This has not been your typical business cycle. The writing was on the wall: a recession was coming. All signs pointed to that inevitability. The only problem was, the old toolbox apparently no longer works. Take the US yield curve, for a start. The treasury yield curve has been inverted for the past 559 trading days. Historically since the early 1970s, every time the yield curve inverted, a recession would ensue, on average 15 months later. But the yield curve clock currently ticks at 26 months of inversion, so at a minimum, this hypothetical recession is very very late. There are a number of reasons why the yield curve may not have worked as a recession indicator this time around. The primary cause of signal failure is that the US economy has grown a lot less sensitive to higher rates, owing to the deleveraging, the past mortgage refinancing, and the stronger cash balances on the part of the consumers and corporates. In addition, as underscored by our Chief Economist, Erik Weisman, the market was likely of the view that the Fed’s neutral rate, the so-called r*, was still very low. With that in mind, the sharp rise in the Fed’s policy rate caused a major deviation from r*, thereby accentuating the inversion bias. But if the market got that wrong, and indeed, if r* was actually higher, the curve would not have inverted by that much. In other words, the US economy could well cope with the impact of higher rates a lot better than we had anticipated, because the real tightening could be smaller than it initially looked. There is also another important factor at play, namely the fact that the Fed had owned a massive chunk of US treasuries as part of its QE program, which may have distorted the yield curve, and a result may have produced a false positive. What about the various leading indicators? Whether we are talking about the University of Michigan’s consumer confidence index, the Conference Board’s LEI or the ISM new orders, all these data points still look pretty depressed, hovering around levels that historically have been associated with previous recessions.
There is a big difference between soft data and hard data, and what we have observed is how the consumer or the firms feel in sentiment surveys has not matched up the reality of stronger macro statistics. Finally, another recession indicator may not be working: the labor market-based Sahm rule, which got triggered this month. There are good reasons to believe as well that this time around, the significant pick-up in the unemployment rate may not be as bad as it seems, mainly owing to the impact of higher labor supply. To be clear, we cannot with certainty rule out that a recession is entirely off the table. But the odds seem to be firmly in favor of a soft landing, and if there ultimately were a recession, it would likely be mild and shallow.
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Resilience is a positive attribute. In the world of fixed income, there are some asset classes that are riskier and others that tend to be more defensive in nature. In a way, it is reassuring to see that the asset classes that were supposed to be defensive behaved exactly that way. This is particularly the case for agency MBS. In the midst of the early August market turmoil, what happened to agency MBS spreads? The short answer is: virtually nothing. Agency MBS defensive characteristics played in full force. While US IG spreads widened by almost 20bp in just three days, agency MBS spreads moved by only 4bp during that time.1 Historically, agency MBS has been at the low end of the risk spectrum, displaying a beta to the US Agg well below 1. In one’s portfolio, it makes sense to have a diversified approach, with a mix of defensive and higher beta asset classes. That resilience has some collateral cost, however, especially in terms of relative valuation. Given that agency MBS did not sell off nearly as much as its peers, the valuation backdrop is somewhat less inspiring in RV terms. This may perhaps justify a somewhat more balanced approach towards this asset class, at least in the near term. At this juncture, the view towards agency MBS of our Fixed Income Portfolio Manager in charge of mortgage-backed securities, Jake Stone, is a lot closer to neutral, compared with a more constructive bias a few months ago. Not that the technicals or fundamentals have necessarily worsened, but it mainly reflects a tactical valuation call.
The total return case for High Yield. High yield is often heavily discussed during the fixed income investment team’s meetings, including at the recent internal brainstorm session on risks and opportunities, simply because of its higher vulnerability to a potential growth shock and its rather challenging spread valuation landscape. But in the words of our co-portfolio manager of the high yield portfolios, Mike Skatrud, HY total yields remain attractive, and unless there is a catalyst for a spread correction, the outlook for total return appears to be broadly positive. Our HY team is more cautious when it comes to excess return expectations, given the tricky spread valuation backdrop.
Looking at break-even yields, it is worth flagging that US high yield produces the highest break-even yields across global fixed income, thereby pointing to some attractive valuation cushion. To be clear, high yield remains a fundamentally bottom-up asset class, which requires a well-researched security selection process. While the asset class may look attractive from a top-down index perspective, it is important to keep in mind that an active approach to portfolio management is critical, given the elevated credit risk involved.
[1] Source: Bloomberg. US IG = Bloomberg US IG Corp index (LUACOAS). Agency MBS = Bloomberg U.S. MBS: Agency Fixed Rate MBS Average OAS. Daily data.
