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Josh Greco: Ed, it’s a really dynamic environment right now, and that’s led to a big shift in income investment strategies. Before we get to where you’re seeing the biggest opportunities for income, what’s your macro view right now?
Ed Perks: Yeah, thanks Josh. Clearly, we’ve seen a very significant decline, pause, in economic activity as we’ve seen now with 1Q and 2Q GDP [gross domestic product]. And certainly, these are subject to further revisions down the line. But when you really look under the covers, you’re seeing some of the signs of say, the impact of higher interest rates. Maybe one of the clearer areas to see that is in is in areas like the housing market where activity levels have come down as rates—mortgage rates in particular—have moved higher and really changed the dynamic around affordability. We are clearly seeing the impact of the commodity influence, rising fuel prices in particular, the direct transmission of that fuel into things like airfares. So, the economy’s clearly feeling the effects and we expect that to likely continue. We don’t obsess too much about whether or not a technical definition of recession has occurred. Are we in one today [in the United States]? We know a lot of focus is being put on that today. We’d rather think about what it means for asset classes, what it means for the potential returns that we might see in different asset classes and how we need to adjust, but clearly starting with the macro and thinking about it, trying to wrap our heads around just how much it has changed in such a short period of time, I think is very important.
Josh Greco: You touched on rates. There have been big changes in the expectations of what the Federal Reserve [Fed] will do this year with interest rates, haven’t there?
Ed Perks: If I were to go back to the end of last year, to the end of September, this is pre any moves by the Fed, right? The first move was just a mere four months ago, a 25-basis point increase in fed funds followed very quickly by the 55, followed very quickly by two sets of 75. So, in a four-month period, a pretty unprecedented shift up in shorter-term interest rates. And I, I think there are a couple of points there. One is just how radically expectations have changed. And this has driven a lot of the movement in markets, both what’s happened in fixed income markets and what’s happened in, in equity markets with really a very substantial adjustment to valuation, meaning P/E [price/earnings] multiples contracting in the equity market. But just to highlight that, if I were to go back to September of last year, at that point, now recall the Fed still hadn’t pivoted. The Fed was still very much thinking about inflationary pressures being transitory. At that time, the market’s expectations for interest rate hikes in 2022 was just one move. And that was very much towards the end of the year.
So, you contrast that with where we are today, the number of rate hikes we’ve already seen, the impact that’s had on the broader yield curve and interest-rate environment in our economy. And that’s a pretty stark contrast that we really don’t see too typically. This is just a very unique period of time. And certainly, there’s a lot that’s contributed to that. Both the pandemic path, the impact that had on the economy, the reopening, just the amount of stimulus, both monetary and fiscal policy that was injected into our economy to get us to get us through this. So, you know, if I were to go and say, okay, well what is driving it? Inflation is clearly the culprit. Now, expectations for Fed hikes in September of ‘21 were at that level for a number of reasons. The CPI [Consumer Price Index] that month was 5.4. It’s nearly doubled (not quite), but it’s had a steady march higher since that 5.4 occurred. We’ve seen the Fed’s pivot away from “inflationary pressures are transitory” to now they are public enemy number one, and they will be targeted to bring that down, to achieve price stability. And that’s clearly the difficulty the Fed faces, the difficulty central bankers globally face threading that needle. How do we get or achieve a more longer-term sustainable level of price stability without really impacting or driving economies into a more dire, difficult scenario, deeper recession? So, unfortunately this macro focus for us is going to continue to remain very much front and center.
Josh Greco: So much to consider and a very complicated environment right now, Ed. Let’s talk about the impact on equities first. We’re in the midst of a lot of companies reporting earnings right now; what’s your reaction so far?
Ed Perks: We’re really in the meat of hearing from companies—how are you performing? How are you dealing with the challenging backdrop? Are margins under threat? The pullback that we’ve seen in equity markets to date has really been a valuation correction. The expectations for earnings remain fairly robust, in fact, as we think about ‘22, as we think about going into 2023, the consensus still lives in positive territory. And that would be very counter to a typical impact in terms of corporate fundamentals and the flow through to corporate earnings in a recession where we normally would expect a pullback, a contraction in in the overall level of earning. So I think for equity markets, this remains one of the key challenges moving forward. The so-called, you know, is there a second shoe to drop? We’ve seen a valuation correction. If we are now to start discounting rolling over of earnings expectations, earnings revisions, starting to really move lower. I think we could be in a challenging position. Now we’ve seen the market respond somewhat favorably. We bounced a little bit off of the recent lows after triggering that bear market territory of a greater than 20% decline—when, when thinking about something like the S&P 500 [Index] there have been signs of, we really need to take earnings down. The financials sector in particular is one of the earlier sectors to report earnings and generally those were misses.
Josh Greco: Ed, what about investing styles right now, and what’s happening with growth and value equities?
Ed Perks: Coming out of the pandemic in 2020, it was very much about growth versus value and certainly growth outperformance. Recall what happened with interest rates falling to record low levels. I think we got down to about 0.5% on the 10-year Treasury in the summer of 2020. And that certainly was a very strong case for long duration, growth equities that could develop fundamentals, revenue, growth, earnings growth over a much longer period of time.
