Market Conversations: Driving by the rearview mirror

Brian Levitt

I'm Brian Levitt.

Jodi Phillips

And I'm Jodi Phillips. And today we have Rob Waldner. Rob is Chief Strategist and Head of Macro Research for Invesco Fixed Income. Fixed income. Not a lot going on there, right, Brian?

Brian Levitt

Yeah, we seem to get the timing right, coincidentally, or maybe not coincidentally with these guests. There's a lot going on in every market, Jodi, but for fixed income it had been particularly rough. I think equity investors have probably become somewhat conditioned for bad environments. We've seen this a lot over the years, even in my career, just 2000, 2008 … I mean we've seen this, but for the bond investors to be down, I think at one point, 14.5%, if you look at the aggregate bond index, in the same year that equities are down 25%, I mean that's a tough pill to swallow.

Jodi Phillips

Well it has and you can see that in the numbers, right? You look at the Investment Company Institute, look at their flow numbers. And there's been about $260 billion in outflows from fixed income mutual funds and ETFs this year. And around $30 billion or so of that has been in the past five weeks.

Brian Levitt

Yeah, I mean investors tend to bail at inopportune times. But remarkably, equity flows have actually been positive over the year.

Jodi Phillips

That's a little surprising to me, honestly.

Brian Levitt

Yeah, I mean maybe, and maybe we're learning, maybe equity investors are realizing how badly they've been burned by selling at those inopportune times in the past. Well, we'll see.

Jodi Phillips

We learn but we learn the hard way, right? So we'll see how this works out. But you know what, it has been a remarkable year for interest rates and inflation, no doubt.

Brian Levitt

Oh, I mean remarkable is, I mean this is one for the history books, right? I don't even know is remarkable the strong enough word?

Jodi Phillips

No, probably not.

Brian Levitt

Probably. Even the two-year rates started below 1%. I mean that was like the market was expecting only a couple of interest rate hikes this year and surged above four. I mean the 10-year was what had climbed from a low of around 1.5% to what, 3.75% or so. So I mean it's been remarkable.

Jodi Phillips

Yeah. And those 10-years that were 1.5% at the start of the year just aren't that valuable when you're looking at three and three-quarters right now. So it is an interesting situation for sure. Not a lot of places to hide.

Brian Levitt

Yeah, there hasn't been. It's not only Treasuries. We've seen borrowing costs go up for corporations as well, but we start to think, look, perhaps a decent amount of the worst is behind us for rates — if we're certainly getting closer. And so at this point, it's really about the market getting more clarity on inflation, on the Fed. How tight does the Fed need to be?

Jodi Phillips

That's the question.

Brian Levitt

Yeah, that's probably the 200 trillion dollar question.

Jodi Phillips

200 trillion dollar question. No pressure there. So that is definitely Rob's cue. Yes?

Brian Levitt

Yeah, that's his cue. I want his view on rates, inflation, credit, how far he thinks the Fed is going to go. Are we finally generating income in fixed income? Is this what we've been waiting for? And now investors are bailing on it. So there's just so much to talk about. Let's bring Rob on.

Jodi Phillips

Great. Welcome, Rob.

Rob Waldner

Thank you, Jodi. Thank you, Brian. Thanks for having me on.

Brian Levitt

Yeah, it's our pleasure. Let's just characterize, Rob, what's going on. What's been driving markets here?

Rob Waldner

Well you've spoken about the poor total return performance we've had this year in fixed income. And I think it's helpful though to disaggregate it into what kind of really drove it. And I think there's a narrative out there that it's all about inflation and that inflation really picked up and therefore fixed income had such negative returns. That's partially true. But really what happened, I think if you're going to look at this, what really drove fixed income this year is that after years of being sort of excessively loose with monetary policy, the Fed took a total pivot and went all the way from the loose side — as loose as possible — to now being essentially as tight as possible.

