May 16, 2024 • 39 mins
Household debt is a good investment as the US economy remains strong, Jeremy Forster, portfolio manager at Wellington Management, says in the latest Credit Edge podcast from Bloomberg Intelligence. “We do still think that the US consumer is in really good shape,” he tells Bloomberg News’ James Crombie and Bloomberg Intelligence Senior Credit Analyst Arnold Kakuda. Forster expects “compelling” returns in fixed income for 2024, which he thinks will be the year of the bond. In addition, Wellington likes financial sector and electric utility debt. Forster and Kakuda also debate liability-driven investing and risk in the banking sector as interest rates stay high.
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Episode Transcript
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Speaker 1 (00:17):
Hello, and welcome to the Credit Edge, a weekly markets podcast.
My name is James Crumbie. I'm a senior editor at Bloomberg.
This week, we're very pleased to welcome Jeremy Forster, portfolio
manager at Wellington Management. How are you, Jeremy.
Speaker 2 (00:29):
I'm doing well today, James. Thank you for having me on.
Speaker 1 (00:32):
Thank you so much for joining us. We're very excited
to dig into your market views and the outlook. Also
delighted to welcome back Arnold Kakuda with Bloomberg Intelligence. Great
to see you again, Arnold.
Speaker 3 (00:41):
Oh yeah, happy to be here.
Speaker 1 (00:43):
So just to set the scene a little bit here,
credit markets are rallying and debt'spreads remain tight. Investors aren't
getting very much compensation for the risk of default or downgrade.
The mood is pretty uniformly bullish, especially on US assets,
and most people are very excited about private markets. The
money really is flowing into that. Even real estate seems
to be coming back into favor, with buyers seeing value
(01:05):
and sellers getting more realistic on the valuations. Issuers, meanwhile,
are piling in. There's a record amount of bond and
loan sales as companies take advantage of the window to
raise debt, front loading it to avoid election volatility coming
later in the year. Potentially, they're accepting the fact that
the FED isn't cutting rates anytime soon, and increasingly borrowing
at longer tenures. The Ball case, though, seems to be
(01:28):
founded on a belief that the US economy will avoid recession,
earnings will remain solid, most companies can handle the higher
borrowing costs, although there's a cohort of very low quality
issuers that may well blow up, and there is still
a lot of stuff to worry about, from commercial real
estate to wars, geopolitics, and elections as I just mentioned.
So I'm sensing kind of a bit of complacency in credit,
(01:50):
given how tight spreads have become. There's an eerie sense
of calm, and it's very hard to find anyone who's
really bearish at the moment. But what's your take, Jeremy,
A lot of guests on this show telling it's the
Year of the Bond, a golden age for credit.
Speaker 2 (02:03):
Do you agree? I agree with the Year of the Bond,
and I still like credit generally, but I would say
our view is more nuanced in that we think the
return relative to the risk you're taking for incremental credit
has really come down. So when we're thinking about yields
(02:26):
at these levels, though, I agree that the market has
swung pretty notably from expecting a series of cuts this
year to flirting with the idea that the FED will
be on hold the entire year, to even potentially increasing.
But when we're looking at longer dated yields, I really
think that the level that we're seeing is an excess
(02:47):
of what the Fed's likely to deliver over the intermediate term.
And so when we're allocating, we still want to have
a pro cyclical position within our portfolios, certainly, but I
do think yields in general look a lot better here
at these current levels, and are anticipating that bond returns
as we look forward will be compelling for investors.
Speaker 1 (03:11):
So then, in terms of the Year of the bond,
is that just because the returns will be the best
since on a pre crisis or what's the supposed why
do we think it's the year of the bond?
Speaker 2 (03:21):
Well, I think we've been faced with obviously, twenty twenty
two was a tough year for bonds in general. Twenty
twenty three tens entered the year and exited the year
ten year treasury yields at similar levels, and so that
was a year where you know, we were really trying
to get our coupon and you had some spread compression
(03:41):
coming through. I think when we're looking into twenty twenty four,
there's been a normalization of the growth environment, and I
think what really came through was that twenty twenty three
we saw a much stronger cyclical improvement in the growth.
So GDP ended up coming in roughly a full percentage
(04:03):
point higher than I think most people were anticipating. And
through twenty twenty three we also had three of the
five largest bank failures in the US, we saw mortgage
rates increase again, and we had one of the large
European broker dealers go bust. So I think we've gone
through a period where expectations, certainly on the credit side,
(04:26):
had reset, and so corporate treasurers CFOs and CEOs are
being more prudent with their balance sheet and spreads are
more likely to be in a range trading environment. And
what we're spending a lot of time talking about is
where inflation is going to deliver and how the federal
respond to that, but really how growth is going to
(04:48):
play out as we look out over the next few
years here, and when we're looking at especially corporate balance sheets,
we see them being really strong, exceptionally strong in investment
grade terms. So even though we're not seeing a ton
of spread, we do think there's enough intrinsic spread price
for the risk of default. So from that perspective, I'm
(05:11):
not really too worried about credit, but I don't want
to have a large overweight position and investment grade credit
just because I know spreads can really widen out here
if we hit any potholes in the economy.
Speaker 3 (05:26):
Great. Hey, Jeremy, this is Arnold Kakuta from Bluemberg Intelligence
Credit analysts covering banks. You know, one of the things
that we've been talking about is you know the discount
right that that bank financials have had, you know, versus
the corporate So we we've liked that space. We've we've
seen it kind of grind tighter. So is that something
that you guys also see or is there kind of
(05:49):
a limit to how how this action can continue or not?
Speaker 2 (05:53):
We agree with you, And when we're looking at banks,
I certainly that's one of the areas where we're still
allocating more or of our corporate capital. I would say
relative to history across sectors, we still see US banks
as providing some compelling opportunities. I would say European banks
as well, some of the Yankees. We see profitability improving
(06:16):
there as rates have moved higher and some of their
issuance needs are allowing us attractive opportunities to dellocate a
little bit of capital there. But we're still, you know,
not out of the woods. When we think about commercial
real estate and when we think about deposits in general,
I would say we really need to pull apart the
bank universe into three different parts. The large money center
(06:40):
banks we think have great balance sheets here. If anything,
they're probably getting closer to being able to provide back
a little bit of capital. So probably not the incremental
place where we're adding exposure, but still a place that
we like compared to the other sectors. The regional banks,
really we think you have to do some strong credit
(07:03):
analysis there to understand what the risks are on the
individual bank balance sheets. And then in the smaller regionals,
in the smaller community banks, we think that's an area
where you're going to continue to see pressure, especially from
commercial real estate, but also deposit outflows and then HB.
Speaker 3 (07:21):
So how do you think about sort of you know,
the the I guess, you know, we had liked the financials.
We still do, right, but I guess the thesis coming
in was, Okay, maybe we'll have some rate cuts, you
know that you know, the pressure in terms of these
unrealized losses might come down. But you know, we've continued
to have this higher for longer narrative, right, and you've
(07:42):
talked about some of these issues with the regionals and
and and you know, the the cre exposure and whatnot
concerns there. So you know, is is that a concern
for you that you know, if we do continue in
this higher for longer environment, you know Vick's kind of rising,
you know, we've called it. You know, financial bond spreads
have been strong like bull right, and it's almost like
(08:03):
kind of ignoring, you know, corporate bonds, kind of ignoring
what's going on in other parts of the market. So
are there any concerns for you going forward?
Speaker 2 (08:13):
I don't think there Isn't the money center banks if
we're in a higher for longer environment, I think the
net interest margins there are still fine. And I think
if anything, the little bit of volatility we've been getting
in fixed income markets provides ample opportunities for especially the
broker dealers to be able to monetize some of that
(08:34):
in trading revenues. When we're thinking about the regional banks,
the higher for longer is more of an issue. Those
are areas where there is a higher need to finance
yourself at what are more expensive deposit rates, and I
think you do have more commercial real estate exposure. I
don't worry as much that that's a near term problem.
