At Zeo, we aim to be risk managers. We tend not to express directional points of view in our portfolios. Our goal is to deliver consistent performance regardless of what happens in the market, and the easiest way to stray from that effort is to start making bets on what will happen in the markets. That said, it is always helpful to have a view as to what may happen. In our experience, most successful risk management efforts start with anticipating, and then aiming to neutralize, scenarios that may happen even if they ultimately don’t. And most unsuccessful risk management efforts end with ignoring risks that could happen simply because they haven’t… yet.
Today, we find ourselves with particularly high confidence in the likelihood of three scenarios to which we believe all investors should be paying close attention. First, we anticipate the current market euphoria will likely last through the summer. Second, the Fed will likely keep interest rates low longer than the market thinks. And third, doing so will result in a yield curve that is as steep or steeper than we’ve seen since the aftermath of the 2008 financial crisis, though this may take a little while to happen.
The first, a continuation of market strength, is probably the most at risk of not being true. However, it is also the simplest and nearest-term projection. We feel it is important for readers to know that we are not natural bulls; in general, risk managers and fundamental investors (both of which we are) always worry more about the sky falling than the sun coming out, and we tend to let that caution creep into how we view market rallies (with skepticism) and market declines (as fundamental reversion).
So, why are we positive right now? Simply speaking, we don’t believe the post-COVID euphoria has fully been priced in. We will be the first to tell you that there are a whole host of risks that could spook the markets lower at a moment’s notice. Regardless, with the economy (slowly) improving, even if we believe fundamentals don’t justify current valuations, earnings are increasingly unlikely to bear that out without a significant hiccup in the financial sector. We will explain later why we don’t think this will happen in the near term, leaving market psychology as the primary driver of any volatility.
It has also been our experience that, as simplistic as this argument is, the mood of Wall Street is largely driven by the mood of traders in New York City. (Perhaps today, we should also consider the mood of Robinhood’s customers also, but that seems to be impervious to company fundamental realities as well, so we don’t see that as a factor to drive markets lower either.) Traders in NYC, taken as a whole, are a simple bunch. They enjoy making money, and they enjoy spending it. They love going to bars in the city and parties in the Hamptons. And they have been deprived of their fun for over a year. To put it simply, their bonuses are burning holes in their pockets.
This summer, with most if not all of these traders vaccinated, with bars and restaurants and Hamptons rentals open for business, and with nice weather conducive to outdoor revelry as is usually the case in the Northeast in June and July, it is virtually impossible for us to imagine a better setting for euphoric moods, which we believe will translate into better outcomes for the markets.
Our second expectation, that the Fed will leave rates lower longer than anticipated, is a point of view that others certainly share. However, even compared to those who agree with us to some extent, we believe the Fed will leave rates lower longer than even their expectations. Why? When we listen closely to Fed Chairman Jay Powell’s comments, we hear that he is not just focused on the Fed’s dual mandate of reasonable inflation and low unemployment. We hear that he is willing to let inflation run a little higher than the Fed has in the past and that he is particularly focused on unemployment among traditionally disenfranchised demographics, primarily that of Black and Hispanic communities.
Nearly a century after Will Rogers coined the term, our society still seems to be “trickle-down” in nature. Unfortunately, any gains are felt first by the wealthy, next by the systemically advantaged and last by those who are traditionally underrepresented. As this pertains to unemployment, this means that when top-line unemployment statistics approach levels most economists believe to be full employment by the Fed’s standards, those jobs will have been distributed disproportionately away from the demographics that the Fed is watching, and we believe they will see that in their more granular datapoints. As a result, the Fed may be likely to keep interest rates lower even longer to see the job creation trickle down to Black and Hispanic communities before declaring that they have met their goal on unemployment, meaning the market will need to wait for an unemployment number much lower than currently anticipated before seeing rates go higher.
Our third viewpoint draws from the second. While the Fed has a very clear lever to control short-term interest rates through monetary policy, their levers to affect the longer end of the interest rate curve are less direct. In the past, they have bought long-term fixed income securities to keep longer rates lower, with the mere presence of the Fed in the capital markets causing speculators to multiply the impact of the Fed’s own actions. They also look to impact inflation through monetary policy (the other half of their dual mandate), and at risk of stating the obvious, inflation is a big input into Wall Street’s long-term interest rate expectations.
With respect to inflation, whether intentionally or not (and we are truly not sure which), the Fed gave themselves cover to allow inflation to run higher and the economy to run hotter than previous Fed regimes through their switch from a 2% inflation target to a 2% average inflation target. Put simply, a 2% target means that history is irrelevant to the goal of 2% inflation. However, a 2% average target means that if inflation has run below 2% in the recent past, the Fed would be ok with allowing it to run higher than 2% for a while to average that out. The Fed has essentially told Wall Street to expect, and set its own policy to allow for, higher inflation and long-term interest rates even as it keeps the short end of the interest rate curve down.
