A strong first quarter, a slight drop in inflation and a banking fissure that disappeared as fast as it arrived are continuing to provide fixed-income opportunities investors should be excited about, according to CIOs at Schwab Asset Management and T. Rowe Price.
Since the fight against inflation is not over and the lag effects of the Fed hikes of the last year or so will take a few months to work through the economy, Brett Wander at Schwab and Andrew McCormick at T. Rowe Price said they are preparing for more volatility throughout the year.
But it’s that same volatility, they said, that will keep fixed-income investing interesting.
“We’re keeping a close eye on reserves as a good indicator for how these pressures are playing out. We’ve seen reserves steadily moving down as the financial conditions have tightened. We expect that to continue and possibly make a more interesting market in about six to nine months when the reserve levels run to a low spot,” McCormick said during a webinar this week timed to follow the latest inflation numbers. “And that will be when the questions about recession will have to be answered.”
The inflation numbers that came out greenlit the Fed for another 25-basis-point hike in May, and then most likely there will be pause, he said.
“A couple of bad inflation prints and they have the ability to raise rates, but it feels to me like they’re starting to see the type of reaction and data they were looking for and the momentum is building a little bit toward softer pressure on inflation,” McCormick continued, adding that the mechanisms that the Fed has put in place likely will push the U.S. toward recession.
It doesn’t matter, however, whether the recession comes in the fourth quarter of this year, the first quarter of 2024, or not at all.
“The bottom line is that you should prepare your portfolio for recessionary pressures at this point in the cycle,” he said. “For next year, the curve has priced in some rate cuts, I think 125 or 150 depending on when you look and which series you look at. Our feeling is that may not be enough.”
Typically when there is a classic recession, the amount of rate cutting is about 300 basis points in order to return to the neutral rate around 250 basis points, he said, or maybe even a deeper cut for a short time in order to spur economic growth.
“All these things make for really interesting markets, but they’re not going to be stories that have a beginning, a middle and an end,” McCormick said. “They’re going to play out over coming years.”
Wander said that part of the preparation should include no longer thinking of recession as a binary thing. Instead, investors should think in terms of a range of possible outcomes for economic growth.
For example, three components of the current environment are the rally of the Treasury market and expectations of the Fed; corporate bonds had a selloff early market but are now stabilizing; and a finance and banking sector that’s been hurt but not decimated, he said.
“To what degree does all of this present a problem in terms of broad economic growth and to what extent will the Fed be responding to it?” Wander said. “We’ve never seen this scenario play out before. There is no playbook for this scenario. It’s hard to imaging getting through the end of the year without a slowdown, so there are reasons to be cautious. But we shouldn’t overreact.”
What investors should be doing is dusting off their tried-and-true approaches to investing in a high-volatility environment, where both business models and credit are tested, McCormick said. Investors should use common sense, and those who don’t do a lot of research shouldn’t take a lot of risk.
“And those that do the research, you have to really lean on your book,” he said. “At T. Rowe, our research platform kept us out of Russia, kept us out of SVB, kept us out of First Republic Bank, and we only own senior bonds from Credit Suisse.”
Specific investment strategies can still include investing in Treasurys, but that sector of the bond market has changed dramatically since the bank stumbles, McCormick continued.
“I don’t know if today, right now, is a great entry point, but I do believe the odds are that yields will be lower in a year. So for the client base that’s been out of fixed income for a long time because rates were really low, it’s the proper time to get your allocations right and move back into the market,” he said.
His own investment group is still a little underweight in equities and displaying a little caution around risk-taking, he said, but they’re also slightly overweight in Treasurys with the thinking being that if there is a recession, that Treasury position is going to be helpful.
“Tactically right now, for people who are following the Treasury market, our highest conviction trade is that the long end of the curve will get steeper in the next year,” he said. “If you want to find entry points into the Treasury market, patience is the word I would use. There are still volatile markets out there, and you’ll get an entry point.”
Wander agreed, adding that some investors will point out that yields right now are higher in the two-year Treasury, leading them to believe they’re getting higher yield with lower risk. But what they’re forgetting, he said, is the potential price appreciation that comes when longer term bonds rally.
“It’s much more likely that 12 months from now, yields will be lower than they are today,” he said. “It seems easier buying a 2-year with a yield that’s higher than if buying a 10-year. But that will ignore the potential price appreciation and also the aspect of a fixed income portfolio having a natural hedging aspect to riskier assets. It takes you out of that, if you’re focusing on the very short part of the yields curve.”
Instead, investors should keep diversifying across the Treasury yield curve and focus on longer maturity Treasurys even if the yields are lower, he said.
In addition, Wander said he’s finding corporate bonds very intriguing and has been heartened by liquidity, demand in the new-issue market and strong spreads.
“If there was ever a time when you would expect to see stress in the corporate bond market, it would be in the midst of everything that’s going on with banking,” he said. “Interestingly, the triple-C corporate bond sector was the number one performing component of the bond market in the first quarter, followed by Treasurys.”
However, Wander warned against being too aggressive in the corporate bond space in the pursuit of yield and recommended investors use high-yield bonds very judiciously.
The municipal bond market, meanwhile, has performed really well and is sustainable, McCormick said.
“You get more yield compensation for better credit, which is fixed-income Nirvana,” he said. “You don’t really get that too often.”