(08:57):
And in fact, if you look at the FEDS HA data,
which is the weekly data on bank balance sheets, we
can see that commercial real estate is still even growing
this year. It's not growing at the near double digit
rates we've seen over the last several years, but it's
still growing in the three to four percent. So I've
been somewhat surprised that banks haven't been pulling back their
(09:18):
exposure more dramatically there. But as you go through time,
if we're existing at these type of interest rate levels,
it's harder to refinance for a lot of those commercial
real estate deals that may have been underwritten at much
lower interest rates, and those debt service coverage ratios are
(09:39):
getting worse and worse, and you're also starting to see
those LTVs kind of move higher. So when you do
get to the refinancing cycle, you're going to have to
be putting more capital up, and that in general is
going to be a disinflationary trend. So when we're thinking
about the kind of headwinds to inflation going forward, I
(09:59):
do think that's one of the ones that will be
in the background, is that we've got capital that's going
to need to refinance a lot of these assets. You've
got capital that's going to need to help finance the
US government as well, and those are going to allow
inflation to abate a little bit, which then will allow
the FED to kind of remove some of the restrictive
(10:20):
policy that we have in place right now. Got it.
Speaker 3 (10:24):
And then I think we've had a prior guest ry
James that that that had come on and kind of
talked about, you know, and this is what the banks
are saying, you know, potential signs of increasing M and
A right. And then in corporate bond world, we worry
about oh, these big, large, you know, leveraging transactions. But
I think so far, what we've seen is that risk
has been pretty muted, you know, with a lot of
(10:46):
equity financing involved, or you know, kind of the regulatory
risk FTC being really harsh. So is that something that
also kind of comes into play for you Do you
see kind of this M and A risk for for
corporates and you know, how do you think about that?
Speaker 2 (11:02):
Right now, we're not seeing as much M and A risk.
I do think if we start seeing the FED being
able to ease policy rates that is not due to
a major cyclical downturn. So something that looks like a
recession or the unemployment rate moving up by half a
point to a point, that you will see more M
and A transactions coming through. So I think the higher
(11:26):
rates in the current environment has been a barrier for
a lot of deals that maybe people are starting to
look at. And so if you're able to get base
rates down closer to four percent or something even below that,
that you'll probably kick start the M and A cycle again.
Speaker 1 (11:42):
So in terms of the sort of big picture credit Jeremy,
you mentioned very very strong balance sheets at corporations. Fundamentals
sound like this solid, although you mentioned that spreads could widen,
possibly for technical reasons or exogenous shot. How do you position.
More broadly, I mean, if you really believe that this
(12:04):
growth is here to stay, should you not be leaning
into high yield risk buying all the way down to
triple C buying all the stuff that everyone else is
somewhat afraid of given the high for longer environment.
Speaker 2 (12:17):
Yeah, I think it's an excellent question. And for the
portfolios that I manage, we have more of an up
and quality tilt, So we are allocating to double B
high yield names that we think really have investment grade
like balance sheets, are either candidates for upgrades or are
kind of smaller companies that may not have as much
(12:39):
coverage from the rating agencies and so end up with
the double B rating. I tend to be a little
bit more cautious when thinking about the triple C allocations
and really down and credit. I think we have seen
capital allocated and credit at probably more generous terms at
(13:02):
some of the lower quality spectrums. And I think we're
also seeing a different marketplace dynamic, especially in the triple
c's in some of the lower quality bank loan market
as well, where you're getting what people are calling credit
on credit or violence, but starting to see workout deals
(13:22):
and things like that. That aren't something that I feel
I have a strong edge it doing and or something
where you have a little bit of an information asymmetry,
So I'm trying to stay away from there. I think
that is an area where higher rates as well are
likely to erode the balance sheet over time through higher
(13:44):
finance and costs. But I think that's an area where
private credit really is coming in, and I think they
have the ability to invest across the capital stack, to
take positions on management, and so they're probably better placed
for some of the like lowest quality issuers compared to
(14:05):
where I might allocate capital.
Speaker 1 (14:07):
So how do you find your edge then, Jeremy, in
terms of you know, we're talking about the financials that
to me and Donald may have used. It seems like
a very crowded trade at the moment. Everyone talks about
it as a as a good one, but but everyone
wants wants some of that. And then you know, the
the double bes that you just mentioned, they seem to
be quite in favor of the moment. So how do
(14:27):
you kind of differentiate yourself, I mean and give them
such low spreads? You know, and I were talking about
this before the show, why not just buy treasuries that
you know almost five percent, so.
Speaker 2 (14:38):
We're doing some of that. I would say over the
year we have taken down our corporate credit exposure, so
doubleb's and banks are some of the areas where we
still have kind of an overweight relative to the benchmark,
which for most of our accounts is the Bloomberg US aggregate.
We are allocating more of our capital over to structured
(14:59):
and securitized credit, where we are seeing much more attractive
valuation and where we're able to take a differentiated view.
I can look at things like non qualified mortgages, which
are an advent post financial crisis, where these are borrowers
that are unable to get a normal qualified mortgage through
(15:23):
a Fanny and Freddy. A lot of these are investor
owned properties, but high FICHO scores relatively low loaned values.
Those bonds are trading in the eighty five dollars price
range and have a lot of variation from bond to
bond and deal to deal, where we can do rigorous
credit research and really understand what we think are going
(15:47):
to be much quicker prepaced, So those type of bonds
are kind of giving you anywhere around one hundred and
forty to one hundred and seventy spread, but we think
that we're probably going to get paid back a couple
of years sooner than the market is pricing right now,
and that that is going to lead to closer to
high single digit returns.
Speaker 3 (16:09):
Okay, got it, This is Arnold again. Thanks Jeremy the
You just talked about getting into structured credit and stuff.
But you know, we've heard a lot about these increased
regulations for these banks and then the banks looking to
do kind of more of these like synthetic risk transfers
that that some of these private credit players are also
getting into. But is that also something that that you
(16:30):
could get into as well when when these banks are
kind of looking to transfer risk or or maybe you
sell some some loans on their portfolios.
Speaker 2 (16:39):
Yeah, So more of the risk transfers that I've been
looking at are really the ones for liability driven investing.
So this is more coming from the insurance side, where
we're seeing a pretty notable pick up in what we
think makes sense from a de risking perspective. So those
(17:01):
risk transfers are really things that when we're estimating kind
of the corporate pension funding gaps right now, we estimate
for the Russell three thousand at least that in the
beginning of the year, funded ratios were close to ninety
seven percent, and now we're up over one hundred and
(17:22):
two percent, and that's the first time we've really had
that level of surplus since pre financial crisis, and so
we think it makes sense for pension plans specifically to
start de risking. I think that's going to be an
area where it's really helping to keep long corporate spreads
(17:42):
in check, and also a reason for keeping treasury yields
in check too. You noted earlier like should we just
be buying treasuries. We do see treasuries as being on
the cheaper side. You can look at that versus swaps.
You can look at longer dated yield year point of
the curve versus the ten year point of the curve.
(18:03):
So we're seeing more of that come through as risk
transfers that we think makes sense. But the synthetic one,
especially if you're transitioning over to the insurance side, we're
seeing some challenges of that in the court UH, and
so we think it makes more sense for those corporate
(18:26):
pension plans really to be taking money away from the
risk assets and employing them in longer data corporate bonds
and longer dated treasuries. Got it.
Speaker 3 (18:38):
You mentioned ld I, So you know, it harkens me
back to that the UK surprise that we got, you know,
a couple of years ago. But you know, just given
you know, the outlook for you know, both I guess
both presidential candidates. You know, we're going to continue to
have you know, big budget deficits. So do you see
you know, the chance of you know, I guess, you know,
rates long end rates potentially really rising, you know, in
(19:00):
the US potentially.
