The CIO’s Take:
For those who see 2024 as another year in which Fed policy is likely to dictate investors’ fortunes, last Friday’s BLS report of job market activity in December was one to watch. The numbers came in significantly hotter than economists expected across the board, though signs of economic strength might not be a good thing for investors hoping for a quick retreat in policy rates. Indeed, we believe wage growth is way higher than what will be comfortable to central bankers, and see little in the data to suggest we’re on course for rapid easing. Unfortunately, the prospect of stock and bond investors’ simultaneous disappointment on the Fed’s timetable for rate cuts seems likely to prolong a trend toward increasing correlation between equities and fixed income. Moreover, those bond investors with a penchant for riskier debt might find today’s ultra-tight credit spreads didn’t offer enough compensation for the risk high-for-longer Fed policy finally sends high yield default rates up. We maintain our cautious footing, including an overweight to safe fixed income and an opportunistic tilt toward relatively cheap, high-quality stocks.
December jobs report comes in hot
As 2023 came to a close, the Fed’s last policy meeting of the year saw FOMC members penciling in three rate cuts for 2024, while markets were pricing in as many as three more than the committee’s quarterly dot plot indicated. How aggressively the Fed actually cuts will obviously depend on what’s happening in the economy—particularly a job market that’s been extremely tight over the last two years. That made last Friday’s jobs report an economic release of particular interest for those trying to gauge the trajectory of rates entering the new year. Given their exuberance toward the US economy, most investors probably weren’t surprised to see another display of the labor market’s remarkable strength. US Bureau of Labor Statistics (BLS) data showed 216k new jobs in December versus consensus estimates of just 170k jobs added, while the unemployment rate stayed level at 3.7% against expectations it would tick up to 3.8% for the month, as depicted below.
Job growth was driven by a strong service sector, particularly in health care, education, and leisure, which combined for 142k new jobs. Even the goods sector saw moderate expansion, largely driven by hiring into construction. That said, signs of continued economic strength aren’t necessarily going to put the Fed in a more dovish frame of mind this year. You can see that in stocks’ tepid reaction to the release—the S&P 500 finished the day up less than 0.2%—as well as an increase in yields and a decline in the market-implied probability of rate cuts to roughly 66%.
Tight labor should keep rates high
That makes sense since, as we’ve discussed before, notwithstanding talk at the most recent FOMC of a time when policy need not be this restrictive, the Fed’s greatest fear is ultimately a resurgence in inflation that results from taking its foot off the brakes too early. The more robust the economy is, the easier it becomes for the central bank to play “wait and see” with the Fed funds rate and give tight conditions time to work against inflation. There was certainly nothing in last Friday’s BLS report to suggest the Fed will do anything but hold tight at its next meeting at the end of January, for which odds of a continued pause currently sit at almost 94%. Those stretching for signs of labor market softening will point to a significant decline in the labor-force participation rate, especially among younger and older groups—the largest monthly drop in nearly three years—and a decrease in the number of full-time employees, including a downturn in employment of temporary help. Those changes get us moving in the right direction, but one or two data points don’t make a trend.
Wage growth a threat to disinflation
In fact, there was a number we were watching more than nonfarm payrolls in the BLS data: average hourly earnings. That’s because US labor market tightness hasn’t just served as an indicator of a robust economy, it’s been one of the driving forces behind what we view as one of the most persistent parts of inflation. Wages clocked 0.4% month-over-month growth in December, equivalent to a 4.1% year-over-year increase; that outpaced estimates of 0.3% and 3.9%, respectively. In other words, economists forecast wage growth significantly higher than the Fed’s target for inflation, and the actual numbers came in higher still. In the absence of much greater progress easing labor market conditions, it’s hard to imagine inflation coming down fast enough to prompt the Fed to cut as fast as investors came to expect in the waning months of 2023.
Investors have used a “60/40” to diversify
When it comes to the notion of a “balanced” asset allocation, the go-to model for many investors is the 60/40 portfolio, which calls for placing 60% of one’s capital in stocks and the remaining 40% in bonds. Indeed, that’s the benchmark we often have in mind when considering how a moderate-risk multi-asset portfolio ought to perform. The hefty dose of fixed income in a 60/40 mix is often assumed to be a good diversifier, with bonds’ stability expected to smooth out a portfolio’s performance during periodic turns down in the business cycle, when companies’ earnings and stocks multiples simultaneously contract. The hope is that stocks and bonds, while both producing positive long-run returns, will move in different directions over any given period (i.e., featuring negative correlation). In reality, as Bloomberg’s Jonathan Levin recently reported, things haven’t always worked out that way. Below we’ve replicated a chart similar to the one Levin was looking at, showing a big jump in the correlation of stocks and bonds over the last few months, and a generally positive correlation since early 2022.
