February 2022

Can the Fed Thread the Needle?

The Fed faces the task of tackling inflation as COVID wreaks havoc on supply chains, without disrupting the U.S. economy

By 
Dominic Nolan, CFA

Chief Executive Officer of Pacific Asset Management

By 

On Feb. 7, 2022, we sat down with Dominic Nolan, CEO of Pacific Asset Management, to get his insights on the markets’ rocky start in 2022, the Fed’s attempt at taming inflation while keeping the economy growing, consumer spending, and opportunities in fixed income.

What’s behind 2022’s rocky start?

What’s mostly weighing on the markets, in my opinion, is the shift in the Fed’s tone. The market-place has gotten very aggressive on the hawkishness of the Fed during ’22. It seems to me that is the primary weight on the capital markets.

Behind that, obviously, is Omicron, inflation, and, in the shorter term, Ukraine. The market’s adapting to some new worries, but I think it’s primarily about tightening monetary conditions. And that’s not only here, but across the pond at the Bank of England, the European Central Bank, etc.

The Fed is attempting to thread the needle between growth, inflation, and the COVID disruption. To begin  with, how is the Fed’s response likely
to impact inflation in the short term?

Traditional thought is that monetary-policy adjustments take time—nine to 12 months is the thinking of most traditional economists. However, the market is a discounting mechanism, and the Fed’s moves are certainly reflected more quickly there.

Will the Fed react if the markets continue to react poorly?

In previous years when there has been either an economic slowdown or an asset-price correction, the Fed has come in quickly to support markets, a reaction  known as by many as “the Fed put.” In other words, investors received a very inexpensive put option.

Today, with the market down 10% on some indices, is the Fed prepared to step in? It feels to me like  the Fed is pretty committed to raising rates and tightening. And what one person calls tightening, another person may call normalizing. I think the Fed put is significantly more out of the money than the past 10 years. So, if the market drops more dramatically, I would expect them to shift to slightly more dovish tone. But even if the markets were to correct another 5 to 10%, I don’t think the Fed would change its tone.

Another COVID wave is receding. Is the Fed looking at the pandemic as impactful to the economy anymore?

To me, it’s a data point, but not the driver at this time. Right now, we’re in a world where an increase in COVID cases is actually an increase in inflation because of the supply-chain disruptions. For the Fed, that’s where it gets a little bit tricky. If you see another surge or another wave, will we have an economic slowdown? On the margin, you may, but that also may be offset because there’s enough demand now for the consumer to pay higher prices, so you will actually have more inflation and more supply-chain disruptions. The pandemic is still a variable, but I do think the Fed looking out beyond another surge with the assumption that COVID will be less of a problem to supply chains going forward, and therefore inflation should subside.

What are your current expectations for rate hikes in ’22?

Trying to look into a crystal ball is typically a dangerous game, but let’s take the base case.  It’s four rate hikes. That would put short-term rates in the low ones. And the curve, you would assume, will steepen from there. Today, the 10-year Treasury is just below 2% range. Again, nothing bold here. But a year ago, 2% seemed like an eternity away. I know that some folks expect it to move to 3% or beyond. I would just say this: Long term, if the Treasury could get up to three, which is a little over a percent from where it is today, then you have, based on historical comparisons, investment-grade credit probably sitting at four plus, high-yield and other instruments yielding 6 to 7%. Assuming appropriate risk premiums, I would love that. I think that would be a fantastic world got paid those spreads and have an economy that long term is probably going to sit at a 2.5 to 3% range.

What do you think would be the most likely candidate for disrupting this view? Inflation? Another COVID wave? Some kind of geo-political issue?

Underwriting the very low probability of high-impact events is difficult.

As for a new COVID wave, will it disrupt the economy? I just don’t think it does. I believe that people are acting as though COVID is more endemic, rather than pandemic. They’re going about their lives in a more normal state.

As far as the economic situation, I think will the price of goods will normalize. The price of labor? That one’s a variable; it’s going to be interesting  to watch over the next year.

I think the biggest threat to the economy now is a mistake in monetary policy. An overly hawkish situation could distort capital markets.

Do you see COVID still having major impacts on consumer behavior?