Speaker 2 (19:03):
I think that's a risk. Certainly, both parties right now
seem very comfortable with deficit spending, uh and it'll likely
need to be the bond market that disciplines that somewhat.
I do think we're a little different than the UK
as far as the LDI problems that they experienced. We
don't have the same pooled collective vehicles that are using
(19:24):
a lot amount of leverage, so that reduces the risk somewhat.
And the US is just a larger and much deeper
market as well. So when we're thinking about the risks
of you know, yields moving in an abrupt point, I'm
not as worried about it. One of the other things
(19:45):
that recently happened, and this is came out with the
Treasury's quarterly refunding announcement at the beginning of the month,
is that they are ready to start doing buybacks. Now,
this is meant only for liquid purposes and will be
in small scale, but I do think that there is
the ability now as they get that program up and running,
(20:09):
to help limit some market volatility should we have some
type of event like the UK experienced. What happened in
the UK resulted in the Bank of England stepping in
to buy, similar to what happened in twenty twenty with
the FED stepping into buy when we had large liquidations
of treasuries into the beginning of the pandemic. And so
(20:31):
even if we're running at higher deficits, I think we
now have a couple of tools to help lessen those
kind of dramatic increases that would have been a risk factor,
you know, pre pandemic and even several quarters ago. Once
the Treasury has their new buyback program up and running.
And again the Treasury has been very pointed that that
(20:55):
is not what that program is used for. But in extremis.
At least you have the plumbing and framework in place
that if you needed to use it you could.
Speaker 1 (21:04):
And I'm going to ask Arnold to explain since he
brought it up, ld I, tell us what does that
mean to the average listener out there, the non specialist.
Speaker 3 (21:13):
I'll let you Dremmy do that. That's as mandate.
Speaker 2 (21:16):
Sorry. So for ld I, it's a liability driven investing
and it's really for pensions in particular, but you can
think about it for the average retiree as well. You're
looking at what your cash flow needs are going to
be over a series of years. If you're a corporate
pension plan, you've got retirees that you're going to pay
(21:39):
out benefits to for the remainder of their life, which
means you're going to have cash flow obligations over that period.
You could have all of your money in kind of
risk assets in the equity market and have a lot
of volatility around that, or you can invest in longer
dated government bonds and corporate bonds that will pay steady
cash flows and then you use the coupon income to
(22:02):
help pay out to the pensioneers as the months go by.
Speaker 3 (22:07):
Hey Trreum is there a like maybe it used to
be I don't know, like six to eight percent, was
that kind of a yield bogie on that, But in
a higher rate environment, does that change at all?
Speaker 2 (22:17):
Or so A couple things have changed. That was certainly
the bogie that they were looking at, kind of like
in the pre financial crisis period. It was also aspirational
as we were coming out of the GFC. I think
plans were really hoping that you would get those type
of returns back. And a couple things have happened. One,
(22:40):
equity returns have been great, and corporates have started adding
more to those pension plans to make sure they get
back up to funded status in part to alleviate PBGC fees.
And so the funded status is in a much better place.
And I think most of those pension funds have reduced
those hurdle rates that they were anticipating and being underweight duration.
(23:04):
So having less of an allocation to bonds and less
of an allocation to specifically longer dated bonds than they
needed has been a winning trade for them over the
last several years. With twenty twenty two, those discount rates
or the rate at which you discount back those future
payments because it's increased so much the value of that
(23:25):
liability has dropped. That's brought those plans into better balance
and is allowing them to reduce some of their allocations
to risk assets and allocate back over to longer duration assets.
And I think that's a large part of why we've
seen long corporate spreads perform so well kind of at
(23:47):
their tights over the last twenty years. We think some
of that performance is really probably run its course, and
we're expecting a little bit more steeping from the corporate curve.
So in kind of account where we're trading across the
full maturity, we're allocating a little bit more into five
to ten year corporates than long corporates. But for the
(24:07):
accounts that we manage against the long corporate benchmark or
the long of credit, we're still making sure that we
have that overweight income profile because I think that that's
still a positive technical that's really impacting that market. And
you're also seeing less supply, especially on the corporate side,
(24:27):
coming through because of higher rates. So you've got, you know,
kind of a good demand story and a beneficial supply
story for the long end, and then you had mentioned
before the pension de risking, So just to be clear
on that, is that where you for I guess, more
of the layman, you know, where pensions had previously or
(24:50):
are currently you know, allocated to some let's say equities,
they have a chance now now that yields are high,
you can take some of that risk off and reinvest
in higher really tries or long daty corporate bonds. Is
that kind of what you're talking about exactly? And for
those plans that actually reduces the risk for them. So
that's getting closer to an immunized position they would call it.
Speaker 1 (25:13):
Are there any other sectors you particularly like at the
moment that you are are buying into.
Speaker 2 (25:18):
I guess one of the areas that we've been adding
some risk long corporate side is in some of the
electric utilities. They're being forced to issue or are less
rate interest rate sensitive than some of the other sectors,
so are increasing their issuance in thirty year bonds. So
that's kind of a sector where we like to make
(25:39):
sure we're continuing to allocate capital too. And then consumer finance,
I guess is one of the other areas where we're
seeing some opportunities. We do still think that the US
consumer is in really good shape. When we're dissecting the
US kind of population in general, we are seeing some
(25:59):
stress come forward at the lower income cohorts, middle income cohorts,
and upper earners are still looking very very strong, healthy
balance sheets, a lot of equity that's been built up
in their homes. And when we're looking at some of
the recent proposals like from Freddie Mack, looking at creating
(26:19):
ways for more homeowners to tap into home equity, we
think that could be the next leg of consumption. As
we look out over the next couple of years, in general,
we're seeing excess savings be pulled down, so the consumer
is probably running out of space there and it's going
to have to start relying more on actual spending or
(26:43):
actual income to drive their spending.
Speaker 1 (26:46):
That's interesting. So our last guest from TCW was very
worried about the US consumer and thought that was the
big vulnerability that you know, the actual levels of unemployment
aren't visible, that all of this buy now, pay later
stuff and all of this debtedness on the consumer balance
sheet was it was then it was going to end up,
you know, potentially bringing markets down. Ultimately, you seem to
(27:08):
have a different view, which is which is also interesting.
So the data must be telling us two different things.
Speaker 2 (27:15):
I think the way we square that circle is that
the buy now, pay later data is not showing up
on credit reports and things like that. So there is
an kind of an area where credit has been lent
and it's new and when that happens. Usually we have
some areas where you know, the credit box was open
(27:35):
too much and maybe some imprudent lending happened. I think
for the large part that again comes back to the
lower income cohorts where we are seeing some signs of stress,
I would say when we're thinking about the labor market
in general. So one of the things that really led
to dramatic outperformance of the economy. We think last year
(27:55):
one government spending, but two were also seeing a lot
more and immigration. So the CBO or the Congressional Budget
Office just updated their statistics on what they think twenty
twenty three immigration was. They think it was roughly three
point three million new immigrants and are expecting another two
point six million this year. When you have that surge
(28:19):
of population coming into the labor market, what we're seeing
is the unemployment rate. If they just entered the labor marketing,
didn't have a job, and not all of those immigrants
are going to have work permits and things like that, obviously,
but they are a pool of potential workers. You could
see the unemployment rate moving much higher. Instead, we're seeing
(28:40):
more employment coming through and this showed up as an
improvement in the supply side of the economy, so we
ended up with more growth in twenty twenty three. The
unemployment rate stayed similar to levels that we saw in
the middle of the year post the regional banking crisis,
and yet inflation was able to decelerate by essentially a
(29:05):
full percentage point in core pce terms, more than the
FED had been anticipated in June. So we ended the
year closer to two point nine percent for core PCEE
after them anticipating three point nine percent with better growth.
