A Busy Week for Central Banks

Marc (00:00):

Welcome everyone to this latest edition of Market Signals Podcast. I'm Mark Zabicki, Chief Investment Officer at LPL Financial. Joining me is one of my favorite gentlemen, fixed income strategist, Lawrence Gillum. Today is Tuesday, December 13^th, on this day of recording the Market Signals Podcast. Lawrence, how are you doing today?

Lawrence (00:25):

I'm doing good, Marc. I appreciate it. And it's crazy to think that the year's almost over, only a couple more weeks left in the year.

Marc (00:33):

Yes, yes. And I ordered a bunch of stuff on online yesterday and it should be delivered before Christmas. So I’m feeling pretty good about it, maybe a little bit ahead of the game. What about yourself?

Lawrence (00:45):

My wife thankfully handles a lot of this stuff, and I know she's doing a great job ordering presents for the kids because I bring in all those Amazon packages as they arrive each day. <Laugh>

Marc (00:58):

Well, that that wasn't a plug for Amazon, but just, you know, but well done. So important disclosures for everybody to kind of recognize. Talking a little bit about last week, you know, you and I have kind of just ahead of this call, Lawrence, went a little bit back and forth about some of the activity in capital markets last week. You know, things were a little bit depressed in terms of most risky asset prices. I think some of the conversation around you know, recession risks and producer price index number here in the U.S. came in just a little bit hotter than expected. And then people extrapolated, okay, well if inflation's not falling as fast as people would like, then the central bank, being the Federal Reserve, is going to have to do some more risk, which adds more, I'm sorry, do more tightening, which adds more risk to the recession picture in the U.S. and also in global economies. Have I got that right, Lawrence?

Lawrence (02:03):

Yeah,  that sounds about right. We did see a hotter than expected PPI index, came down from last month, but hotter than expected. So there was a kind of a risk off tone during the week last week for sure. Yeah.

Marc (02:15):

And, and then we're going to maybe touch on, you know, core bonds here maybe in the next couple slides, I'll leave that for that. But in continued conversations in China around COVID exit expectations that market has still got a little bit of a bid, but broadly, EM kind of faded in general terms with overall global equity markets, you know, last week and recession speculation continues to weigh on oil markets in general, although commodities broadly were a little bit higher. So looking at more individual markets, you know, as mentioned, most equity markets broadly were weaker. Although, Europe continues to get some semblance you know, of a bid. You know, notably European economies and equity markets are a little bit lagging where the U.S. is in terms of the Federal Reserve’s inflation fight. So that continues to go on quite dramatically in the eurozone as the ECB begins to tackle or has been tackling inflation.

Marc (03:29):

And that's a little bit more problematic in the eurozone than it is in the U.S. at this point. I think, you know, probably in double digit, you know inflation readings around the U.K. and other parts of the eurozone. So although European markets are continuing to get some semblance of a bid, the jury's still out as far as our asset allocation committee is concerned. I think we're still favoring, or we are still favoring U.S. equity markets over the rest of the globe. But the activity in eurozone equity markets has, has caused us to raise our eyebrow just a little bit. The EFA index lagged the overall central world index and the S&P 500, the emerging market index, also, you know, lagged as well. Moving on to bonds. Lawrence, this is your wheelhouse, obviously, so bonds are acting like bonds all of a sudden. What's your take?

Lawrence (04:30):

Yeah, no,  it's good to finally see that negative correlation with equity markets as equity markets have sold off, fixed income markets have rallied. Your point about recession risks increasing, and that risk off bid that we saw last week, that was beneficial to core bonds and in particular interest rates. We saw interest rates continue to move lower last week, and that certainly helped a lot of those more interest rate sensitive asset classes like investment grade corporate bonds, or even emerging market debt, which a lot of people don't understand or realize that that's one of the more interest rate sensitive asset classes within the fixed income market. So that has been  a headwind most of the year. But over the, the past month or so, it's been a tailwind, which is helping claw back some of those negative returns that we've seen this year,  which is certainly a relief.

Marc (05:20):

Yeah, yeah, yeah. Like we said, the bond market's kind of acting like the bond market again, which we're glad to see that, you know,  and Lawrence we've talked about in this forum and other forums, actually, at LPL Research where there's some definitive value to be had in bonds. I mean, you know, you know the, the recent drop in market interest rates is maybe, as we mentioned yesterday in the asset allocation committee, may be slightly overdone, and we could see some retrenchment of that. But, you know, still bonds are offering attractive returns over the next 12 months. Do I have that right?

Lawrence (06:00):

You're absolutely right. And we just released our 2023 Outlook piece, which talks about the prospects for fixed income returns over the next 12/24 months. Even though yields have come down a little bit over the past month, month and a half, they're still higher than what we've seen over the past decade. So we think that the fixed income asset class, broadly, is in the best shape it's been in over decade. So bonds are back.

