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The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Amar Reganti, Investment Director
The first half of 2022 has been marked by heightened turmoil across all global markets, but the bond markets in particular have experienced a rude “wake-up” call delivered by changing US Federal Reserve (Fed) policy and rhetoric, exacerbated by the geopolitical risks associated with the Ukraine/Russia conflict. The upshot: After a long hiatus, volatility has roared back into the interest-rate and credit markets this year.
Accordingly, we believe now may be an opportune time to allocate marginal capital to shoring up your fixed income “flank” – the part of your portfolio that is intended to defend against elevated or potentially accelerating volatility, as well as against the threat of economic recession. (To be clear, we are not yet forecasting a recession in the months ahead, but we do see some concerning signs that asset markets may face continued challenges, at least in the immediate term.)
With the fixed income landscape having shifted in this manner, perhaps your portfolio should as well.
1) Increased market volatility and macro uncertainty. As shown in Figure 1, looking at the “normalized” volatility of the 1-year/10-year portion of the US Treasury yield curve (i.e., a gauge of where the 10-year Treasury yield is likely to be a year from now), market volatility has increased meaningfully over the past several months. In fact, recent volatility levels have surpassed those reached during the throes of the COVID-19 pandemic. In general, the higher this metric, the greater the uncertainty around where the forward 10-year yield will be 12 months from today. Basically, this reflects a lack of market consensus these days as to the future trajectories of both inflation and interest rates.
2) A more hawkish US Fed. US financial conditions have continued to tighten in recent months. In prior years, such tightening might have altered the Fed’s path to less accommodative monetary policy. Not this time, though. The Fed’s latest policy guidance suggests that it will be inclined to “look through” current weakness in financial conditions. And with the market now pricing in more than 200 basis points (bps) of Fed interest-rate hikes over the next 12 months, a great deal of hawkishness is already baked into the forward yield curve. In my view, the Fed will have to outperform those expectations for the market to determine that there will be additional policy-driven rate hikes. While there is room for further upward pressure on rates, the pace of rate increases may slow, particularly if economic data underwhelms.
3) A flattening yield curve. The recent flattening of the US yield curve is worrisome because such a phenomenon has historically often been seen as a reliable indicator of an impending economic recession. Some market participants have characterized the behavior of the yield curve as portending recessionary headwinds for the US economy. Others, citing robust demand conditions and a deleveraged consumer, think “this time is different” (and it very well may be) and do not believe a recession is imminent. For now, it’s a fierce debate that is playing out across the capital markets.
While market participants might notice the flatness of the short end of the Treasury yield curve versus its 10- and 30-year points, astute observers will notice that forward rate curves were already inverted prior to the latest flattening move.
Considering the strong position of the US economy, including the less leveraged state of its consumers (relative to 2007), we think it’s still too early to call a recession. but the market is telling us that if the Fed does execute the currently priced in rate hikes, then we are closer to a time when aggregate demand drops enough that the Fed would need to cut rates. Given today’s more volatile markets, I expect the yield curve to periodically steepen and flatten, but it’s important to note that the initial inversion has already taken place.
4) Flagging consumer sentiment and other indicators. As noted above, US consumers are in better shape overall than they were leading up to the 2008 financial crisis, at least in terms of having amassed greater household savings and being burdened with much lower debt levels. That being said, consumers now face the formidable challenge of having to navigate persistently higher inflation in staple areas such as rising energy and food prices and lofty housing/rent costs. Less debt and more savings notwithstanding, this inflationary trend will eventually begin to weigh on consumers’ disposable incomes and spending, creating a headwind for the US economy.
In addition, housing and industrial capex have already started slowing, with sharply lower new home sales (now approaching 2019 levels) and regional Federal Reserve survey data showing a downward trend in US manufacturing expectations and sentiment. While these moves by themselves do not foreshadow a recession, they do signal slowing economic activity.
1) Look to fixed income strategies that can benefit from rate and currency volatility. These are predominately global rate currency strategies that have flexible mandates, use relative value metrics, and have historically provided a degree of downside protection and capital preservation – features that many investors expect from their fixed income allocations. In addition, we think global macro investing remains an area that may be helpful during periods of heightened and “stickier-than-expected” volatility.
