The waiting game

In 2022, one of the most challenging years ever for bonds, a majority of Federated Hermes fixed-income portfolios outperformed their benchmarks. A key reason? Our rate strategies. Amid 40-year high inflation and the most aggressive Fed tightening since Paul Volcker was chair, our fixed-income committees that advise on rates (aka the duration and yield curve Alpha Pods) generated significant alpha in an extraordinary rising-rate environment. The year saw yields soar across the curve and particularly on the short-to-intermediate end, from more than 200 basis points on the 30-year Treasury to almost 370 basis points on the 2-year.

It’s unrealistic to expect as much alpha from interest-rate rate management this year. With the Fed nearing the end of its cycle and last year’s massive repricing creating more symmetric risks, a rangebound trade seems more likely as countervailing forces play out. On the one hand, a slowing if not outright recession in the U.S. and Europe, easing headline inflation and an eventual Fed pause represent downside risk to yields. On the other hand, tight labor markets, persistent wage and services inflation, continued global central bank hawkishness and a reopening China argue for the opposite. It’ll take time to see which “hand” wins.

Passing the baton

In the meantime, we enter the year with a similar but not as defensive stance as last year: underweight our two biggest credit areas, investment grade (IG) and high yield corporates; modestly overweight in smaller, specialized areas such as trade finance and bank loans; and neutral on both duration and the yield curve, where we would expect to react tactically depending on which hand is winning (see above). One credit area where we are cautiously overweight is emerging-market debt. Fundamentally, this asset class stands to benefit from dollar weakness, a reopening China and higher resource prices. From a valuation perspective, its yields offer enough income to offset reasonable price depreciation even if spreads—the yield gap vs. comparable maturity Treasuries—widen.

At some point this year, we would expect to pass the alpha baton to IG and high yield. Despite last year’s volatility, spreads remained relatively well behaved on both fronts, suggesting there’s room to generate more alpha by adding to these underweights if a slowing economy disrupts earnings enough. This is particularly true for high yield, which tends to be more sensitive to earnings misses and whose shorter maturities make it more vulnerable to refinancing. Issuers that have to refinance this year would have to do so at much higher rates relative to the historic lows of just a few years ago. IG is more of another “on the one hand, on the other” case. It could suffer spread widening if earnings decline. But as a holder of companies that tend to have relatively strong balance sheets and sustainable earnings, IG may hold up better and improve more quickly, making it a more tactical play. Once it appears the economy is nearing its nadir, a shift to overweight in both IG and high yield likely will be warranted.

What if 3% is the new 2%

It all comes down to what the economy, and the Fed does. On the former, the consensus call is a recession, the only questions being of magnitude and timing. An abrupt downturn in the first half could be great for our ability to add value in credit; our underweight would protect the portfolios as spreads blowout, and then would give us an opportunity to reset overweights for a new run. A slower downturn that flirts with recession—a “slow-cession” as some call it—could prolong uncertainties and keep markets in a holding pattern, i.e., rangebound. It does seem unlikely the economy, which closed 2022 much stronger than many thought, will rapidly downshift to negative growth, especially with the labor market remaining so tight and consumer and corporate balance sheets still relatively healthy.

As for the Fed, this underlying consumer and corporate financial health may be the issue. It seems desperate to get inflation back on track to 2%. It would have to do an awful lot of damage given the economy’s relatively solid underlying state. And what if in today’s global economy, where aging demographics and massive sovereign debt represent significant structural headwinds to disinflation, 3% is the new 2%? For its part, the Fed seems to be playing chicken with the market, which continues to price an earlier end to tightening than Fed rhetoric and dot plots suggest. The market was right about the Fed being wrong about “transitory.” Will it be right again about an earlier end? Does the answer matter? Nuggets to chew on as we make small bets on the margin and play the waiting game.