And how does that make sense, Well, it means that
you had an improvement in the supply side of the economy.
(29:25):
I think a large part of that had to do
with the influx of labor, and that's meant that you
do continue to have more people working, you have more
productive labor, and I think from the US consumer perspective,
that's why we're still seeing overall payroll income running between
five and six percent. Historically that would have been a
(29:47):
very strong labor market. So I do think the unemployment
rate might move a little bit higher as we look
through this year. And that's part of the reason that
the Fed's task is becoming more difficult because they're going
to have to balance more the labor market trade off
with kind of that last mile of getting inflation down.
Speaker 3 (30:08):
And so it sounds like you're in the camp of
you know, the FED can manufacture the soft landing. But
if I can ask, like, what do you think are
the biggest risks out there? I mean, if maybe you
know what keeps you up at night, is it is
it a stagflation you know, potential environment where inflation remains
high but then growth slows or what what are some
(30:29):
of these things that that might you know, that that
concern you.
Speaker 2 (30:33):
Yeah, I liked the way Powell answered this in his
press conference. I don't see the stag or the flation.
I think that's generally right. It's it's a risk that
we're worried about, like should we go into an environment
where we are seeing much weaker growth and much higher inflation?
But right now inflation is relatively contained compared to what
(30:55):
we saw in the seventies and early eighties, and the
unemployment rate is still very very low by almost all
historical standards. So against that backdrop, it doesn't seem like
a stagflationary environment. That is a toxic mix for policy
makers though, So when we're thinking about tail risks, yeah,
(31:16):
that if we have an exogenous shock that really impacts inflation. Again,
like when Russia invaded Ukraine and we saw energy prices spike,
we saw food prices spike, all of those feed into
a de anchoring of inflation expectations by consumers and by
the general population. I think that's one of those big worries.
(31:38):
I also worry about anything that disrupts the US dollars
safe haven status. That could be something that's geopolitical in nature,
or it could be something that is natural disaster related
outside of the US that causes safe haven flows or
(32:00):
kind of individuals to repatriate to home country biases. Given
we have been the recipient of so much kind of
foreign money over the years.
Speaker 1 (32:11):
And when you look at credits spelifically, I mean all
of the money that's flowing in and it just seems
to be, you know, relentless, and then you know, in
terms of the net supply, it's not that big. It
seems on a growth space there is a lot of supply,
but you drill down it's mostly REFI. So there is
this huge demand supply imbalance which is just growing. When
you ask most investors about it, they cically about spreads.
(32:35):
They say, well, the yields are just so high we
can't resist. You know, you've been in the market for
quite some time. You've seen situations where there is a
more demand than supply. And I'm thinking also about private
credit here. It doesn't always end well. Are you worried
about froth and potential accidents in the market.
Speaker 2 (32:55):
I think that's something that is an ever present danger always.
I would say right now, I think we had a
shock in twenty twenty two, in early twenty twenty three.
I think that reset expectations. So if we think about
twenty twenty two, with how much global central banks increased
(33:15):
policy rates, you know, we reset the IPO machine, We
broke spacks crypto, you uncovered several frauds like things that
would typically happen in a recession. We just didn't have
a labor market recession, and so as we're looking forward,
I'm anticipating more of a range trading environment for corporate
spreads and for risk gussets in general. And I think
(33:39):
that's an outcome that is more consistent with probably the
two thousand and four to two thousand and six period
where you get to, you know, the FED being on hold.
It's not clear where big excesses are. Of course that
cyclo is in housing, and then also in what was
(34:00):
happening in shadow banking this time around. Could it be
on the lower end consumer side, if there was a
lot more by now pay later lending, Could it be
in private credit markets? You know, there's a lot of
areas where we don't have a ton of transparency and
leverage has probably increased. But right now I'm not seeing
(34:24):
signs that, you know, a stop is imminent.
Speaker 3 (34:28):
And so what are some of these things that you're
kind of tracking in the background that that kind of
gives you confidence that, hey, you know, maybe there is
still potential for a rate cut at the end of
this year or kind of going forward.
Speaker 2 (34:42):
Well, a lot of it has to do with where
real policy rates are. So over time, the FED tends
to be thinking about setting policy based on real policy
rates or the phenomenal policy rate deflated by the either
inflation we're expecting to get over the near term or
the most recent inflation that's been delivered, and as inflation
(35:04):
has decelerated, that's actually making policy rates a little bit
more restrictive. So if they keep policy rates in the
five and qure to five and a half range as
we go through the year, and inflation does decelerate down
in core PC terms closer to something like two and
a half, all of a sudden, you're going to have
(35:26):
a real policy rate that's closer to three percent, which
historically would be very restrictive for the US and would
likely lead to a more pronounced slowing in the labor market.
We're already seeing that slowing come through in the labor market.
We can look at the most recent view payroll prints,
but we can also look at some of the labor
(35:46):
market reads, whether it's from the NFIV Small business surveys
or from like the isms, you'll see the employment expectations
are beginning to come down. We're even seeing that in
some of the consumer confidence surveys, where there's a little
bit more worry about personal finances and job prospects as
(36:06):
you look forward, So those can be good leads to
where we think inflation is also going to come out.
But when we're doing kind of the bottom up analysis
within CPI and things like that, I think shelter still
has room for deceleration. We can look at some of
the high frequency data that we get from things like Zillow,
(36:28):
which would suggest that we should be anticipating more downside surprise.
I think as we look at things like vacancy rates,
as we look at the potential for oncoming multifamily units,
as we look out over the next eighteen months, there's
a lot of supply that's going to come on that'll
likely also take some of the sting out of rents.
(36:50):
So I'm anticipating that that'll show up in owners equivalent
rent the large shelter component within CPI. But the area
that we are a little bit more concerned about is
the service sector outside of shelter, and that ends up
being driven more by wages, and wages have proved to
be a little bit stickier now. We're continuing to see
(37:14):
moderation in things like average hourly earnings. When we look
at the Atlanta Fed measure, and we can look at
indeed postings and things like that. They're all suggesting that
wages are probably going to come down into the three
to four percent range after being in the high single digits.
That's much closer to normal. But I think as we
go through we did have a change come out of
(37:36):
the pandemic. We adopted remote work policies in a much
more rapid fashion than we would have adopted them, and
that's causing a lot of sectors where you need to
have people be present on site five days a week
to have to pay more and more in wages. You
can think about education, you can think about healthcare fatality,
(38:01):
and over time we're seeing those wages pressures kind of
build in those sectors. And I think that's an area
where we're seeing more stickiness come through and kind of
that core service inflation. So that's what we're watching. But
as the labor market softens, I think some of that
wage pressure is going to come out as well.
Speaker 1 (38:22):
So to wrap it up, Jeremy, in this year of
the bond, what's the best opportunity? Where is the best
relative value right now?
Speaker 2 (38:29):
For us? We're really seeing it in some of the
structured markets that's where we've probably allocated more of our
capital decent bet in US consumer and US residential housing.
We still think there's a large kind of undersupply for
especially single family homes in the US, and so over
(38:50):
time we're anticipating that that's going to be one of
the better performing sectors.
Speaker 1 (38:55):
So the specificity and stretched its non agency mortgages, is
that right.
Speaker 2 (38:59):
That's where we have we have a large amount of
our position.
Speaker 1 (39:02):
Yeah, yep, okay, brilliant, great stuff. Jeremy Forster with Wellington Management,
it's been a pleasure having you on the Credit Edge.
Speaker 2 (39:09):
Many thanks, thank you, it's been a pleasure.
Speaker 1 (39:12):
And to Arnold Kakuda with Bloomberg Intelligence, thank you so
much for being on the show.
Speaker 3 (39:16):
Absolutely pleasure is mine.
Speaker 1 (39:17):
Check out all of Arnold's excellent analysis on the Bloomberg Terminal.
