Bond opportunities in a resilient US economy

Listen to the full conversation with Matt here

Key takeaways

A resilient economy

Despite widespread concerns about whether the Federal Reserve could hike rates enough to lower inflation without sparking a recession, the economy has remained resilient.

The Federal Reserve

The Federal Reserve is cutting because it can, not because it has to, with 150 basis points in cuts expected from now through 2025.

Investment grade credit

The supply of investment grade credit is light and the demand is strong, coming domestically from retail and institutional investors, and internationally from Asian and European investors.

Matt Brill recently joined the Greater Possibilities podcast to discuss the resilience of the US economy, his expectations for the Federal Reserve (Fed), and why he’s bullish on investment grade credit. He also discussed opportunities in high yield, emerging markets, commercial real estate, and retail. Here are some of the highlights.

The economy has exceeded expectations

Despite widespread concerns about whether the Fed could hike rates enough to lower inflation without sparking a recession (resulting in the much-anticipated “soft landing”), the economy has remained resilient even as rates have been high. “We did expect a soft landing,” Matt says, “but just the continued notion that there might be no landing at all has been a surprise.”

The economy moves in ebbs and flows, gradually correcting itself over time. While the ebbs never have a definitive or predictable “end,” overall, inflation has been going down. “We’re not looking at 8% to 9% inflation, like we saw back in 2022,” Matt said. “You’re around 2.5% to 3%, which isn’t where the Fed wants it to be, but it’s pretty darn close.” When asked about the Fed’s position on this improvement, Matt says, “Growth is pretty good. The Fed is not in a panic mode at all right now. So, I’d say that you’ve gotten a lot of middle-of-the-fairway, middle-of-the-runway type activity, which is exactly what the Fed wanted.”

Forecasting the Fed for the year ahead

According to Matt’s analysis, “The Fed is cutting [rates] because they can, not because they have to. They can because inflation has come down. They can because there are signs the economy is slowing. But they don’t have to, meaning that they’re not behind the curve and they’re not in this panic mode.”

This by no means is a suggestion that Fed rates are neutral — in other words, at a level that neither stimulates or restricts economic growth. Far from it. Matt says his conservative estimate of the neutral rate is 3.5%, compared to the current target Fed funds rate of 4.75% to 5.00%. So a less restrictive policy will be key to becoming neutral. He has a few ideas as to how that can happen:

“Our expectation is they’ll cut in the November meeting, they’ll cut again in the December meeting — just 25 (basis points¹) though, not the big 50 that they did just last time. So, 25, then 25. And then next year, they will do every other meeting 25 basis points. So that gets you about 150 basis points lower than you are today, which (would be) in the low threes.”

Where are opportunities in bond markets?

Matt notes that the “risk-free rate²“ — generally considered to be the rate on “safe haven³” 10-year US Treasuries — is elevated by the deeper fear of inflation getting out of control as well as budget deficits. How does this impact his view of opportunities in the bond markets? “Corporations are issuing less debt. However, countries are issuing more debt. So the technicals are less positive in the risk-free rate … rather than corporate. So we prefer corporate credit and other asset classes, but we prefer high yield, investment grade as well as emerging market corporate debt over sovereign treasury debt right now. The overall fundamentals are better just because these corporations have done a better job with their balance sheets than the governments.”

Investment grade credit

Spreads (the additional yield compensation you get over Treasuries or risk-free securities), indicate there is not a lot of fear in the market right now, Matt said, and yields on investment grade credit are attractive to savvy investors. The market believes the fundamentals are good and the technicals are strong, with yields on investment grade credit slightly above 5%. Matt explains, “We’ve been seeing kind of a Goldilocks environment for investment credit. The supply is light and the demand is incredibly strong. Demand is coming domestically from institutional investors, and it’s coming internationally from Asian as well as European investors. And then the new entrant to the party is the retail investor.”

High yield bonds

When asked about his view of high yield investments, Matt says he expects high yield to do well when growth is doing well. “High yield doesn’t do well when you enter recession. So, if you can eliminate the tail risk of a recession, which I think the Fed has done, I like high yield.” He also noted that there have been a significant number of upgrades relative to downgrades in high yield so far this year.

Emerging markets (EM)

According to Matt, the expectation that lower US rates would weaken the US dollar and drive investors into EM bonds has been delayed simply due to the resilience of the US economy. If the Fed has to keep rates a bit more elevated or cut at a slower pace because of the resiliency of the economy, that generally leads to a strong dollar, which may not be good for EM local currency, Matt says. However, he also notes that a strong US economy isn’t necessarily bad for EM corporations: “At the end of the day, if the US economy is doing well, you would expect the derivative to be foreign economies doing well also.”

Commercial real estate

With corporations pushing for a return to office, commercial real estate has seen an unexpected resurgence of opportunities, and CMBS (commercial mortgage-backed securities) have done well.

Retail

Last year’s uncertainties never fully materialized in the market. In fact, retail sales continue to thrive. “If [people] have a job, they’re going to spend,” Matt says, “and if you don’t believe the US is going to go into recession, you don’t believe that the job losses are going to be material. And in fact, we’re still generating 150,000 to 200,000 jobs a month. People are going to spend.” With this in mind, Matt believes retail may be an “undervalued area of the market,” ready to be tapped into.

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Footnotes

• a unit of measure used to indicate percentage changes in financial instruments. Basis points are typically expressed with the abbreviations “bp,” “bps,” or “bips.” One basis point is equal to 1/100th of 1%, or 0.01%. In decimal form, one basis point appears as 0.0001 (0.01/100).
• the interest rate an investor can expect to earn on an investment that carries zero risk
• a type of investment that is expected to retain or increase in value during times of market turbulence. Investors seek out safe havens in order to limit their exposure to losses in the event of market downturns.

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Originally Posted November 18, 2024

Podcast: Bond opportunities in a resilient US economy By Invesco US

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