Published on January 12, 2023
2022 was a difficult year for bond investors, but the combination of high inflation and tighter Fed policy should keep yields elevated, creating materially stronger fixed income returns in the new year.
Was This a Crazy Year or What?
2022 was a year for the record books – one we believe investors are happy to put behind them. Virtually all asset classes fared poorly due to inflationary pressures rearing up after being dormant for many years, exacerbated by the uncertainty of war. We have discussed the reasons for low inflation in past outlooks and do believe that we are entering a new era with both higher inflation and interest rates. Once the markets have adjusted for the absence of free money (or in the case of Europe, “pay you to take it” money), what comes next? Barring a black swan event, life will continue, coping mechanisms will take hold, and markets for financial and real assets will find their equilibrium. Sometimes it helps to take a step back to have a broader view of what markets are offering today versus what we have gotten accustomed to in the past decade or so in order to find the right path to better returns.
Equities, bonds across the ratings spectrum, cryptocurrency, SPACs, etc. all had a bad year. Some have called it the everything bubble. While some energy commodities did well, we believe the factors responsible for that are not repeatable, hopefully. Eventually, supply and demand will come back into balance, so we do not expect a repeat of 2022. We have already seen a round trip in prices of some commodities like lumber, aluminum, steel, and wheat while others are down from their 2021 peaks but still have further to go. Treasuries had an especially bad year, despite their year-end rally. As we have stated in the past, the math of starting a tightening cycle from historically low yields would certainly bring tears. And it has. It is even worse in Europe, where yields were negative to start. Insanity.
For equities, the biggest driver of negative returns has been the contraction of multiples caused by the rise in interest rates. The question remains: How much further do we have to go, and will the E in the P/E start to shrink, making it a vicious circle? For most of 2022 there was a widespread belief that weak economic data would cause the Fed to lose its nerve in its fight against inflation and pivot to a more accommodative monetary stance, despite Fed messaging to the contrary. Whenever weaker economic data hit the tape, equity markets would rally, as would Treasuries. We thought it odd that a rise in the prospects for a recession would be a cause for celebration given what has typically happened to equities during past recessions. Hint: they have not fared well. Temporary insanity? Maybe.
The equity market has recently sold off following some weak economic releases. What has changed? Economic revisions usually barely register on investors’ seismic map. However, on December 13th, the Federal Reserve Bank of Philadelphia admitted they made an addition error regarding the number of jobs created in the second quarter of this year. Rather than the previously estimated (yes, initial jobs numbers are estimates) 1,121,500 jobs created by the sum of the states’ method, in reality only 10,500 net new jobs were added nationally! The equity markets reacted by reversing a good part of the recent November rally.
Job creation is important because it is a determinant of consumer confidence and in turn general economic health. This new lower estimate, if correct, may explain why past “healthy” jobs numbers did not add much to the labor participation rate, which remains lower than would be expected in the face of presumably healthy job creation. Following the error, the Bureau of Labor Statistics (BLS) pointed out that other regional Federal Reserve Banks, such as the one from Philadelphia, have conducted their own research in the past, but that they have generally resulted in “lower quality data” than the official BLS data. Eventually we will get to the bottom of what happened, but for now we will let the various statisticians work it out. On the day of that revision, the equity market traded down over 2%. Another revision that got less notice was the revision to third quarter real GDP growth from 2.9% to a stronger 3.2%. This compares to second quarter real GDP of negative 0.6%. One would have thought that would be cause for celebration, but the market continued its downward path going into yearend. Sanity? Time will tell.
Treasuries have generally rallied into yearend as expectations for weaker economic growth take hold, but we can still find value in some of the shorter tenors, given the steep yield curve inversion. A conspiracist could argue that the ghosts of past bond vigilantes have returned and are tormenting the Fed by keeping longer rates at lower levels until it pivots to a more accommodative monetary stance, but we are not buying into that yet. The Fed still has a long fight on its hands before declaring victory over inflation. The CPI is still quite elevated and most of the recent improvement has come from lower energy prices, which are volatile and could reverse. While the Fed may need to cause a more severe contraction in demand, we hope that it is not too draconian. Stay tuned.
In high yield, sanity is returning to the market. Specifically, we are finally seeing more selectivity regarding what investors think is an appropriate rate of return for risks taken. This has been especially apparent in the private equity sponsored leveraged buyout (LBO) deals, which were backstopped by banks in headier times. As yearend approached, banks wanted to get these “hung deals” off the books, often at painful losses. Double-digit coupons and slightly better covenants have been the norm and even those have not kept some deals above water. Non-LBO debt in less leveraged companies has repriced as well, which means better yields for investors looking to re-enter the market. While the high yield market did not quite attain double-digit yields during the latest correction, peaking out at 9.6% in October, even at 9.0% currently, we believe it offers very good value. With a par-weighted price of $85.9 and a par-weighted coupon of ~5.8%, the current yield translates to ~6.7%, a solid return that will only get better thanks to the pull-to-par effect over the next few years. While it may not be a straight line from here, the return outlook in the high yield market is far from bleak.
Yearning for the good old days is not a realistic or practical investment strategy. We hope that central banks have learned their lesson regarding excessive amounts of free money coming back to bite with higher inflation. We view the past 13 years as an aberration in the long-term historical record, much like how the period between 1975 and 1982 is viewed now. Even Japan, the last zero-interest rate holdout, acquiesced and raised their target rate for Japan’s 10-year Treasury, albeit to only 0.50%. They also raised the monthly repurchase target amount, just to make sure everyone knows they are still fully committed to their (insanely large) QE. It may not seem like much, but the yen had the biggest single day rally against the dollar since 2000 following the announcement. Subsequently, the Bank of Japan has had to intervene in order to keep yields on shorter tenors at their target range and the yen fell again vs. the dollar. Baby steps.
Investors also need to live in the present while preparing for the future. The era of free money and sky-high equity multiples is hopefully a thing of the past. The adjustments the markets have seen in the past year are painful, but they are presenting us with better opportunities for rational investing such as getting paid a decent return to lend money. What an old-fashioned concept! Selectivity and flexibility should be winning gambits. That said, we have been investing at the front end to take advantage of the inverted yield curve and focusing on stronger companies while eschewing the temptingly high coupons offered by some highly leveraged companies needing to finance today. Let’s hope for better times ahead.
Co-President, Co-Chief Executive Officer, Chief Investment Officer – Strategic Income & Managing Director – Fixed Income
Vice President & Portfolio Manager
Vice President & Portfolio Manager
Past performance does not guarantee future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
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A special purpose acquisition company (SPAC) is a company with no commercial operations that is formed strictly to raise capital through an initial public offering (IPO) for the purpose of acquiring an existing company. Also known as “blank check companies,” SPACs have been around for decades.
Price-to-Earnings (P/E) Ratio is the ratio of a company’s stock price to its twelve months’ earnings per share.
Treasuries are securities sold by the federal government to consumers and investors to fund its operations. They are all backed by “the full faith and credit of the United States government” and thus are considered free of default risk.
A yield curve is a graph that plots bond yields vs. maturities, at a set point in time, assuming the bonds have equal credit quality. In the U.S., the yield curve generally refers to that of Treasuries.
Yield is the income return on an investment, such as the interest or dividends received from holding a particular security.
Consumer Price Index (CPI) reflects the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care.
A leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company.
Coupon is the interest rate paid by a bond. The coupon is typically paid semiannually.
QE, or quantitative easing, is a monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.