Rob Waldner

But the reason I say that is if you look at what happened in real yield, so in fixed income we like to talk about real yields, which are the yields that you get by comparing inflation-adjusted securities, or TIPS (Treasury Inflation-Protected Securities), to Treasuries and what the implication is for inflation. That TIP gives you the real yield. Real yields have risen by almost 250 basis points. So we started out at negative in the 10-year sector, we started at negative yields at a year ago, about minus 1%. We're now at plus 1.5% percent. And that's really not inflation, because the inflation compensation component of that has moved kind of sideways. That's really driven by the Fed getting very aggressive. And so that's the story, is that the Fed is pivoted from being super easy with QE (quantitative easing) to being very tight with QT (quantitative tightening).

Jodi Phillips

So Rob, talking to you the other day, just to put a point on this, you mentioned that you hear so often from investors, "What do I do about inflation? What do I do about this?" And that that's really not necessarily the right question to be asking. So what should investors be asking right now?

Rob Waldner

Well, I think with what the Fed has done, what the Fed has told us is they are going to get inflation back down to 2% no matter what. So the question really isn't, “How do I protect my portfolio from inflation?” It's “How do I protect my portfolio from the Fed?” Because the Fed told you what they're going to do, which is they're not going to rest until they have clear signs that inflation is headed to 2%.

Rob Waldner

And by the way, that's what the market is implying. So market breakevens, again looking at TIPS versus nominal Treasuries, tell you that the market has confidence in the Fed. And so what we need to do is figure out exactly how far the Fed is going to go and to cut to the chase. We think that we're getting pretty close to the time when it's a good opportunity to buy fixed income and that the Fed has tightened policy quite a lot. We see signs that inflation has peaked. It may take a while to come back down, but we think that this narrative that is out there — “This is the 1970s, and we’ve just got to keep raising rates and raising rates” — is just not the right narrative.

Brian Levitt

I mean that's good from an investment perspective, but not from my wardrobe. I just went out and I bought a polyester leisure suit and Jodi's been crocheting sweaters.

Jodi Phillips

I'm so glad this is audio only.

Brian Levitt

But to that point, Rob, I mean when I think of ’73, ’74, ’75, I think of the idea at the time that the Fed had kind of lost the narrative, whether it was previous to Arthur Burns, William McChesney Martin doing the bidding of Lyndon Johnson or then Arthur Burns doing the bidding of Richard Nixon and long-term inflation expectations getting out of whack. The bond market is telling you that this is a very different situation. Is that what you're saying?

Rob Waldner

Exactly right.

Brian Levitt

And so when we think about them pushing so hard on this, even with inflation expectations pretty benign. What starts to happen with growth expectations? What starts to happen with financial conditions? I mean how worrisome is what's transpiring to you?

Rob Waldner

Okay, so let's break this down because I think that's a great question, Brian. So when we think about this, thinking about how the market's going to behave, we like to break it into three components, which is what's inflation going to do, what is growth going to do, and what is central bank essentially policy going to do? Right? And we already talked about inflation. We think inflation's peak is going to come down slowly, but will be maintained. This is not the 1970s. So then the question is, the Fed’s tightening policy, what is that going to do for growth? And so we have a bit of a horse race here between tightening policy and growth, and how much will the Fed slow growth, when will they pause to see how much tightening they’ve put into the system? And so the thing that worries us a little bit is that with longer-term inflation expectations remaining well-contained and the Fed just continuing to deliver for global central banks.

Rob Waldner

That's just like, global central banks continuing to deliver hawkish surprise after hawkish surprise after hawkish surprise. And really we've never seen, globally, central banks raise rates at this pace. There's really a real risk that we could see something break, or that they overtighten. And I think we could point to a couple of things that might point to that: tightening financial conditions, the dollar is on a tear, real yields are rising globally. So that's kind of what we're worried about.

Brian Levitt

Okay, Rob. So Jodi's Jay Powell, what do you say?

Jodi Phillips

Sorry.

Rob Waldner

Well, so the message for Jay Powell is you've set up this narrative where you are the new (Paul) Volcker and you are going to raise rates essentially until you see the whites of the inflation eyes. Right? And the problem with that is that we know that inflation is a lagging indicator, and we know that the inflation that we have today is about what we did two years ago in terms of fiscal policy and monetary policy, that really juiced the economy and gave people money to spend on cars, and houses, and they had low mortgage rates.