Marc (06:25):

Yeah. Yeah. Bonds are back, and again, as we we've mentioned it in other forms, including this one,  if you're an income oriented investor take down some fixed income exposure because we think that that makes sense at this stage and now that you're getting paid for waiting it even makes more sense. On the economic calendar in the U.S., the CPI number this morning is  of notable interest as we sit here on a Tuesday recording the Market Signals podcast. The CPI number year over year for the U.S. was 7.1%, and that compares to the 7.3% estimate and the 7.77% prior reading. So good news for Federal Reserve watchers, good news for equity market participants, in general, so far this morning. We'll get an FOMC meeting tomorrow, so we'll talk a little bit about that and we’ll hear Lawrence's perspective on that. Retail sales later on this week

Marc (07:41):

and also industrial production numbers in the U.S. capacity utilization as well. So a fairly heavy week in in U.S. economic circles. Turning to the rest of the globe,  inflation data and a whole heck of a lot of central bank activity. And again,  we'll pause on that for just a second, let Lawrence, you know, cover that at the latter portion of this podcast. CPI numbers in the eurozone will be also something to watch  and clearly the PMI manufacturing composite and services numbers out of the eurozone in Germany. Also, something to pay attention to as everyone this week is going to be watching new inflation data, everybody across the globe, new inflation data and also what the central banks are going to do about it. Turning to that, you know, lot of central bank activity, as we mentioned, the Federal Reserve, the Bank of England, the European Central Bank amongst others, are going to go to work this week and adjust policy according to their view of inflation and global economies.

Marc (08:56):

And we mentioned inflation data across the globe is coming out as well. If you happen to be suffering from the inability to find proper amounts of sleep during the course of this week, I would recommend the Bank of England Financial Stability Report as a cure for that ailment. Because while there was great information in there, and I would encourage people to kind of, at least pay some semblance of attention to it, it can be a little bit of a dry read. So Lawrence Gillum talk to us about what's going on in central banks across the globe this week and how should we think about it as investors?

Lawrence (09:40):

Yeah. So now that the CPI data is behind us, markets are going to shift their attention to central bank week. We have nine central banks meeting this week, as you mentioned, highlighted by the Federal Reserve, the Bank of England and the ECB. Those are the three large central banks that are meeting this week. All of them are expected to raise interest rates, albeit, at a slower clip than they have in the previous months. The Fed, for example, has raised interest rates by 75 basis points in four of its last meetings. We expect 50 basis points tomorrow, so certainly a continued increase in interest rates, but at a slower pace. But it is going to be a busy week for central banks. I have a couple factoids for you here, Marc, as it relates to central bank activity.

Lawrence (10:29):

You know, we talk about the Fed a lot, but it's not just the Fed raising rates. There's 90% of central banks have raised interest rates this year. And if you count up all those interest rate hikes, 275 rate hikes this year have taken place. 275, 25 basis point rate hikes. So if the Fed raises rates by 75 basis points, for example, that counts as three rate hikes. So if you do the math 275 times 0.25%, 25 basis points, close to 69% in interest rate hikes cumulatively this year. So an aggressive rate hiking campaign globally. Now, a lot of that's  in the emerging markets. You know, if you look at the Latin AM region,  the Latin American region consider, you know, Brazil, Colombia, Mexico, they've raised interest rates by, again, cumulatively by 31%. So we think the Fed's aggressive—emerging market central banks have been overly aggressive as well, which is one of the reasons why we've preferred U.S. fixed income assets over emerging market debt assets. Again, despite the fact that the Fed is raising rates at a pretty aggressive clip, it pales in comparison to what we're seeing out of the emerging market economies.

Marc (11:42):

Yeah, emerging market economies clearly are attempting to protect some relatively weak currencies. So that's one of the reasons for  that activity you know, certainly. So if the Federal Reserve is going to raise 50 basis points, we think this week, as well as ECB and the Bank of England you know, I think the expectation, the way we think about it in our asset allocation committee, is that they'll likely continue to ease those interest rate increases over the next, you know, several meetings to the point where the next meeting after Wednesday's  FOMC meeting could be 25 basis points. And then there may be another 25 basis point hike in the following meeting. But just kind of put it in context for the audience,  it looks to me like inflation is doing some of the heavy lifting in terms of the trend for the Federal Reserve,  and we are getting what we expected as an asset allocation committee from inflation and also from the Federal Reserve as well. Is that fair?

Lawrence (12:58):

I think that is fair, and I think it's important to point out that today's inflationary report, the CPI report, is a good story in and of itself, but it's also the second report in a row where  inflation has come under inflation expectations, right? So there's been two months in a row now where we've seen inflation fall faster than expected. That's good news for the Fed, and that should give the Fed the ability to not pivot or anything like that, but maybe just pause at these elevated rate hikes. No more 75 basis point rate hikes, maybe one 50 basis point rate hike tomorrow, and then to your point, maybe 25 in January and another 25 in in February. And then kind of see how things work themselves out on the inflationary front. One caveat I would say is that while inflation is falling, we still see a pretty tight labor market. So it'll be interesting to see how that conversation unfolds tomorrow with Chairman Powell, you know, he has that press conference after the meeting, and I'm sure that'll be brought up about the tightness of the labor market. So  I don't think, or the Fed probably doesn't think its work is done yet, but they're certainly moving in the right direction.