Meanwhile, we believe the market will see the economy as overheating while the Fed continues its unemployment management efforts discussed earlier, which will further exacerbate inflation expectations. With both real rates (from economic growth assumptions) and inflation (from economic overheating predictions) going up, the long end of the rate curve should continue to climb, and it may do so dramatically. With short end rates staying low due to Fed rate-setting policy, such a move would result in a steep upward-sloping yield curve.
The table below shows the US Treasury yield curves for several recent points in time (3m rate shown with other rates relative to the 3m point) to illustrate what could happen:
If 2010 is any indication, a post crisis yield curve can be much steeper than the current one, and even a more normalized economic yield curve (2016) has room for steepening. If our expectations are correct, we are more likely to see the long end of the yield curve higher than not at some point in the coming two to three years, possibly by 2% or more, with intermediate points seeing +1-1.5% potential as well.
Meanwhile, steep yield curves are a positive for bank earnings. Bank business models, when reduced to their most basic form, lend long-term and borrow short-term. The steeper the yield curve is, the more profitable banks are without having to take credit risk. Notably, in “stronger” economies where the rate curve is flatter – 2006 and 2019 in the table above are prime examples – banks tend to take more credit risk to make their profits, which puts the overall markets at risk. Bank trading desks tend to use less balance sheet if they are already exposed to credit risk, with market dislocations starting in exactly the asset class that the banks are most exposed to and have the least capacity to provide liquidity in.
In 2006, that credit exposure was to Main Street, and with that lesson learned, banks tightened retail lending standards. This led to credit profitability in 2019 driven by corporate lending instead. The market crisis in March 2020 was particularly acute precisely because corporate leverage was called into question due to the pandemic and resulting quarantine, with repercussions to Main Street creating a waterfall effect. We believe the Fed is likely ok with a steeper yield curve, as it is a high priority for the Fed after the 2008 financial crisis to see stronger banks, and if credit spreads (and risk spreads in general) are compressed while banks profit more from the rate curve shape than from credit, that is likely an acceptable medium-term state for the Fed. As a result, we don’t see them doing much (though possibly not nothing) to rein in a steep yield curve.
What does this mean for investors? First, we don’t see longer-duration expected total returns as particularly robust. With low rates at risk of going up and a relatively tight credit curve, the yields from longer duration corporate bonds are probably as good as they get, with total return expectations lower than the yields due to the asymmetric probability of higher rates and spreads. Meanwhile, we also don’t see the catalyst for a short-term credit correction, though we don’t dismiss the possibility of market hiccups that can be used as entry points. Longer term, however, the risk of an overheated economy also means that, at some point, the market is setting up for another potential implosion. We just don’t know when.
As a result, we believe it is prudent to focus on individually selected, shorter duration fixed income, while taking advantage of some higher-volatility and/or longer-duration opportunities if an investor feels strongly about a credit. One can accomplish this through a fundamentally focused and selective investment manager or by focusing on only those companies or industries in which she has an expertise that provides a competitive advantage. Investors should be very cautious with loan portfolios, as we are wary of the lesser-known longer-term credit spread exposures that come with the well-known shorter-term interest rate exposures. Many investors miss that such floating-rate strategies tend to only be protected from rate moves but are fully exposed to credit moves. This can be mitigated with a selective focus, and right now, that means shorter-maturity loans, with exceptions made only with high conviction in the underlying credit.
In general, our view is that the best risk to take in the market right now is reinvestment risk. We advocate for keeping exposures relatively short while not being too conservative given the short-term likelihood of continued market strength. Due to the risk every investor takes putting all eggs in one basket, even if one is nervous about today’s markets, we would encourage a cash balance best described as cautious but not tactical. If we see entry points in the coming months, a cautious cash position would provide the dry powder to take advantage of them. If we don’t see entry points, investors would still be well-positioned to capitalize on the “risk” of a continued benign market.
That said, it is worth reiterating that, especially within fixed income allocations, investors who aim to preserve capital with a risk management mindset are not well served to position tactically for the potential outcomes we describe above. We believe they are much better off focusing on company fundamentals and security selection, which we believe to be less prone to the slings and arrows of the markets. In doing so, investors may find that they can worry less about whether they are right and more about whether they are positioned to capitalize on the best risk/rewards in the market, regardless of what happens.
By Venk Reddy
Important Disclosure Information
Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
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