It's really great and everyone should be paying attention to
the banks right now. And please do subscribe wherever you
get your podcasts. We're on Apple, Spotify and all other
good podcast providers, including the Bloomberg Terminal. Give me a review,
tell your friends, or email me directly at jcromb eight
at Bloomberg dot net. I'm James Cromby, it's been a
(39:38):
pleasure having you join us again next week on the
Credit edge.
Hello, and welcome to the Credit Edge, a weekly markets podcast.
My name is James Crumbie. I'm a senior editor at Bloomberg.
This week, we're very pleased to welcome Jeremy Forster, portfolio
manager at Wellington Management. How are you, Jeremy.
Speaker 2 (00:29):
I'm doing well today, James. Thank you for having me on.
Speaker 1 (00:32):
Thank you so much for joining us. We're very excited
to dig into your market views and the outlook. Also
delighted to welcome back Arnold Kakuda with Bloomberg Intelligence. Great
to see you again, Arnold.
Speaker 3 (00:41):
Oh yeah, happy to be here.
Speaker 1 (00:43):
So just to set the scene a little bit here,
credit markets are rallying and debt'spreads remain tight. Investors aren't
getting very much compensation for the risk of default or downgrade.
The mood is pretty uniformly bullish, especially on US assets,
and most people are very excited about private markets. The
money really is flowing into that. Even real estate seems
to be coming back into favor, with buyers seeing value
(01:05):
and sellers getting more realistic on the valuations. Issuers, meanwhile,
are piling in. There's a record amount of bond and
loan sales as companies take advantage of the window to
raise debt, front loading it to avoid election volatility coming
later in the year. Potentially, they're accepting the fact that
the FED isn't cutting rates anytime soon, and increasingly borrowing
at longer tenures. The Ball case, though, seems to be
(01:28):
founded on a belief that the US economy will avoid recession,
earnings will remain solid, most companies can handle the higher
borrowing costs, although there's a cohort of very low quality
issuers that may well blow up, and there is still
a lot of stuff to worry about, from commercial real
estate to wars, geopolitics, and elections as I just mentioned.
So I'm sensing kind of a bit of complacency in credit,
(01:50):
given how tight spreads have become. There's an eerie sense
of calm, and it's very hard to find anyone who's
really bearish at the moment. But what's your take, Jeremy,
A lot of guests on this show telling it's the
Year of the Bond, a golden age for credit.
Speaker 2 (02:03):
Do you agree? I agree with the Year of the Bond,
and I still like credit generally, but I would say
our view is more nuanced in that we think the
return relative to the risk you're taking for incremental credit
has really come down. So when we're thinking about yields
(02:26):
at these levels, though, I agree that the market has
swung pretty notably from expecting a series of cuts this
year to flirting with the idea that the FED will
be on hold the entire year, to even potentially increasing.
But when we're looking at longer dated yields, I really
think that the level that we're seeing is an excess
(02:47):
of what the Fed's likely to deliver over the intermediate term.
And so when we're allocating, we still want to have
a pro cyclical position within our portfolios, certainly, but I
do think yields in general look a lot better here
at these current levels, and are anticipating that bond returns
as we look forward will be compelling for investors.
Speaker 1 (03:11):
So then, in terms of the Year of the bond,
is that just because the returns will be the best
since on a pre crisis or what's the supposed why
do we think it's the year of the bond?
Speaker 2 (03:21):
Well, I think we've been faced with obviously, twenty twenty
two was a tough year for bonds in general. Twenty
twenty three tens entered the year and exited the year
ten year treasury yields at similar levels, and so that
was a year where you know, we were really trying
to get our coupon and you had some spread compression
(03:41):
coming through. I think when we're looking into twenty twenty four,
there's been a normalization of the growth environment, and I
think what really came through was that twenty twenty three
we saw a much stronger cyclical improvement in the growth.
So GDP ended up coming in roughly a full percentage
(04:03):
point higher than I think most people were anticipating. And
through twenty twenty three we also had three of the
five largest bank failures in the US, we saw mortgage
rates increase again, and we had one of the large
European broker dealers go bust. So I think we've gone
through a period where expectations, certainly on the credit side,
(04:26):
had reset, and so corporate treasurers CFOs and CEOs are
being more prudent with their balance sheet and spreads are
more likely to be in a range trading environment. And
what we're spending a lot of time talking about is
where inflation is going to deliver and how the federal
respond to that, but really how growth is going to
(04:48):
play out as we look out over the next few
years here, and when we're looking at especially corporate balance sheets,
we see them being really strong, exceptionally strong in investment
grade terms. So even though we're not seeing a ton
of spread, we do think there's enough intrinsic spread price
for the risk of default. So from that perspective, I'm
(05:11):
not really too worried about credit, but I don't want
to have a large overweight position and investment grade credit
just because I know spreads can really widen out here
if we hit any potholes in the economy.
Speaker 3 (05:26):
Great. Hey, Jeremy, this is Arnold Kakuta from Bluemberg Intelligence
Credit analysts covering banks. You know, one of the things
that we've been talking about is you know the discount
right that that bank financials have had, you know, versus
the corporate So we we've liked that space. We've we've
seen it kind of grind tighter. So is that something
that you guys also see or is there kind of
(05:49):
a limit to how how this action can continue or not?
Speaker 2 (05:53):
We agree with you, And when we're looking at banks,
I certainly that's one of the areas where we're still
allocating more or of our corporate capital. I would say
relative to history across sectors, we still see US banks
as providing some compelling opportunities. I would say European banks
as well, some of the Yankees. We see profitability improving
(06:16):
there as rates have moved higher and some of their
issuance needs are allowing us attractive opportunities to dellocate a
little bit of capital there. But we're still, you know,
not out of the woods. When we think about commercial
real estate and when we think about deposits in general,
I would say we really need to pull apart the
bank universe into three different parts. The large money center
(06:40):
banks we think have great balance sheets here. If anything,
they're probably getting closer to being able to provide back
a little bit of capital. So probably not the incremental
place where we're adding exposure, but still a place that
we like compared to the other sectors. The regional banks,
really we think you have to do some strong credit
(07:03):
analysis there to understand what the risks are on the
individual bank balance sheets. And then in the smaller regionals,
in the smaller community banks, we think that's an area
where you're going to continue to see pressure, especially from
commercial real estate, but also deposit outflows and then HB.
Speaker 3 (07:21):
So how do you think about sort of you know,
the the I guess, you know, we had liked the financials.
We still do, right, but I guess the thesis coming
in was, Okay, maybe we'll have some rate cuts, you
know that you know, the pressure in terms of these
unrealized losses might come down. But you know, we've continued
to have this higher for longer narrative, right, and you've
(07:42):
talked about some of these issues with the regionals and
and and you know, the the cre exposure and whatnot
concerns there. So you know, is is that a concern
for you that you know, if we do continue in
this higher for longer environment, you know Vick's kind of rising,
you know, we've called it. You know, financial bond spreads
have been strong like bull right, and it's almost like
(08:03):
kind of ignoring, you know, corporate bonds, kind of ignoring
what's going on in other parts of the market. So
are there any concerns for you going forward?
Speaker 2 (08:13):
I don't think there Isn't the money center banks if
we're in a higher for longer environment, I think the
net interest margins there are still fine. And I think
if anything, the little bit of volatility we've been getting
in fixed income markets provides ample opportunities for especially the
broker dealers to be able to monetize some of that
(08:34):
in trading revenues. When we're thinking about the regional banks,
the higher for longer is more of an issue. Those
are areas where there is a higher need to finance
yourself at what are more expensive deposit rates, and I
think you do have more commercial real estate exposure. I
don't worry as much that that's a near term problem.
