Abundant Income

Rick Rieder and team argue that the economy is making further progress towards normalization and continues to offer a once-in-a-generation investing opportunity, which isn’t adequately represented by the benchmarks.

You wouldn’t need a large-language model to predict that AI would be the Collins dictionary word of the year for 2023. The two-letter acronym has been a dominant theme in the investing landscape since it stormed into public attention in 2022, and we see no reason to take a contrarian view on that. While its relevance to equities and infrastructure investing is well known, we extend the significance of these two letters to be the cornerstone of today’s fixed income allocation, characterized by Abundant Income and Antiquated Indices.

Investors are navigating an economy that is coming down from the shock of the largest public-to-private wealth transfer in history. The COVID stimulus saw household wealth jump by the most in decades in the span of a couple of years, unleashing a surge in spending that put immense pressure on prices. And if easy policy was ‘pushing on a string’ in the 2010s, higher rates are akin to pulling on a runaway train in today’s economy. Interest rates simply don’t affect the economy as broadly as they used to. Services-oriented share of GDP has overtaken goods to become the majority of the economy, and this sector is much less reliant on the cost of financing than the more cyclical goods sector. Meanwhile, the low rates of the last decade created balance sheets, both corporate and individual, that have termed out their debt and are ambivalent to higher rates. In fact, 61% of IG and 68% of HY debt in the last 10 years was issued when the overnight rate was under 1%. No number of rate-hikes can change that. The record infusion in 2020 had the extraordinary effect of increasing household cash past their level of debt to make households net creditors for the first time in 30 years. Near perfect timing when coupled with the fastest hiking cycle in 40 years. The result is a record amount of cash sitting in generationally high risk-free yields throwing off $1.2 trillion of new income each year.

As we highlighted in last month’s blog, however, the stimulative aspects of restrictive policy mostly accrue to the wealthiest individuals and corporations. Whereas the tightening effect of rates is much more concentrated than it used to be, and those parts of the economy (real estate, low-income households, capital-intensive industries) are disproportionately feeling the burden of higher borrowing costs. With 79% of the S&P 500’s borrowing in long-term fixed-rate debt, corporations have actually seen their interest expense halve since 2019. And one in five of them now earn more interest income than they pay in interest expense! This indifference towards the cost of borrowing shows up in the Cap Ex plans for companies surveyed this month. 71% of firms with revenues exceeding $1 bn said borrowing costs have no effect whatsoever on their Cap Ex spending plans. It’s worth asking, then, how effective interest rates can be in slowing activity beyond the progress already made. The evidence would say not very - and that they may even be having a perversely accommodative effect in some instances!

So, while we are seeing slowing in aggregate figures as the economy emerges from the froth of the COVID years, it is slowing from an extraordinarily high growth rate to a healthier, more normal run-rate. This normalization is also evident in the employment data. Despite unrelenting strength in payroll numbers, demand for workers is clearly settling down as industries dealing with staffing shortages in the last couple of years, like Leisure & Hospitality, have found a balance. Structurally understaffed sectors like Education & Healthcare Services will continue to underpin a healthy labor market, though we should see more cyclical sectors continue to moderate. Job openings in these cyclical sectors have come back down to their 2019 levels; in the case of retail jobs, labor demand is plumbing 10-year lows.

We’re also seeing continued progress in the inflation data after a noisy start to the year. Sticky services components finally began to soften in May’s number, with core services ex. Shelter prices deflating MoM for the first time since 2021. In goods, May saw the greatest YoY decrease in core goods prices in more than 20 years. Core CPI ex. Shelter has stayed around 2% on a 6m annualized basis for most of the last year and has recently improved further with the 3m annualized rate falling below 2%. The disinflation trend is still on track after what was likely some excess seasonality in Q1 (and the seasonal trends turn favorable into the back half of the year). We believe this data is supportive of a Fed that can start gradually bringing rates down.

What does this all mean for how we invest? We maintain the view that this is a golden age for fixed income investing, characterized by high front-end yields and a global easing cycle that is just kicking off. The unique setup where convex, short-dated maturities out yield longer-dated paper, and spreads across quality are historically tight means investors have the opportunity to create a portfolio that yields 7% with a realized volatility of less than 3%! All without taking any substantial duration or credit risk. That we’re in a golden age shouldn’t encourage complacency, however. Quite the opposite. The areas of fixed income that have outperformed the benchmark indices in the last couple of years (short duration, quality high yield, securitized products, etc.) are all very poorly represented in those benchmarks! The US and Global Aggregate benchmarks worked well enough in the 40-year bull-market with upward-sloping curves, but the construction of these indices looks very antiquated today. The concentration in low-spread, long-dated assets makes no sense at all when you consider that the yield pickup you get for going out the curve is the lowest it’s been this century. With so many quality, short-dated assets with yields that are substantially higher than their volatilities, fixed income doesn’t have to just mean duration. The opportunity for income and convexity of returns is, arguably, the best we’ve seen in a long time.

On this topic, we reiterate that duration isn’t much of a hedge in today’s environment either. Consider that in each of the last 12 CPI prints where there has been a surprise, upside or downside, the reactions of the S&P 500 and the 30Y were positively correlated. Unless you have some long-dated liability to match, owning the long bond potentially just adds unnecessary volatility to your portfolio. The 30Y has the lowest yield/vol ratio of any point of the curve, offering ~1/10^th of the yield per unit of volatility as the front-end! Instead, we prefer to own our duration in equities - also a long-duration asset, except it accretes at 18.5% RoE and is buying back its issuance. Returning to the AI theme, we see the big tech winners continuing to be the most attractive part of the equity market as they maintain healthy margins and earnings growth. The muted levels of equity volatility also provide a unique opportunity to lever up your equity delta at extraordinarily cheap implied vols. Combined with today’s elevated yields, the proportion of the income from your yielding assets you need to fund your equity exposure is at historical lows.

Putting this all together, our investment thesis remains largely the same as prior months. With the potential to build a diversified and dynamic portfolio that doesn’t need to take undue risk striving to achieve a 6-7% return, we are positive on short-dated, high-quality assets and like a number of global markets where your FX hedge can work to increase your yield. For those with the flexibility to do so, a 10% allocation to bespoke/private opportunities may improve the risk/return profile even further. The convexity of outcomes is unlike anything we’ve seen in a long time. For a hypothetical portfolio with a 6% to 7% yield and a ~3% standard deviation, it would take a more than 2 standard deviation move to deliver a negative return on the year, whereas a 1 standard deviation upside scenario would potentially return ~10%. In this environment where income is abundant, and benchmarks are redundant, we find the best portfolio takes full advantage of the fact that you may not be getting paid much for taking more risk. We continue to pick our spots in fixed income, use equities as our vehicle for duration, and leverage opportunities in derivatives and private markets to enhance the risk/return profile further.

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