Do rising correlations threaten the balance?
Indeed, despite correlations having been negative for much of the last hundred years, there can be spikes in stock-bond correlations—sometimes precisely when they’re meant to be especially diversifying. That can happen during recessions that trigger falling rates, which naturally boost both stocks and bonds. It can also happen when volatility in prices triggers sharp changes in investors’ inflation expectations, affecting stocks and bonds in a similar fashion. The positive correlation between stocks and bonds in the center of the chart above was a disaster for investors in a 60/40 portfolio during 2022, in which both stocks and bonds registered large drawdowns. Seeing the two asset classes moving together again entering 2024 might make investors targeting a balanced asset allocation uneasy once again. On the one hand, we’re inclined to believe that the dynamics just described are likely to persist, in which case the diversification advantage of pairing stocks and bonds could be less than we’ve all come to expect for some time to come. On the other hand, a correlation of 0.3 is still very low, such that there’s still plenty of benefit in a multi-asset approach.
Credit ballooned under ZIRP
It’s important to remember that the bond allocation suggested by the argument for diversification above doesn’t absolve investors from thinking hard about how exactly they get that fixed income exposure. Given the current market environment, there’s considerable risk, even in fixed income. As Oaktree’s Howard Marks bluntly explains, a big chunk of investors’ profits over the past 40 years come from one place: a 2,000-basis-point decline in interest rates between 1980 and 2020. You didn’t need to be a genius to reap the rewards of that massive shift in monetary policy. And lower interest rates have truly been magical for asset prices, including in credit markets, where they meant easier debt repayment and lower default risk. Over the last few decades, that led to a boom in both the amount of debt, and the number of speculative lending vehicles available to investors. The 2020 pandemic-induced zero interest rate policy (ZIRP) further expanded an already swollen credit market. It’s not hard to imagine how that might go wrong, particularly as rates moved higher over the last two years.
High yield spreads imply smooth sailing
To make matters more precarious, credit markets seem to be pricing an altogether different set of circumstances. On the back of strong recent macro data, including higher-than-anticipated growth and lower-than-expected inflation over the past two months, central banks have begun signaling a halt to their hikes and Wall Street banks have favorably revised their predictions for future Fed policy, forecasting major rate cuts by the end of this year. Yields reflect this growing optimism, with long-term US investment grade bonds rallying to the point that spreads are narrower than at any time in the last 20 years, while US junk risk premia are sitting at roughly 360 basis points, also remarkably low, historically—not least at the tail end of one of the most aggressive tightening cycles in recent memory. Investors seem ready to put the last couple years of restrictive policy behind them, enjoy an economic soft landing, and let the goods times with super-low rates roll once again.
Past tightening brought rough waters
From a historical perspective, that optimism seems misplaced. Fed data from past tightening cycles show a strong correlation between stricter lending standards and rising credit spreads in the past, as can be seen in the plot below. That pattern simply failed to materialize in 2023, though lending officers have done their part, significantly tightening credit conditions to a level that historically led to a recession (see below). That naturally reflects a heightened level of concern among bankers about future economic prospects—a view which has been at odds with the market’s assessment, as implied by credit spreads.
Credit faces serious downside risks
One potential catalyst for a rerating of credit risk is the strain of refinancing as huge debts mature in the next few years. Even if central banks achieve a soft landing and rates come down a little as a result, refinancing costs might still be too high, leading to more defaults and a jump in spreads. Some strategists do see a significant rise in defaults, with Deutsche Bank putting peak default rates on US high-yield bonds as high as 9%, and JPMorgan—a bank that we recently highlighted as less than bullish about this year’s market prospects—predicting defaults to exceed 10% in 2024. Likewise, economists at Fathom Consulting recently applied the famous “Altman Z-score” methodology to US companies, and found only 10% of US-listed firms exhibit “strong” financial health, with a record 36% nearing bankruptcy by the end of the last financial year. Credit analysts are notoriously cautious, but even adjusting for high yield pundits’ “glass-half-empty” mindset, we’re inclined to steer clear of risky credit as long as spreads imply distressed borrowers’ cups runneth over.
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