(08:57):
And in fact, if you look at the FEDS HA data,
which is the weekly data on bank balance sheets, we
can see that commercial real estate is still even growing
this year. It's not growing at the near double digit
rates we've seen over the last several years, but it's
still growing in the three to four percent. So I've
been somewhat surprised that banks haven't been pulling back their
(09:18):
exposure more dramatically there. But as you go through time,
if we're existing at these type of interest rate levels,
it's harder to refinance for a lot of those commercial
real estate deals that may have been underwritten at much
lower interest rates, and those debt service coverage ratios are
(09:39):
getting worse and worse, and you're also starting to see
those LTVs kind of move higher. So when you do
get to the refinancing cycle, you're going to have to
be putting more capital up, and that in general is
going to be a disinflationary trend. So when we're thinking
about the kind of headwinds to inflation going forward, I
(09:59):
do think that's one of the ones that will be
in the background, is that we've got capital that's going
to need to refinance a lot of these assets. You've
got capital that's going to need to help finance the
US government as well, and those are going to allow
inflation to abate a little bit, which then will allow
the FED to kind of remove some of the restrictive
(10:20):
policy that we have in place right now. Got it.
Speaker 3 (10:24):
And then I think we've had a prior guest ry
James that that that had come on and kind of
talked about, you know, and this is what the banks
are saying, you know, potential signs of increasing M and
A right. And then in corporate bond world, we worry
about oh, these big, large, you know, leveraging transactions. But
I think so far, what we've seen is that risk
has been pretty muted, you know, with a lot of
(10:46):
equity financing involved, or you know, kind of the regulatory
risk FTC being really harsh. So is that something that
also kind of comes into play for you Do you
see kind of this M and A risk for for
corporates and you know, how do you think about that?
Speaker 2 (11:02):
Right now, we're not seeing as much M and A risk.
I do think if we start seeing the FED being
able to ease policy rates that is not due to
a major cyclical downturn. So something that looks like a
recession or the unemployment rate moving up by half a
point to a point, that you will see more M
and A transactions coming through. So I think the higher
(11:26):
rates in the current environment has been a barrier for
a lot of deals that maybe people are starting to
look at. And so if you're able to get base
rates down closer to four percent or something even below that,
that you'll probably kick start the M and A cycle again.
Speaker 1 (11:42):
So in terms of the sort of big picture credit Jeremy,
you mentioned very very strong balance sheets at corporations. Fundamentals
sound like this solid, although you mentioned that spreads could widen,
possibly for technical reasons or exogenous shot. How do you position.
More broadly, I mean, if you really believe that this
(12:04):
growth is here to stay, should you not be leaning
into high yield risk buying all the way down to
triple C buying all the stuff that everyone else is
somewhat afraid of given the high for longer environment.
Speaker 2 (12:17):
Yeah, I think it's an excellent question. And for the
portfolios that I manage, we have more of an up
and quality tilt, So we are allocating to double B
high yield names that we think really have investment grade
like balance sheets, are either candidates for upgrades or are
kind of smaller companies that may not have as much
(12:39):
coverage from the rating agencies and so end up with
the double B rating. I tend to be a little
bit more cautious when thinking about the triple C allocations
and really down and credit. I think we have seen
capital allocated and credit at probably more generous terms at
(13:02):
some of the lower quality spectrums. And I think we're
also seeing a different marketplace dynamic, especially in the triple
c's in some of the lower quality bank loan market
as well, where you're getting what people are calling credit
on credit or violence, but starting to see workout deals
(13:22):
and things like that. That aren't something that I feel
I have a strong edge it doing and or something
where you have a little bit of an information asymmetry,
So I'm trying to stay away from there. I think
that is an area where higher rates as well are
likely to erode the balance sheet over time through higher
(13:44):
finance and costs. But I think that's an area where
private credit really is coming in, and I think they
have the ability to invest across the capital stack, to
take positions on management, and so they're probably better placed
for some of the like lowest quality issuers compared to
(14:05):
where I might allocate capital.
Speaker 1 (14:07):
So how do you find your edge then, Jeremy, in
terms of you know, we're talking about the financials that
to me and Donald may have used. It seems like
a very crowded trade at the moment. Everyone talks about
it as a as a good one, but but everyone
wants wants some of that. And then you know, the
the double bes that you just mentioned, they seem to
be quite in favor of the moment. So how do
(14:27):
you kind of differentiate yourself, I mean and give them
such low spreads? You know, and I were talking about
this before the show, why not just buy treasuries that
you know almost five percent, so.
Speaker 2 (14:38):
We're doing some of that. I would say over the
year we have taken down our corporate credit exposure, so
doubleb's and banks are some of the areas where we
still have kind of an overweight relative to the benchmark,
which for most of our accounts is the Bloomberg US aggregate.
We are allocating more of our capital over to structured
(14:59):
and securitized credit, where we are seeing much more attractive
valuation and where we're able to take a differentiated view.
I can look at things like non qualified mortgages, which
are an advent post financial crisis, where these are borrowers
that are unable to get a normal qualified mortgage through
(15:23):
a Fanny and Freddy. A lot of these are investor
owned properties, but high FICHO scores relatively low loaned values.
Those bonds are trading in the eighty five dollars price
range and have a lot of variation from bond to
bond and deal to deal, where we can do rigorous
credit research and really understand what we think are going
(15:47):
to be much quicker prepaced, So those type of bonds
are kind of giving you anywhere around one hundred and
forty to one hundred and seventy spread, but we think
that we're probably going to get paid back a couple
of years sooner than the market is pricing right now,
and that that is going to lead to closer to
high single digit returns.
Speaker 3 (16:09):
Okay, got it, This is Arnold again. Thanks Jeremy the
You just talked about getting into structured credit and stuff.
But you know, we've heard a lot about these increased
regulations for these banks and then the banks looking to
do kind of more of these like synthetic risk transfers
that that some of these private credit players are also
getting into. But is that also something that that you
(16:30):
could get into as well when when these banks are
kind of looking to transfer risk or or maybe you
sell some some loans on their portfolios.
Speaker 2 (16:39):
Yeah, So more of the risk transfers that I've been
looking at are really the ones for liability driven investing.
So this is more coming from the insurance side, where
we're seeing a pretty notable pick up in what we
think makes sense from a de risking perspective. So those
(17:01):
risk transfers are really things that when we're estimating kind
of the corporate pension funding gaps right now, we estimate
for the Russell three thousand at least that in the
beginning of the year, funded ratios were close to ninety
seven percent, and now we're up over one hundred and
(17:22):
two percent, and that's the first time we've really had
that level of surplus since pre financial crisis, and so
we think it makes sense for pension plans specifically to
start de risking. I think that's going to be an
area where it's really helping to keep long corporate spreads
(17:42):
in check, and also a reason for keeping treasury yields
in check too. You noted earlier like should we just
be buying treasuries. We do see treasuries as being on
the cheaper side. You can look at that versus swaps.
You can look at longer dated yield year point of
the curve versus the ten year point of the curve.
(18:03):
So we're seeing more of that come through as risk
transfers that we think makes sense. But the synthetic one,
especially if you're transitioning over to the insurance side, we're
seeing some challenges of that in the court UH, and
so we think it makes more sense for those corporate
(18:26):
pension plans really to be taking money away from the
risk assets and employing them in longer data corporate bonds
and longer dated treasuries. Got it.
Speaker 3 (18:38):
You mentioned ld I, So you know, it harkens me
back to that the UK surprise that we got, you know,
a couple of years ago. But you know, just given
you know, the outlook for you know, both I guess
both presidential candidates. You know, we're going to continue to
have you know, big budget deficits. So do you see
you know, the chance of you know, I guess, you know,
rates long end rates potentially really rising, you know, in
(19:00):
the US potentially.
Speaker 2 (19:03):
I think that's a risk. Certainly, both parties right now
seem very comfortable with deficit spending, uh and it'll likely
need to be the bond market that disciplines that somewhat.
I do think we're a little different than the UK
as far as the LDI problems that they experienced. We
don't have the same pooled collective vehicles that are using
(19:24):
a lot amount of leverage, so that reduces the risk somewhat.