Rob Waldner

All of these things are what's driving inflation now. So that's gone, right? Those stimulus checks have been cashed, you can't get those back. Those mortgages at 2.5% or 2.75% — we never thought we'd see — people took them out. Those are all in place. You can't undo that. So that as well is one of the things that's really driving our inflation now. So those are trailing indicators, if you like, right? That's something that did happen. Meanwhile, the Fed has monetary policy and so I'd say Jodi, you're setting a forward-looking instrument which is monetary policy based on a backward-looking indicator. And I wouldn't recommend driving looking in the rear view mirror, just not a good strategy.

Rob Waldner

And so we would say, hey, maybe it's time to see, with all this tightening, to see what ... take a bit of a pause. We've been calling it pivot, and we've been hoping that they would pivot over the last several months. No signs of it yet. But they would take a bit of a pause.

Jodi Phillips

Absolutely. So do you have a sense, or I know everyone's looking, listening to every word that's spoken in every press conference, at every release, looking for signs of that pivot. What do you think it's going to take or what do you think they're looking for before they begin that process?

Rob Waldner

So I think it's either something breaks, right? And we have two recent examples of things that, well two minor, maybe, could start to chart the path. One, we had this whole episode in the UK last week where we basically had, for a variety of reasons, we had the gilt market come unhinged, the bond market there become unhinged, and put quite a lot of – that created quite a lot of collateral calls in the pension system there, due to the structure of the pensions, and really the Bank of England was forced to come in and stabilize things. So what they did is they bought bonds, they went back to essentially, it's not really QE, but they bought bonds the same thing basically as QE. And that is after they'd been planning on doing QT. So they really did a sort of pivot towards a more dovish stance, not a big pivot but that's that something was breaking. The liquidity in the market was deteriorating, causing a breakage in the market and they came in and stabilized it.

Brian Levitt

The market told us we shouldn't be lowering taxes on the wealthiest people in an inflationary environment or at least the British shouldn't be.

Rob Waldner

Yeah, well yes. That, and also it told us that with rates, when rates are moving this quickly and this aggressively, it doesn't take much for portfolios to get twisted, for these total returns to really become a problem. And so I think it said to the UK, you need to calm down, you need to take it a little bit slower, you can't move rates that aggressively. That was one. And the other is we've got the Reserve Bank of Australia recently and they delivered a dovish rate hike which is only 25 basis points. So I think the narrative there is that a little bit, maybe they are, we'll see whether the Fed might do something similar. We'd certainly love to see that.

Brian Levitt

Rob, how would you position, so many investors when they built the 60/40 (portfolio), the 40% was going to be longer-duration ballast in the portfolio, maybe not the highest yielding securities you could find in the fixed income market, but certainly protection or the perception of protection. When Jodi and I were talking about the flows data, it seems that that's probably where, or a good amount of it has come out of what was to be the ballast. If you're talking about excessive tightening, slowdown in the economy, dare we say a recession, is that a return back to longer-duration assets?

Rob Waldner

Well I think I agree with the way you kind of characterized it in the beginning, Brian, which is just when I can tell you there's some value in fixed income, for the first time in many years, the flows are still out. So I'm getting hoarse going out and talking to people about the value that fixed income can bring to your portfolio now. Because if you go back to the way I set this up a moment ago, we have tightening policy and we have growth. These are the two things we're worried about. Well if we game this out and let's say that the Fed does what we hope it will do, which is or that we think they should do, which is sort of take a pause, that would be a little bit dovish received by the market, overall level of rates would stabilize, might come down a bit, and you'd see probably credit spreads coming because that would be a better liquidity environment, less recession risk.

Rob Waldner

The bad scenario there would be the Fed continues to tighten and continues to tighten, and then we get a recession and we get a nasty recession. And the advantage in that environment though, I still can see fixed income performing a decent role in your portfolio relative to some of the other choices. I'm not saying investment grade bonds are going to give great total returns, but they're going to hold up relatively well to most of the other assets that you could put in your portfolio such as lower quality credit or equities. So I really do think bonds are back to being a great investment here for the first time in quite a few years. The investment grade index is yielding about 5.4%. So you can buy a basket of investment grade bonds, collect 5.4%, which by the way, everybody thought that a year ago people would've been falling all over themselves for 5.4%.

Brian Levitt

Absolutely.