Marc (14:08):

Yeah. And  moving in accordance with our expectations as an asset allocation committee. We've been cautiously constructive on risky asset prices for several months now with the expectation that the inflation was going to continue to roll over and thus the Federal Reserve was going to eventually have to do less work. And we are seeing that markets are beginning to recognize that we've seen that over the last, you know, several weeks or so. So that's in fact, you know, coming to pass. So we'll see what the next couple weeks as we move on to the holiday season,  see what's in store for us over the next couple weeks, and see certainly what comes out of J. Powell's mouth tomorrow, which will also be very important. So with that in mind Lawrence,  let's turn our attention to, again, your wheelhouse, which is fixed income markets,  specifically the municipal bond market, where you are seeing quite a bit of value, and that's based on your expectation for default rates and munis compared to other areas of the market. How does  this read to you?

Lawrence (15:19):

Yep, for sure. So because of that aggressive central bank rate hiking campaign that's taken globally, you know, those recessionary risks have increased. And during recessionary periods, we tend to see default rates increase for investment grade, corporate credits and high yield corporate credits in particular. We do think that the corporate credit markets are in pretty good shape but default rates will increase. That's just tends to happen during these recessionary periods. We think the default rate's going to peak lower than what we've seen  in the past, but, you know, default rates are still going to increase from current levels. Municipal securities, however,  have tended to have a lower default rate, and this is important because fixed income, there's not a lot of upside return, there's a lot of downside potential returns.

Lawrence (16:07):

So fixed income returns tend to be pretty asymmetric. You can lose more than you can gain in a lot of situations. One of those ways to lose more money than you can gain is through defaults. Defaults represent a permanent impairment of capital, means you're not going to get your money back at par, unlike if your bond is trading, you know,  and volatility's happening, and  the prices of the bonds are going all over this place. You hold that bond to maturity, you're still going to get that bond back or that money back at par. You don't have that same sort of benefit if a bond defaults. So investors, fixed income investors, they try to limit the amount of default activity in a portfolio, because that does represent a permanent impairment of capital. Municipal securities, which are the blue line here that we're showing, have tended to have lower default rates.

Lawrence (16:54):

So they've been a higher quality credit, relative to corporate credit. So if we do enter into a recessionary period, corporate credit default defaults increase, the muni market tends to be a pretty attractive place to park some money and to avoid a lot of that default activity. Now, munis have been under a lot of the same pressures that we've seen in other markets this year, rising interest rates, you know, munis have these fixed coupons associated with them, so they've sold off as well as other markets. Adding to that, we've seen about 10% of the market being taken out to investor withdrawals. And the muni market is still pretty illiquid, meaning that any sort of investor redemption, especially about 10% of the market, is going to put downward pressure on prices, upward pressure on yields.

Lawrence (17:43):

We're starting to see that trend change a little bit though, we're starting to see money move back into the muni market. So we do think that that technical headwind is turning into a technical tailwind and also given the strong fundamentals and the relatively attractive valuations, munis could be a pretty attractive alternative to corporate credit over the next 12 to 24 months. So it's an area that we like, it's been an area that has been beaten up this year, but we do think the worst is behind us. And the outlook for munis  is pretty positive, in our view.

Marc (18:15):

Yeah, that makes sense to me. Again, clearly the tax benefits are part of that story. And again, you know, for income oriented investors who are looking for more attractive yields that the market has given us in 2022 and some tax benefits out of the muni market, I think that makes a lot of sense. So other than munis Lawrence, throw you a little bit of a little bit of curve ball here, outside of core bonds, whether it's, you know, treasuries, mortgage-backed securities, investment grade corporates, outside of those core bonds,  other than the muni market,  where would you suggest investors turn for some attractive opportunities?

Lawrence (19:09):

Yeah, so for those other areas  that we look at, considered spread sectors, those involve high yield bonds, bank loans, emerging market debt, which we talked a little bit about today, and then non-U.S. developed debt. Of those four, we think the best value is in just high yield bonds. You know, U.S. corporate high yield bonds, eight and a half type percent returns. As I mentioned just a second ago, we do think defaults are going to increase a little bit, much less than what they have in previous recessionary type periods. So there is risk associated with them, that's why we advocate for  a three to five year time horizon for high yield bonds. But given the backup in yields that we've already seen this year, high yield corporate credit bonds look pretty attractive. Again, if you can hold them through any sort of near term volatility that may come as these rate hiking campaigns continue.

Marc (19:59):

Yeah, good points. You and I have been on this podcast several times over the last six to eight weeks, and we've been systematically, call it, pounding the table, on fixed income, especially for income oriented investors. And I think we want to collectively maybe pound the table again. So whether it's the muni market, high yield for bonds, you know, again, we think the risk reward in fixed income makes a lot of sense for a lot of folks. So with that Lawrence,  we'll close out this session of the Market Signals podcast. I wanto to thank you for joining me today talking about Central Banks, talking about the municipal bond market. And we want to thank the audience for joining as well. So have a good week everybody, and we will see you next Tuesday.