I’d say minor impacts in certain areas. When I look at Bank of America’s credit-card spending data, a few things stand out to me. You are seeing states, which have lower amount of COVID cases per capita, spending more per capita than states with higher case counts.

Compared to two years ago, consumer spending  is up a ton—nearly 20% in some sectors. And compared to a year ago, spending is up almost across the board—restaurants up 26%, transit up 30%, gas up 37%.What is down versus a year ago  is online electronics, which tells me that people  are resuming their normal lives.

With the stability in bank loans so far this year and volatility almost everywhere else, how do you see opportunities changing for fixed income?

For the past 12-plus months, I’ve been very much  a proponent of short-duration credit, in particular, floating rate because the economy was doing well, and corporations were doing well. I felt very constructive on spread, and inflation was uncertain. So, I believed that you wanted to be away from the long end of the curve, especially where things were.

That story is still intact for floating rate. What has changed a little bit is that high yield got hit—it’s down 2.5 to 3%. Investment grade is slightly more compelling as rates tick up. I still lean toward loans, but if this continues, you may start to hear a different message from me. But the story of loans being defensive against inflation and being constructive  on credit is absolutely still in play.

Time for the lightning round. I’ll prompt you with a short phrase or word, and  you provide the first thing that comes  to mind. Are you ready?

I hope so.

5.7% GDP growth in 2021.

Incredible.

GDP growth in 2022?

I think it will be around 4.5%.

Market volatility this year.

High.

Chances of a rate hike in March?

Probable. Let’s say a 60% chance.

Wages?

Higher.

Job openings?

Higher.

Quit rate?

Higher. There’s a theme here.

How about the Omicron variant BA.2?

In proper context, an annoyance. But I say that with the utmost respect for people’s health, but from a global economy standpoint, an annoyance.

What about business travel?

Short term up, longer term probably meaningfully lower than where it was pre-pandemic. People have just become comfortable with Zoom-type meetings, but as we open up, people will want to see each other.

The Winter Olympics in China.

Cold.

And finally, who do you got in the Super Bowl? The Los Angeles Rams or the Cincinnati Bengals?

It’s the year of the tiger.

To end the interview, can you give us a personal reflection?

I’ll keep it short and sweet. The Lunar New Year started a couple days ago, and, like many holidays, one of its great traditions is reaching out to family members. This month, I’m making a special effort to reach out to family members I haven’t been in contact with for a long time. I think it will lead to a more fulfilling February.

Definitions

Dovish refers to the tone of language used by the Federal Reserve bank to indicate that it is unlikely that it would take aggressive action to lower inflation.

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates.

Floating-rate securities are called “floating rate” because interest rates on the loans adjust to reflect changes in interest rates.

GDP stands for gross domestic product and is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period.

Hawkish refers to the tone of language used by the Federal Reserve bank to indicate that it is likely that it would take aggressive action to lower inflation.

High-yield bonds or junk bonds are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds.

An investment grade is a rating that signifies that a municipal or corporate bond presents a relatively low risk of default.

Monetary policy is a set of tools that a nation’s central bank has available to promote sustainable economic growth by controlling the overall supply of money that is available to the nation’s banks, its consumers, and its businesses.

A put or put option is a contract giving the option buy the right, but not the obligation, to sell—or sell short—a specified amount of an underlying security at a predetermined price within a specified time frame.

Stock and bond market indexes consist of a hypothetical portfolio of securities representing a particular market or a segment of it.

The 10-year Treasury note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance.

Tightening policy occurs when central banks raise the federal funds rate, which can significantly help to slow or keep the domestic currency from inflation.

Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security.

You cannot invest directly into an index.

Pacific Asset Management LLC is the sub-adviser for the Pacific Funds Fixed Income Funds. The views in this commentary are as of Feb. 8, 2022 and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Any performance data quoted represents past performance which does not guarantee future results. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Sector names in this commentary are provided by the Funds’ portfolio managers and could be different if provided by a third party.

Past performance does not guarantee future results. All investing involves risks including the possible loss of the principal amount invested. High-yield/high-risk bonds (“junk bonds”) and floating-rate loans (usually rated below investment grade) have greater risk of default than higher-rated securities/higher-quality bonds that may have a lower yield. Corporate bonds are subject to issuer risk in that their value may decline for reasons directly related to the issuer of the security.

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