Rob Waldner

Got 5.4% and you don't really have an investment grade index, you don't have the worries about near-term defaults, et cetera. And you have duration in that index. So if you do get the recession, the duration will help offset some of the spread widening, and if you get the dovish Fed pivot, that's going to be a great entry point.

Jodi Phillips

So Rob, you mentioned that you were going hoarse a little bit spreading that message out and I'm glad you regained your voice in time to join us today. But when you are talking about this story out there, what kind of questions are you getting, or what kind of concerns are you hearing that maybe you're having to work through, and really communicate to investors what they're looking at right now?

Rob Waldner

Well I think there's two things. One, the US Agg is down 12%, 13%. So your fixed income portfolio is really taking a beating. And so I think that makes one cautious. Two, while we think we've seen inflation peaking out, you haven't seen the decisive turndown that the Fed is looking for. And it's going to be messy. We know that there will be some persistence in inflation in housing, and so you're going to have to look through some noise really. So you have to look through the noise and ignore the negative total return so far this year, if you're going to buy into that story that I just gave you.

Brian Levitt

Are you surprised where credit spreads are today? And by that, I mean historically low relative to where they typically are in an environment where growth is slowing?

Rob Waldner

Yeah, I think the answer would be yes. I think we haven't really priced a recession in the credit markets or in probably some of the other markets as well. Even if I do a very simple look at, I think what we've largely priced into a lot of these markets is the rise in real yields and what the discount rate that that implies for companies and others. And so that means you got to take down your multiples in equity market and it means slightly wider spreads, but it doesn't seem to us that you've priced in a recession. Certainly, particularly in lower quality credit, you can see much wider spreads in a recession that we have now. And that's why I've been talking about investment grade, I was talking about investment grade and not high yield.

Brian Levitt

Yeah.

Rob Waldner

The other areas that, there are going to be areas in credit that could be challenging, or if you're a company, in a recession, if your funding costs are going up, let's say your floating rate debt and your top line is under pressure, your revenues are under pressure because of recession, we could get a default cycle there or at least a downgrade cycle picking up.

Rob Waldner

So that would bring you wider spread. So we're not positive on credit overall, but I think we like higher quality credit.

Brian Levitt

And to your point, you start to compound those attractive income level or that attractive income stream that we haven't been able to compound in a very long time.

Rob Waldner

Right. I think there's some benefit from that duration, buying fixed rate assets.

Brian Levitt

And in terms of the currency, it's all part and parcel of the same trade, is it a dollar trade until the Fed pivots?

Rob Waldner

Yes, I think that's what's driving it here is the Fed.

Jodi Phillips

So Rob, you had talked a little bit earlier about how it's not just the Fed, it's global central banks really almost working in tandem on this. Looking at this regionally, are there any spots that you would particularly highlight maybe in emerging markets or elsewhere?

Rob Waldner

Yeah, I think that that's one of the stories about this cycle that's interesting, is that while the Fed was quite late, not all central banks were late to the cycle. So particularly there's some central banks in emerging markets and in LatAm (Latin America) for instance, who really have been hiking rates for a while, increasing rates were out ahead of the Fed. And so there are some situations where the cycles are a little bit more divergent from the typical scenario. And we think that's quite positive. And actually some of these countries, like a Brazil for instance, has actually had relatively good performance in this year. I think partly because they got out in front of it, started raising rates sooner. So there is some divergence in the cycle. Another place is China, where China's kind of been in recession and the policymaking has been much more stable.

Rob Waldner

I.e., real rates never really went negative. They haven't really moved much, interest rates haven't really moved up with China for a number of years. So they're at a different point in the cycle. So I think we're really starting to see some real benefits of diversification globally. If you look outside of the western US/European bloc, you're starting to see some benefits from diversification. So I think that's a really interesting thing. Now it is clear though that the Fed is, it can really realize a lot of value here. From some of these markets, you probably do need to get the Fed to pivot or just to slow down the rate hikes.

Brian Levitt

Okay Rob, we're going to put you back in Fed Chair Jay Powell’s seat. We're not going to make it 2022 though, we'll make it Powell's retirement day, whenever that may be. And we're going to have you look back on how this all played out. How are you feeling? Did you emerge with the Powell name intact?

