Transcript

Amada Agati:  

In the span of just a few short weeks, we had three bank failures in the US, the emergency rescue deal of UBS acquiring Credit Suisse, and the Fed raising rates in the fight against inflation. In this month's edition of "Adding Alpha," we discuss what it all means for investors. 

The March Fed meeting amplified investors two primary concerns--one, that inflation is still too high so the Fed is going to keep raising rates, and, two, that cracks are starting to appear in the economy given how fast interest rates have moved higher.

We've long said our biggest concern is the Fed is fighting a battle it can't ultimately win with this type of pandemic-driven inflation in the driver's seat. It's making its usual policy tools in the toolkit, like raising interest rates, less effective. That's why it's concerning with the most recent CPI report that inflation is still at about 6%, and core inflation, when you exclude food and energy, is still running at about 5.5%.

Both are well above the Fed's long-term targets. So it wasn't surprising the Fed raised rates 25 basis points at its last meeting, and Powell indicated they don't plan to cut rates in 2023. With interest rates at the highest level in 15 years, something was bound to crack in the economy, and we've seen that forming with the recent bank failures.

We can't expect to go from 0 to 4.75% in just 12 months time without inflicting some level of pain on the economy. Powell himself said that last summer in his Jackson Hole speech.

Now we're seeing it broaden out with consumer sentiment falling again, retail sales slowing, and industrial production growth rates turning negative in March. Broadly speaking, the banking system as a whole still appears very solid with good credit quality and lots of high-quality assets relative to deposits.

But recent bank failures highlight the increased stress in the financial system resulting from higher interest rates, and as a result, we expect it to further tighten credit and financial conditions through slower loan growth, widening credit spreads and ultimately higher borrowing costs. It's hard to precisely quantify how much additional tightening will come because one of the biggest variables is a complete unknown, and that's, of course, lending activity.

But various analyzes suggest it could be as much as 50 to 100 basis points of additional tightening. We know it has an impact, and Powell certainly agrees with that assessment. When combined, all of these variables put policymakers in a very challenging position.

The terminal rate in the dot plot was unchanged from the Fed's outlook back in December, remaining at 5.1%, which implies they still plan to do maybe one more rate hike and then take a pause, but definitely not planning to cut rates in 2023. And in spite of the Fed's latest forward guidance and once again, much like what we saw in 2022, the market and the Fed are not on the same page.

The market is expecting the Fed to pause in May and potentially start cutting rates as early as June. That disconnect between investor expectations and fed guidance is actually making interest rate volatility break last year's levels. It's even higher than what happened in March 2020, and now we're entering the realm of 2008-level volatility. 

So what's an investor to do with volatility this high and the path forward seemingly more and more uncertain? In this period, we're really focused on quality exposures for both stocks and bonds. On the stock side, we're looking at companies with fortress-like balance sheets that can deliver consistent earnings growth even when times get tough and have low leverage so they're not quite as impacted by sustained higher interest rates.

In fixed income, we think it's a very good idea to reduce exposure to leverage loans and below investment grade credit, which, believe it or not, have actually served investors quite well over the last few years. But we think the path forward for those exposures looks less attractive compared to high quality investment grade fixed income, particularly as we continue to march down a slowing growth path towards recession.