Fixed Income Update: Now is the Time to Prepare for a Downturn in Cyclical Activity

Matt Freund, CFA, Christian Brobst, and Chuck Carmody, CFA

• Inflation will decline through the third quarter of 2023.
• Although the Fed may hike short-term rates once more, its hiking campaign is largely complete. However, the Fed will be hesitant to cut rates unless the economic picture deteriorates significantly.
• Elevated interest rate volatility should continue.
• Tighter financial conditions from here will be driven by banks’ changing lending standards.

It’s remarkable that only three months have passed since our last outlook. It feels as though a year’s worth of events is getting packed into each quarter. With pandemic-era protocols being rolled back in most Western countries alongside coordinated tightening of global monetary policy, stress in the banking system, and continued inflation, there are many issues at play. We expect elevated uncertainty and high volatility to persist as the market digests the impact of tighter policy and financial conditions. Market liquidity remains adequate, but execution costs have increased across asset classes due to significantly higher volatility. The FDIC takeover of Silicon Valley Bank and Swiss National Bank’s sale of Credit Suisse to UBS have the market on high alert, but we expect that the steps taken by regulators to calm the market (reassurance from the US Treasury Department, the Bank Term Funding Program, and the possibility of further deposit guarantees) will result in a continuation of tight monetary policy for the balance of the calendar year.

One area of growing concern is the potential for lending activity to slow, given the newly uncovered stressors on bank balance sheets. Lending standards were tightening before March’s bank headlines. A further tightening of lending standards will result in lower access to credit, reducing the availability and increasing the cost of capital for the expansion and incubation of new businesses, which in turn could impact labor demand. Additional regulations out of Washington could further exacerbate the issue.

Market expectations change quickly. Investors should remember that in February the market was questioning whether the Fed would need to accelerate its rate-hiking campaign (employment conditions were very tight, and inflation reaccelerated in January). It takes time for changes in lending standards to impact the economy overall. Given the economic momentum we have seen so far, we do not see a 2023 recession as inevitable.

We believe the Fed is nearing completion of its policy-tightening campaign. The possible risks to growth associated with further shocks to the financial system are now balanced with inflation pressure and concerns about the tightness of the labor market. An additional quarter-point hike is possible in May, but we expect the Fed has completed the bulk of its work and will now pause to see how data develops from here.

Although the credit market remains fundamentally strong with modest leverage and solid interest coverage, measures of revenue and earnings from high-yield companies are beginning to roll over. Through the Covid era, management teams wisely locked in fixed-rate funding at historically cheap levels. Refinancing needs are modest until 2025. Although default rates remain below long-term averages, they are increasing from the unsustainable pandemic-era lows, and we expect them to migrate to above 3% by year-end.

Positioning Implications

In this environment, we believe the market’s pricing of multiple cuts in 2023 is too aggressive. If further liquidity pressures do not materialize in the banking industry, our bias continues to be in favor of short-duration positions because the curve must steepen further to reflect the reality of 5% overnight rates for the balance of the year. As such, we continue to position portfolio durations modestly short of benchmarks. We also recognize that the conviction behind our view on rates and the economy is relatively low given we are in the very late innings of this cycle. The next move for portfolio duration is likely to be longer, specifically a move longer than benchmark durations.

Our relatively optimistic view of macroeconomic activity should not be confused with complacency. We agree with the market that the next move for fundamentals is in a weaker direction, and the time to prepare for that environment is underway. We are actively reducing exposure to credits that we consider to be more exposed to a downturn in cyclical activity, and those with weak contingent liquidity or exposure to rapid deterioration of asset value. We are maintaining allocations to select high-yield issuers where we believe we are being well-compensated for the risks taken as we follow our disciplined research process to identify value.