2) Consider adding duration exposure as the year progresses. Barring unforeseen macro or market developments, interest rates may be prone to “range trade” at their current higher levels, potentially allowing for more attractive entry points into some core fixed income investment strategies. In our view, any such portfolio allocations that are designed to add duration exposure should be directed primarily toward traditional, higher-quality fixed income approaches.
3) Add low-volatility credit “carry” strategies to complement strategic credit allocations. Such strategies that I’d expect to fare relatively well in the current environment include certain short-duration and floating-rate approaches, as well as often-overlooked securitized asset exposures. If appropriate, these allocations can be combined with a multi-sector credit strategy with the ability to rotate into dislocated or out-of-favor fixed income sectors.
Tom Simon, CFA, FRM, Portfolio Manager
Cat Dickinson, Investment Specialist
As markets churn in 2022, we are keenly focused on the specific risks and opportunities among value and growth stocks. Here, we offer the Fundamental Factor Team’s perspectives on value and growth in the evolving economic and market environment.
The economic growth backdrop is an important consideration when evaluating inflation’s impact on value and growth stocks. Our research shows that when the market is expecting stagflation (high inflation paired with a negative change in economic growth), growth stocks typically outperform value stocks, as demand for stock-specific growth rises (Figure 1). Conversely, when the market is concerned about rising inflation paired with positive economic growth, value is generally favored. We believe balancing allocations to growth and value can help provide a hedge against these different types of inflationary environments.
Within the US growth universe, we have seen signs of excessive speculation in recent years as markets have bid up high-growth names in the apparent belief that some companies will gain share and grow profits indefinitely (even as macro trends point to potential headwinds). This has created a group of growth stocks we think are “priced for perfection,” with reward-to-risk profiles that are heavily skewed to the downside — i.e., they have a long way to fall should they fail to deliver on expectations.
We measure these excessive expectations using a Holt valuation metric referred to as “percent future,” which uses a discounted cash flow (DCF) framework to assess the percentage of a company’s current market value that is attributable to future cash-flow generation from assets that don’t yet exist. As shown in Figure 2 (dark-blue bars), the number of US stocks with a percent future reading greater than 90% has in recent years surpassed the levels seen during the dot-com bubble. (We find a similar result for global markets ex-US.) While the level of speculation has started to normalize in 2022, it remains higher than the historical average, and we believe it could have further to go.
Our research indicates that reaching a percent future reading of 90% or more can be an inflection point associated with significant underperformance for a stock. We’ve seen this begin to play out recently, as shown in Figure 3.
While the market has been focused on more speculative growth names, we think the quality growth segment of the market (e.g., companies with a growing asset base and positive economic profits) has been overlooked. Valuations have been especially striking in the US, where quality growth has actually traded at a discount to the market. Given the likelihood of additional interest-rate hikes in the coming months, the difference in the impact of rising rates on profitable versus unprofitable growth stocks will become an important consideration. Our research shows much of the interest-rate sensitivity affecting growth stocks more broadly appears to come from the unprofitable areas of growth (Figure 4). Conversely, profitable growth stocks, such as quality growth, tend to be less sensitive to rising interest rates.
Within value, we are wary of the staying power of deep value names (e.g., low price to book) given weaker fundamentals — including lower growth, earnings, and profitability — compared to quality value, which we believe looks more attractive. Our research also shows that deep value stocks have historically exhibited more sensitivity to macro factors than quality value stocks. In other words, quality value may be driven more by mean reversion in company fundamentals, while deep value may be tied more closely to macro signals, such as the direction of rates or oil prices.
Many commonly used valuation multiples, such as price to book (P/B), are impacted by the size of a company’s balance sheet. Yet the economy is increasingly driven by “asset-light” companies that are more reliant on technology, intellectual property, and research and development (R&D) — none of which are captured on corporate balance sheets (Figure 5). We think this economic evolution requires a broader set of tools for measuring value, and in particular we think traditional multiples should be complemented with a DCF valuation metric that is more comparable across companies with different business models, profitability, and risks.