And the US is just a larger and much deeper
market as well. So when we're thinking about the risks
of you know, yields moving in an abrupt point, I'm
not as worried about it. One of the other things
(19:45):
that recently happened, and this is came out with the
Treasury's quarterly refunding announcement at the beginning of the month,
is that they are ready to start doing buybacks. Now,
this is meant only for liquid purposes and will be
in small scale, but I do think that there is
the ability now as they get that program up and running,
(20:09):
to help limit some market volatility should we have some
type of event like the UK experienced. What happened in
the UK resulted in the Bank of England stepping in
to buy, similar to what happened in twenty twenty with
the FED stepping into buy when we had large liquidations
of treasuries into the beginning of the pandemic. And so
(20:31):
even if we're running at higher deficits, I think we
now have a couple of tools to help lessen those
kind of dramatic increases that would have been a risk factor,
you know, pre pandemic and even several quarters ago. Once
the Treasury has their new buyback program up and running.
And again the Treasury has been very pointed that that
(20:55):
is not what that program is used for. But in extremis.
At least you have the plumbing and framework in place
that if you needed to use it you could.
Speaker 1 (21:04):
And I'm going to ask Arnold to explain since he
brought it up, ld I, tell us what does that
mean to the average listener out there, the non specialist.
Speaker 3 (21:13):
I'll let you Dremmy do that. That's as mandate.
Speaker 2 (21:16):
Sorry. So for ld I, it's a liability driven investing
and it's really for pensions in particular, but you can
think about it for the average retiree as well. You're
looking at what your cash flow needs are going to
be over a series of years. If you're a corporate
pension plan, you've got retirees that you're going to pay
(21:39):
out benefits to for the remainder of their life, which
means you're going to have cash flow obligations over that period.
You could have all of your money in kind of
risk assets in the equity market and have a lot
of volatility around that, or you can invest in longer
dated government bonds and corporate bonds that will pay steady
cash flows and then you use the coupon income to
(22:02):
help pay out to the pensioneers as the months go by.
Speaker 3 (22:07):
Hey Trreum is there a like maybe it used to
be I don't know, like six to eight percent, was
that kind of a yield bogie on that, But in
a higher rate environment, does that change at all?
Speaker 2 (22:17):
Or so A couple things have changed. That was certainly
the bogie that they were looking at, kind of like
in the pre financial crisis period. It was also aspirational
as we were coming out of the GFC. I think
plans were really hoping that you would get those type
of returns back. And a couple things have happened. One,
(22:40):
equity returns have been great, and corporates have started adding
more to those pension plans to make sure they get
back up to funded status in part to alleviate PBGC fees.
And so the funded status is in a much better place.
And I think most of those pension funds have reduced
those hurdle rates that they were anticipating and being underweight duration.
(23:04):
So having less of an allocation to bonds and less
of an allocation to specifically longer dated bonds than they
needed has been a winning trade for them over the
last several years. With twenty twenty two, those discount rates
or the rate at which you discount back those future
payments because it's increased so much the value of that
(23:25):
liability has dropped. That's brought those plans into better balance
and is allowing them to reduce some of their allocations
to risk assets and allocate back over to longer duration assets.
And I think that's a large part of why we've
seen long corporate spreads perform so well kind of at
(23:47):
their tights over the last twenty years. We think some
of that performance is really probably run its course, and
we're expecting a little bit more steeping from the corporate curve.
So in kind of account where we're trading across the
full maturity, we're allocating a little bit more into five
to ten year corporates than long corporates. But for the
(24:07):
accounts that we manage against the long corporate benchmark or
the long of credit, we're still making sure that we
have that overweight income profile because I think that that's
still a positive technical that's really impacting that market. And
you're also seeing less supply, especially on the corporate side,
(24:27):
coming through because of higher rates. So you've got, you know,
kind of a good demand story and a beneficial supply
story for the long end, and then you had mentioned
before the pension de risking, So just to be clear
on that, is that where you for I guess, more
of the layman, you know, where pensions had previously or
(24:50):
are currently you know, allocated to some let's say equities,
they have a chance now now that yields are high,
you can take some of that risk off and reinvest
in higher really tries or long daty corporate bonds. Is
that kind of what you're talking about exactly? And for
those plans that actually reduces the risk for them. So
that's getting closer to an immunized position they would call it.
Speaker 1 (25:13):
Are there any other sectors you particularly like at the
moment that you are are buying into.
Speaker 2 (25:18):
I guess one of the areas that we've been adding
some risk long corporate side is in some of the
electric utilities. They're being forced to issue or are less
rate interest rate sensitive than some of the other sectors,
so are increasing their issuance in thirty year bonds. So
that's kind of a sector where we like to make
(25:39):
sure we're continuing to allocate capital too. And then consumer finance,
I guess is one of the other areas where we're
seeing some opportunities. We do still think that the US
consumer is in really good shape. When we're dissecting the
US kind of population in general, we are seeing some
(25:59):
stress come forward at the lower income cohorts, middle income cohorts,
and upper earners are still looking very very strong, healthy
balance sheets, a lot of equity that's been built up
in their homes. And when we're looking at some of
the recent proposals like from Freddie Mack, looking at creating
(26:19):
ways for more homeowners to tap into home equity, we
think that could be the next leg of consumption. As
we look out over the next couple of years, in general,
we're seeing excess savings be pulled down, so the consumer
is probably running out of space there and it's going
to have to start relying more on actual spending or
(26:43):
actual income to drive their spending.
Speaker 1 (26:46):
That's interesting. So our last guest from TCW was very
worried about the US consumer and thought that was the
big vulnerability that you know, the actual levels of unemployment
aren't visible, that all of this buy now, pay later
stuff and all of this debtedness on the consumer balance
sheet was it was then it was going to end up,
you know, potentially bringing markets down. Ultimately, you seem to
(27:08):
have a different view, which is which is also interesting.
So the data must be telling us two different things.
Speaker 2 (27:15):
I think the way we square that circle is that
the buy now, pay later data is not showing up
on credit reports and things like that. So there is
an kind of an area where credit has been lent
and it's new and when that happens. Usually we have
some areas where you know, the credit box was open
(27:35):
too much and maybe some imprudent lending happened. I think
for the large part that again comes back to the
lower income cohorts where we are seeing some signs of stress,
I would say when we're thinking about the labor market
in general. So one of the things that really led
to dramatic outperformance of the economy. We think last year
(27:55):
one government spending, but two were also seeing a lot
more and immigration. So the CBO or the Congressional Budget
Office just updated their statistics on what they think twenty
twenty three immigration was. They think it was roughly three
point three million new immigrants and are expecting another two
point six million this year. When you have that surge
(28:19):
of population coming into the labor market, what we're seeing
is the unemployment rate. If they just entered the labor marketing,
didn't have a job, and not all of those immigrants
are going to have work permits and things like that, obviously,
but they are a pool of potential workers. You could
see the unemployment rate moving much higher. Instead, we're seeing
(28:40):
more employment coming through and this showed up as an
improvement in the supply side of the economy, so we
ended up with more growth in twenty twenty three. The
unemployment rate stayed similar to levels that we saw in
the middle of the year post the regional banking crisis,
and yet inflation was able to decelerate by essentially a
(29:05):
full percentage point in core pce terms, more than the
FED had been anticipated in June. So we ended the
year closer to two point nine percent for core PCEE
after them anticipating three point nine percent with better growth.
And how does that make sense, Well, it means that
you had an improvement in the supply side of the economy.
(29:25):
I think a large part of that had to do
with the influx of labor, and that's meant that you
do continue to have more people working, you have more
productive labor, and I think from the US consumer perspective,
that's why we're still seeing overall payroll income running between
five and six percent. Historically that would have been a
(29:47):
very strong labor market. So I do think the unemployment
rate might move a little bit higher as we look
through this year. And that's part of the reason that
the Fed's task is becoming more difficult because they're going
to have to balance more the labor market trade off
with kind of that last mile of getting inflation down.
