With pain comes opportunity, and we believe that the current landscape offers a compelling entry point for fixed income investors. At the start of 2023, the yield-to-worst on the Agg stood at +4.68%, the highest level since 2007. As recently as the beginning of 2020, the Agg yield-to-worst was a paltry +1.12%; in other words, value has finally returned to the bond market.
We believe a number of factors will provide fixed income investors with an attractive opportunity, including an improvement in yields relative to recent history; forthcoming favorable spread levels in credit sectors (anticipated at some point in 2023); and duration transitioning from a headwind to a tailwind. Regarding duration, we believe the fundamental outlook is far more promising than the past few years. Unpacking that view, we focus on three key items:
1. Inflation data improves
In terms of inflation in the U.S., prices are now declining across major goods categories, including used autos, apparel, and furnishings. Consumer Price Index (CPI) core goods over the past three months have averaged -4.8% (annualized), which has been the primary driver of the recent improvement in inflation.
Core services inflation, on the other hand, remains “sticky” and well above the Fed’s +2% target, running +6.1% (annualized) over the past three months. Digging deeper, we see substantial progress in core services ex-shelter, which averaged +8.6% (annualized) in the first half of 2022 but only +4.0% in the second half and has continued to trend lower in recent months. CPI owners’ equivalent rent (OER) has yet to show signs of significant improvement, averaging +8.6% (annualized) over the past three months, just off of the cycle’s peak. OER tends to be a heavily lagging measure, partly because the vast majority of leases are twelve-month leases, while it takes a full year for the rental cycle to fully reflect current home prices (which in turn lag changes in interest rates). As the Cleveland Fed noted, “Rent inflation for new tenants leads the official Bureau of Labor Statistics (BLS) rent inflation index by four quarters”.1
Such timely measures of new lease signings, such as the Zillow and Apartment List indices, peaked more than a year ago and have posted sharp declines recently—certainly a good sign that official measures are soon to follow. After a record +17.6% in 2021, Apartment List’s rent index cooled to +3.8% in 2022, about in line with pre-pandemic levels. Each of the past four months has been negative.
2. Fed nears the finish line
While the nascent improvement in inflation is a welcome development for the Federal Reserve (Fed), the labor market remains strong by most measures. Additionally, the Fed is still reeling from credibility issues after erroneously expecting a transitory spike. Therefore, as the December Federal Open Market Committee Minutes state, “Participants continued to anticipate that ongoing increases in the target range for the federal funds rate would be appropriate to achieve the Committee’s objectives.” However, they also recognize a risk, “that the lagged cumulative effect of policy tightening could end up being more restrictive than is necessary to bring down inflation to 2% and lead to an unnecessary reduction in economic activity, potentially placing the largest burdens on the most vulnerable groups of the population.” While additional hikes are likely, we think that continued progress on inflation and slowing economic data should allow the Fed to pause in the first half of 2023.
3. Probability of recession grows
The current cycle of Fed/global central bank tightening has been much more aggressive than recent cycles. The steady 25 basis point per meeting stair step function gave way to 75 basis point hikes. Historically, it is unusual for the Fed to continue hiking as the manufacturing sector enters a period of contraction, but that is exactly what has been happening. The following graph shows ISM manufacturing new orders versus the Federal Funds rate, with the terminal hike highlighted for each cycle. New orders have declined substantially and are now below the 50-diffusion line, consistent with a contraction. Historically that has occurred after the Fed has been on pause, but this time new orders are already contracting and trending even lower as the Fed continues to hike.
ISM new orders vs. federal funds rate