Morningstar - Q1 2024 - 51

Brian Moriarty: There's been a dramatic turnaround
in the fixed-income markets over the last six
weeks or so. Ford, can you lay out what has happened?
Ford O'Neil: At the beginning of 2023, lots
of smart economists were expecting a recession.
We were in a late cycle from a monetary policy
perspective; whether it was an inverted yield curve
or leading economic indicators, or global
short rates, it all made sense. Our work said that
we were more midcycle from a private-sector
perspective. As the year unfolded, you had China
reopening its economy, and you still had significant
fiscal largesse from the U.S. government
spurring on the economy. Additionally, the consumer
remained very, very strong: They had locked
in their mortgage rates at 3%, and they hadn't
expended all their savings, as a lot of people
expected. Lastly, the September SEP [the Federal
Reserve's Summary of Economic Projections]
still expected another hike in December.
Then, sentiment reversed in the middle of
October. Suddenly, there were expectations for
weaker growth in the fourth quarter. You
started seeing green sprouts in the inflation data.
Lo and behold, you started hearing from some
Fed governors that they were taking a more
balanced view-meaning that they were as likely
to hike as they were to lower rates.
That rang the bell, and we got the " everything rally "
in November. The Bloomberg Agg had its
best month since 1985, the first year I was in the
business. The Fed hadn't unfurled the mission
accomplished banner yet, but they clearly started
hinting that the hiking cycle was nearing
a peak, which the market viewed as good news.
Andrew Norelli: It's been a paradigm shift
in fixed income for several reasons. The
primary one is, of course, the Fed tightened
monetary policy dramatically, almost setting a
new precedent for how quickly it could be
done. It's been a complete reset in the amount
of future return and future income that can
be expected from fixed-income markets across
the quality spectrum.
The data that was released in October increases
the probability of a soft landing. When market
practitioners talk about that, commonly
it's a knee-jerk reaction to stock markets being
buoyant, interest-rate markets being well
behaved, and the economic data being not too hot
and not too cold.
But when you define it mathematically, it's
very difficult for the central bank to engineer a soft
landing because we are at or near full employment.
That means the central bank has to balance
four things in perfect harmony in order to
achieve a durable soft landing. First, you need the
unemployment rate to stay stable at NAIRU, the
nonaccelerating inflation rate of unemployment,
neither higher nor lower.
Second, you need growth to stay at our
potential growth rate [the rate of growth that an
economy can sustain at full employment
without generating excess inflation]. Putting
unemployed workers to work adds growth
and doesn't really add inflation pressure. But once
you're at full employment, potential growth acts
like a speed limit on growth.
Then you need the policy rate to be right, the
neutral rate. Right now, we are above the neutral
policy rate. Because inflation-and growth-
are responding to tight monetary conditions, it's
clear that we're in fairly restrictive territory,
and the Fed would acknowledge that.
Finally, you need inflation to be stable at the
inflation target-not above, not below,
and not trending up or down. You need to flatline
at the inflation target of 2%. And most of the
ways that you can look at inflation today would
suggest that we're still a bit above target,
and it's trending downward.
In November, we got very encouraging data from
a soft-landing perspective. Growth slowed
sequentially compared to Q3; it's kind of right at
potential right now, but maybe trending downward.
And we had an encouraging inflation report
toward target and the unemployment rate
not really rising, and in fact, dropping by two
tenths. However, when you look back in history to
1948, when the unemployment rate data starts,
we've never spent longer than about 24 months at
full employment without the unemployment rate
going higher and having a recession.
Moriarty: Jerome, it's possible now to get quite
an attractive yield on the short end of the fixed-income
markets. Have recent market moves done anything
to change that attractiveness?
Jerome Schneider: Investors have been
challenged over the past decade or two to produce
returns in a low-rate environment. Driven by
expectations of low rates for longer, they pressed
on the accelerator of capital appreciation.
That fundamentally changed as we got into 2023.
The second component of total return-
income and yield generation-is now providing
a glide path for investors to reduce risk while
at the same time hoping to obtain historically
attractive total returns. When rates recalibrated,
it elicited a response from a whole generation
of investors who had never even thought
about fixed income primarily. Cash became king
very quickly.
But now begins the discussion of how to create
portfolios that are more diversified to withstand
the intermediate future that we see in 2024.
Perhaps not a hard recession, but something less
than the 5%-plus growth rate we witnessed
in the third quarter of 2023. There's going to be
a natural tendency for people to move out of cash
into duration strategies, which may not necessarily
be at the far end of the curve but at least
gets them out of that money market mindset.
The marketplace right now has begun to expect
that the Federal Reserve will cut rates to buoy risk
markets and the economy as we enter 2024.
At the same time, the expectation is that investors
should move out the curve, add interest-rate
exposure on the fixed-income side, because
there's potential for capital appreciation. That's
a discussion that's beginning to percolate within
the advisor and investor landscape.
Are there better ways to adapt to the
fixed-income market for a landing that may
not be the soft landing that the broader
market expects? We think that there's a better
opportunity slightly beyond that money
market space, leading to structural
outperformance over the secular horizon.
Moriarty: Ford and Andrew, how have higher
short-term yields affected your portfolio construction?
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