Speaker 3 (30:08):
And so it sounds like you're in the camp of
you know, the FED can manufacture the soft landing. But
if I can ask, like, what do you think are
the biggest risks out there? I mean, if maybe you
know what keeps you up at night, is it is
it a stagflation you know, potential environment where inflation remains
high but then growth slows or what what are some
(30:29):
of these things that that might you know, that that
concern you.
Speaker 2 (30:33):
Yeah, I liked the way Powell answered this in his
press conference. I don't see the stag or the flation.
I think that's generally right. It's it's a risk that
we're worried about, like should we go into an environment
where we are seeing much weaker growth and much higher inflation?
But right now inflation is relatively contained compared to what
(30:55):
we saw in the seventies and early eighties, and the
unemployment rate is still very very low by almost all
historical standards. So against that backdrop, it doesn't seem like
a stagflationary environment. That is a toxic mix for policy
makers though, So when we're thinking about tail risks, yeah,
(31:16):
that if we have an exogenous shock that really impacts inflation. Again,
like when Russia invaded Ukraine and we saw energy prices spike,
we saw food prices spike, all of those feed into
a de anchoring of inflation expectations by consumers and by
the general population. I think that's one of those big worries.
(31:38):
I also worry about anything that disrupts the US dollars
safe haven status. That could be something that's geopolitical in nature,
or it could be something that is natural disaster related
outside of the US that causes safe haven flows or
(32:00):
kind of individuals to repatriate to home country biases. Given
we have been the recipient of so much kind of
foreign money over the years.
Speaker 1 (32:11):
And when you look at credits spelifically, I mean all
of the money that's flowing in and it just seems
to be, you know, relentless, and then you know, in
terms of the net supply, it's not that big. It
seems on a growth space there is a lot of supply,
but you drill down it's mostly REFI. So there is
this huge demand supply imbalance which is just growing. When
you ask most investors about it, they cically about spreads.
(32:35):
They say, well, the yields are just so high we
can't resist. You know, you've been in the market for
quite some time. You've seen situations where there is a
more demand than supply. And I'm thinking also about private
credit here. It doesn't always end well. Are you worried
about froth and potential accidents in the market.
Speaker 2 (32:55):
I think that's something that is an ever present danger always.
I would say right now, I think we had a
shock in twenty twenty two, in early twenty twenty three.
I think that reset expectations. So if we think about
twenty twenty two, with how much global central banks increased
(33:15):
policy rates, you know, we reset the IPO machine, We
broke spacks crypto, you uncovered several frauds like things that
would typically happen in a recession. We just didn't have
a labor market recession, and so as we're looking forward,
I'm anticipating more of a range trading environment for corporate
spreads and for risk gussets in general. And I think
(33:39):
that's an outcome that is more consistent with probably the
two thousand and four to two thousand and six period
where you get to, you know, the FED being on hold.
It's not clear where big excesses are. Of course that
cyclo is in housing, and then also in what was
(34:00):
happening in shadow banking this time around. Could it be
on the lower end consumer side, if there was a
lot more by now pay later lending, Could it be
in private credit markets? You know, there's a lot of
areas where we don't have a ton of transparency and
leverage has probably increased. But right now I'm not seeing
(34:24):
signs that, you know, a stop is imminent.
Speaker 3 (34:28):
And so what are some of these things that you're
kind of tracking in the background that that kind of
gives you confidence that, hey, you know, maybe there is
still potential for a rate cut at the end of
this year or kind of going forward.
Speaker 2 (34:42):
Well, a lot of it has to do with where
real policy rates are. So over time, the FED tends
to be thinking about setting policy based on real policy
rates or the phenomenal policy rate deflated by the either
inflation we're expecting to get over the near term or
the most recent inflation that's been delivered, and as inflation
(35:04):
has decelerated, that's actually making policy rates a little bit
more restrictive. So if they keep policy rates in the
five and qure to five and a half range as
we go through the year, and inflation does decelerate down
in core PC terms closer to something like two and
a half, all of a sudden, you're going to have
(35:26):
a real policy rate that's closer to three percent, which
historically would be very restrictive for the US and would
likely lead to a more pronounced slowing in the labor market.
We're already seeing that slowing come through in the labor market.
We can look at the most recent view payroll prints,
but we can also look at some of the labor
(35:46):
market reads, whether it's from the NFIV Small business surveys
or from like the isms, you'll see the employment expectations
are beginning to come down. We're even seeing that in
some of the consumer confidence surveys, where there's a little
bit more worry about personal finances and job prospects as
(36:06):
you look forward, So those can be good leads to
where we think inflation is also going to come out.
But when we're doing kind of the bottom up analysis
within CPI and things like that, I think shelter still
has room for deceleration. We can look at some of
the high frequency data that we get from things like Zillow,
(36:28):
which would suggest that we should be anticipating more downside surprise.
I think as we look at things like vacancy rates,
as we look at the potential for oncoming multifamily units,
as we look out over the next eighteen months, there's
a lot of supply that's going to come on that'll
likely also take some of the sting out of rents.
(36:50):
So I'm anticipating that that'll show up in owners equivalent
rent the large shelter component within CPI. But the area
that we are a little bit more concerned about is
the service sector outside of shelter, and that ends up
being driven more by wages, and wages have proved to
be a little bit stickier now. We're continuing to see
(37:14):
moderation in things like average hourly earnings. When we look
at the Atlanta Fed measure, and we can look at
indeed postings and things like that. They're all suggesting that
wages are probably going to come down into the three
to four percent range after being in the high single digits.
That's much closer to normal. But I think as we
go through we did have a change come out of
(37:36):
the pandemic. We adopted remote work policies in a much
more rapid fashion than we would have adopted them, and
that's causing a lot of sectors where you need to
have people be present on site five days a week
to have to pay more and more in wages. You
can think about education, you can think about healthcare fatality,
(38:01):
and over time we're seeing those wages pressures kind of
build in those sectors. And I think that's an area
where we're seeing more stickiness come through and kind of
that core service inflation. So that's what we're watching. But
as the labor market softens, I think some of that
wage pressure is going to come out as well.
Speaker 1 (38:22):
So to wrap it up, Jeremy, in this year of
the bond, what's the best opportunity? Where is the best
relative value right now?
Speaker 2 (38:29):
For us? We're really seeing it in some of the
structured markets that's where we've probably allocated more of our
capital decent bet in US consumer and US residential housing.
We still think there's a large kind of undersupply for
especially single family homes in the US, and so over
(38:50):
time we're anticipating that that's going to be one of
the better performing sectors.
Speaker 1 (38:55):
So the specificity and stretched its non agency mortgages, is
that right.
Speaker 2 (38:59):
That's where we have we have a large amount of
our position.
Speaker 1 (39:02):
Yeah, yep, okay, brilliant, great stuff. Jeremy Forster with Wellington Management,
it's been a pleasure having you on the Credit Edge.
Speaker 2 (39:09):
Many thanks, thank you, it's been a pleasure.
Speaker 1 (39:12):
And to Arnold Kakuda with Bloomberg Intelligence, thank you so
much for being on the show.
Speaker 3 (39:16):
Absolutely pleasure is mine.
Speaker 1 (39:17):
Check out all of Arnold's excellent analysis on the Bloomberg Terminal.
It's really great and everyone should be paying attention to
the banks right now. And please do subscribe wherever you
get your podcasts. We're on Apple, Spotify and all other
good podcast providers, including the Bloomberg Terminal. Give me a review,
tell your friends, or email me directly at jcromb eight
at Bloomberg dot net. I'm James Cromby, it's been a
(39:38):
pleasure having you join us again next week on the
Credit edge.
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