Rob Waldner

Well I'm going to feel a little bit uncertain about it, I got to say, because I know that kind of already, I made a policy mistake in sort of 2021, 2022 by keeping rates too low, too long. I bought into the lower employment forever kind of narrative that I made a mistake in 2022, 2023 by hiking rates too aggressively and keeping them too high. I bought into the “inflation is the big problem” narrative. And so hopefully the US economy will continue to power forward, so it will do great over this longer term period. But I think I won't feel that good about that period, this period here. And when I express that to my wife and say I feel kind of bad about that, she'll say, "Well, honey, you remember how much pressure you were under. Remember all the political pressure and the narrative of the time," and she'll try to make me feel better. And all that's true that tremendous amount of political pressure to get unemployment low, then to keep rates low, then now deal with inflation. But I do think that I will, with hindsight, I would have implemented a different policy.

Brian Levitt

Implement a different policy. But the key takeaway I'll take there is we'll get through it, and the US economy will continue to be a growing concern and an ongoing investible opportunity.

Rob Waldner

Absolutely.

Jodi Phillips

We'll get through it. It sounds like the perfect place to wrap up to me. Thank you so much, Rob, for joining us and for taking our questions and putting yourself in that hot seat, putting yourself there for a time. Not an easy question, Brian.

Brian Levitt

He needs a hug. Thanks, Rob.

Rob Waldner

Well, thank you all.

NA2517956

Important information

The opinions expressed are those of the speakers, are based on current market conditions as of October 4, 2022, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Some references are U.S. centric and may not apply to Canada.

All figures are in U.S. dollars.

Past performance is not a guarantee of future results.

Diversification does not guarantee a profit or eliminate the risk of loss.

All investing involves risk including risk of loss.

Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the simplified prospectus before investing. Copies are available from Invesco Canada Ltd. The opinions expressed are those of the presenter, are based on current market conditions and are subject to change without notice. 

These opinions may differ from those of other Invesco investment professionals.

Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although we make such statements based on assumptions that we believe to be reasonable, there can be no assurance that actual results will not differ materially from our expectations.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions. The information and opinions expressed do not constitute investment advice or recommendation, or an offer to buy or sell any individual security

Invesco is a registered business name of Invesco Canada Ltd.

Invesco® and all associated trademarks are trademarks of Invesco Holding Company Limited, used under license.

© Invesco Canada Ltd., 2022

Data quoted for the aggregate bond index refers to the Bloomberg US Aggregate Bond Index, an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.

Equities performance data refers to the S&P 500 Index.

Data for US two-year and 10-year Treasury yields is from Bloomberg, L.P.

Yield data for the investment grade index refers to the Bloomberg US Corporate Bond Index, which measures the investment grade, fixed-rate, taxable corporate bond market.

Fund flow data from the Investment Company Institute.

All data as of October 4, 2022, unless otherwise specified.

Breakeven inflation is the difference in yield between a nominal Treasury security and a Treasury Inflation-Protected Security of the same maturity. Statistics on the 10-year, 5-year, and 2-year breakeven inflation levels are from Bloomberg and the US Treasury.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer’s ability to make payments of principal and/ or interest.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Investments in companies located or operating in Greater China are subject to the following risks: nationalization, expropriation, or confiscation of property, difficulty in obtaining and/or enforcing judgments, alteration or discontinuation of economic reforms, military conflicts, and China’s dependency on the economies of other Asian countries, many of which are developing countries.

Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates.

Quantitative easing, or QE, is a monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective.

Quantitative tightening, or QT, is a monetary policy used by central banks to normalize balance sheets.

A basis point is one hundredth of a percentage point.

Real yields are the returns that a bond investor earns from interest payments after accounting for inflation.

Treasury Inflation-Protected Securities, or TIPS, are US Treasury securities that are indexed to inflation.

UK gilts are bonds issued by the British government.

Credit spread is the difference in yield between bonds of similar maturity but with different credit quality.

A collateral call is a demand by a counterparty for an investor to transfer cash or securities to cover movements in the value of derivatives contracts.

Floating rate debt are bonds with variable interest rates that are allowed to move up and down with the market.