvest the short maturing bills as the Fed continues raise. However, as the ten-year to two-year spread continues to invert deeper, history tell us that the economy will slow, just as it did after the tightening cycles of 1994-1995 when GDP fell from 5.5% in 1994 to 1.2% in 1995.
• Mortgage-backed securities may be worth cautious consideration. For the most part, we have steered clear of mortgage-backed securities (MBS) for the last several years due to exceptionally low yields. On the other hand, MBS are close to the cheapest they have been since the great financial crisis by some measures, and institutional investors are beginning to take notice. Keep in mind that MBS are in a world all their own—they are complex and investing in them requires specialized analytics using a Bloomberg terminal or similar resource, and a deep understanding of rates, housing, and the structure of the bond, along with established trading relationships.
• More traditional investments. An alternative to buying individual bonds might be an exchange traded fund (ETF) or even a mutual fund, if the fees are justified for your clients. Also, funds do not mature, which is the primary reason we manage our own portfolios. Mortgage real estate investment trusts (REITs) are also a great alternative for those advisors who do not want to do it themselves or pay an expert to build a separately managed account.
It appears long-term rates and inflation may have peaked, but it’s important to remember that every cycle is different. So, what is a fixed-income investor to do? Investors should approach fixed income investing in 2023 with a few key tenets in mind: consistent cash flow, potential price appreciation and lowering credit risk. By balancing this, advisors can take advantage of higher rates we haven’t seen since 2008. Done right, a thoughtful fixed income approach can deliver a strong portfolio yield, capture potential price appreciation when the Fed starts lowering rates, and help insulate portfolios from a potential recession. While fixed income investing requires a thoughtful approach and deep understanding, doing so successfully can help advisors build more resilient portfolios in the face of these challenges in 2023 and beyond.
Don Burrows is the founder and managing partner of Burrows Capital Advisors. Burrows is based in Galveston, Texas. Click here for more information about Burrows Capital Advisors.