Then we got to the point where visibility on vaccines, development, deployment, moving forward in the pandemic and reopening trades, a broader a group of companies could benefit. And we saw a pretty stark flip from growth to value. Now, growth didn’t necessarily underperform, but value really started to improve and really started to catch up. And that was to a large extent, that was the experience in equity markets from say March, April, of 2020 through the middle to latter part of 2021. Now what’s really played out in our mind is less about growth and value over the last three to four quarters and much more about individual sectors. So, while that broader equity market has experienced a bear market, if you will, dispersion, looking under the cover, looking at the performance of individual sectors has varied tremendously. And that’s been quality companies, defensive business models, stability in earnings and cash flow, stability and dividends have been the darlings, and they’ve really outperformed.
Josh Greco: When you think from a multi-asset view with a focus on income generation, up until recent months, I know you saw more opportunities in equities than fixed income. But the environment has shifted quickly, and now you see a lot of opportunities with fixed income, right?
Ed Perks: The movements that we’ve seen in rates has been staggering and really one that we can’t recall other than the global financial crisis occurring in such a condensed or compressed period of time. But just to take these different asset classes and break them down a little bit, if we were to look at investment-grade corporate bonds and think about the average price across the entire index, the entire universe of investment grade corporate bonds in the US a year ago, we were trading at prices in excess of 113. So, a fairly significant premium to the face value of those bonds, or par. And the yield had declined as low as 1.9%. The average yield to worst in investment-grade corporates. To look at where we’ve been over this past month, nearly 20 points lower in the average bond price. So now, more in the low-to-mid-90s on an average basis. It’s fairly easy to actually find investment-grade corporate debt that’s now down well into 80 cents on the dollar. And similarly, as rates have moved, investment-grade corporates are a longer-duration asset class that have really felt the brunt, borne the brunt of higher interest rates. But we’ve also seen some of this fear of recession, contractions, slowdown in corporate fundamentals, start to bleed into it as well. So, there’s been some spread widening in corporate credit as well. That’s exacerbated some of this downward move. But to now be sitting on an average basis in the low 90s, and to have that yield, which once again was a paltry 1.9% last year with a lot of interest rate risk, today to be more in the 4.5% to 5% range with now discount bonds, really changes the landscape in terms of the attractiveness of things like investment-grade corporate bonds.
And certainly, we can look at high yield and see a similar dynamic. Obviously, high yield is a shorter-duration asset class in general, a little bit more connected to the pace, direction and outlook for corporate fundamentals, but a similar story. That asset class has gone from a premium a year ago, average bond prices around 105—today sub-90 yields, more importantly, a paltry 3.7% last year for high yield, non-investment grade corporate debt securities on average, across the entire universe. Today, we’ve seen them generally between 8% and 9%. So, a much different landscape.
Ed Perks: But, there’s another really important point as it relates to high yield. And that is the opportunity that many of these issuers have had certainly since the pandemic reopening and rates plummeting, but really it goes back even prior to the pandemic. Companies very focused on taking advantage of low coupons of issuing debt securities of terming maturities out.
Ed Perks: So, when we look at the high yield market today and think about what are the maturities that are upcoming for many of these companies, and we look out to 2023, we look out to 2024. In many cases, we even look out to 2025 and we see very little in the way of upcoming maturities. So, companies are really being given a little bit of a gift here or are being rewarded quite frankly, for their focus on terming out maturities, of taking advantage of the low rates that were available to them. We think these companies can be pretty resilient, even in a modest downturn and economic activity, because they have tremendous runway. Those triggers to create a liquidity crunch or crisis—and ultimately trigger some kind of default—we just think doesn’t quite exist. So, we think defaults are going to stay relatively low in any kind of modest downturn in the economy here over the next four to six quarters.
Josh Greco: So, it sounds like investment-grade bonds and high yield are where you see strong, income investing opportunities right now.
Ed Perks: Yeah, clearly the move higher in interest rates more extreme a little bit earlier in the second quarter, it’s backed off somewhat with you know, with now expectations of some economic softness and the pullback in inflation expectations that’s occurred. But we are continuing to see very attractive opportunities in investment-grade corporate bonds in particular. We’re really targeting some of these securities that now have between kind of seven-to-10-year maturities.
Ed Perks: Typically on the shorter side, these were 10-years that were maybe issued here in the past year or two—lower coupons, but they’ve now borne the brunt of the backup in rates and some of the spread widening and really are trading out those deeper discounts. So that’s been a nice area and it’s a really broad universe of companies across a range of sectors and industries.
Josh Greco: Ed, thanks so much for taking the time and joining us on Talking Markets. That’s Ed Perks, chief investment officer for Franklin Templeton Investment Solutions.
Host End Wrap: Thanks, Josh and Ed. And thank you for listening to this episode of Talking Markets with Franklin Templeton. If you’d like to hear more, visit our archive of previous episodes and subscribe on iTunes, Google Play, Spotify, or just about anywhere else you get your podcasts. And we hope you’ll join us next time, when we uncover more insights from our on the ground investment professionals.
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