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Marc (00:00):

Welcome folks to this edition of the Market Signals podcast. My name is Marc Zabicki, Chief Investment Officer, , at LPL. Joining me today is our fixed income strategist , Lawrence Gillum. We're going to talk a little bit about credit conditions , today. Talk a little bit about Fed speak or Federal Reserve policy, surprise, surprise. So, Lawrence, how are you doing today?

Lawrence (00:24):

Oh, I'm doing great, Marc. Looking forward to the Thanksgiving Day holiday to relax and, and watch football with my friends and family.

Marc (00:33):

I think we'll all be watching football on Thursday and, and Friday. If you're not  , maybe you've got a plate full of Turkey in front of you, or both. , Today, by the way, as we're recording this is , Tuesday, November 22nd. So this edition is being recorded on Tuesday, November 22nd, as we do typically with this, , program. Let's start off with just kind of a little bit of a review of where, where we've been. ,  Some of the logs have been taken off the fire a little bit, and in U.S. equity markets, so not quite as robust as they, as they were, you know, a couple, few weeks  ago. And we'll get into some of the reasons why. Perhaps a little bit of the, you know, additional Federal Reserve speculation, some expectations, kind of growing that, you know, recession risks, however modest we believe, may be on the horizon, that same can be seen for the commodity space. You know, again, you know, , not as robust in the commodity markets, although commodity markets in general have been, , rather lackluster here in, in, in recent months. But, you know, some of the recession discussion, , and Fed talk from some key  Fed members  also driving that commodity space as well. So, turning to you Lawrence, on the bond side, since that's  your area of expertise, your wheelhouse , what's been driving the bond market over the last week or so?

Lawrence (02:15):

Yep. Over the last week and actually the last month, it's been a good month for fixed income, as we've seen longer end  treasury yields lower.  Some of that may be because of the expectation of  a slowing economy. Some of it is maybe due to the fact peak inflation may be behind this, but it's been a good month, good week for fixed income, finally, after the rough start to the year that we've had this year. You know, the, the more interest rate sensitive parts of the fixed income markets, investment grade corporates, emerging market debt, they've all rebounded pretty nicely over the past week and month.

Marc (02:48):

Yeah, a little sigh of relief for our fixed income strategist, I would guess. It's good to see some rationalization  in fixed income. Certainly have been, , welcome indeed, given the year that we've had. So let's go back to last week's, you know, key drivers, retail sales actually were better than expected in October, which is good news perhaps for the consumer as we head into the holiday selling season starting Friday, I think, officially.  Weaker than  anticipated industrial production capacity utilization, the Philly Fed business outlook, U.S. leading index showing  slowing business activity. So that speaks to  the ongoing progression toward what we believe  at LPL Research is going to be some, some chance for  a modest recession in the early part of 2023. So some of the business  data that we're getting seem to point to that  in that direction.

Marc (03:56):

I'm going to touch on some activities out of  China and then turn it over to you, Lawrence, on, on the Bullard and Mester commentary.  So, so there was a relatively constructive meeting as we understand it, between  XI Jinping and  Joe Biden  talking about the U.S. China relationship. That's added a little bit of a tailwind  to Chinese equities, you know, last week.  And also as it's been discussed  by us and by other  market participants and certainly by policy makers,  China's kind of stepping toward an economic reopening post-COVID maybe more on a sustainable basis, reducing some  restrict COVID restrictions that they've enforced across China for, you know, a couple years now.  That's leading or has led into some semblance of a, a modest rebound in China equities and modest rebound in EM. We don't know that that continues with any sustainability.

Marc (05:02):

So something to kind of keep an eye on. We're still  overweight the U.S. relative to the rest of the world in equities.  So I don't know that this, you know, China balance and EM balance is going to  you know, kind of find itself, find its way into a, an overarching trend. At least that's the way we think about it. So, interesting activity, but I don't know that it's going to last for a terribly long time.  Lawrence, turning to you, what is very interesting for us is really, obviously, the Fed speak that we're getting  from members  and some of the tumult that may have been caused by that, you know, in, in recent days. What's your take on that?

Lawrence (05:48):

Yep. So last week was a busy week for Fed speak 14  Fed speaking events last week. So Fed officials continue to deliberate monetary policy in public  but really the one that maybe outdid the rest was Jim Bullard, , mentioning that maybe the Fed funds rate has to get between five to 7%. 7% was a new number that we've not heard before. So that certainly took risk assets down, took, , treasury yields higher, particularly on the front end of yield curves.  but Jim Bullard is a, is a noted hawk, so he is one of the more aggressive  members of that FOMC, the Fed officials  by the way he's speaking today. So we'll have to see what kind of comments he makes today. But  there was a lot of Fed speak last week, and there we'll continue to be a lot of Fed speak running up into that December meeting. We got some meeting minutes this week  which we'll talk about I'm sure, but busy week for Fed speak last week, which pressured a lot of those risk assets, we think.

Marc (06:46):

Yeah.  yeah, they, they kind of, you know, are engaging in  in certainly rate policy, but also  jawboning as well, which that's part of  their job. Looking ahead this week to economic data, it's, it's going to be a relatively  white week in economic data, if you can say, although some important  events obviously on Wednesday, the FOMC minutes, and we'll discuss those in a second.  PMI numbers coming out of ,the U.S. both on a manufacturing services or, and also a composite level  turning into international  economic data. You know, again, a fairly light week, although a PMI manufacturing services and composite  numbers out of the Euro zone  some German  you know, business climate, consumer confidence, their business confidence numbers out of out of Germany, , and then also a, a Friday's GDP reading, you know, out of Germany as well.

Marc (07:50):

So some, some items to kind of keep an eye on this week from an economic calendar perspective. , you know, this obviously with the trading and the Thanksgiving holiday, the trading being  shortened this week  on Friday.  And obviously markets being closed on Thursday.  Probably not a whole lot of activity. Some interesting things to kind of keep an eye on, as we mentioned, Eurozone and U.S. manufacturing and services activity, there's been some discussion, speculation is probably the proper word, on OPEC+ production, what OPEC+ may in fact do with production. And we have those ongoing conversations around  China COVID policy and the outlook that China's perhaps changing there, in terms of the way they're going about restricting their, their population in and around, you know, COVID. So that's been beneficial, not only for China, but for the world. We'll see what the end policy looks like. Those conversations are ongoing. And then Lawrence, , again, to you, , which is probably the key item this week in terms of the economic calendar is the FOMC minutes at 2:00 PM on Wednesday.  What is your expectation in terms of that outcome?

Lawrence (09:11):

Yep, so these are the, the meeting minutes from the November meeting, that was three weeks ago. , and since then, we've, like I said, we've had a lot of Fed speakers out there discussing monetary policies. So frankly, I'll be surprised if there's any surprises in this release, but you never know  there could be some nuggets that the media takes away and, and looks more closely at. But generally speaking, we do expect the Fed minute meetings to suggest that yes, there's still work, more work that needs to be done to tame these inflationary pressures, but maybe they can, whether it's called a pivot or a pause or a transition, maybe they can slow the pace of rate hikes over the past four meetings. As we know, there's been  you know, 4 75 basis point rate hikes. That's pretty unprecedented. Since the 1990s, there's only been five total, and four of them happened over the last four meetings. So we do think that, you know, that the Fed is in that camp where maybe they can raise rates by 50 basis points in December and then slow down to 25 basis points thereafter. But you know, whether they're pivoting or pausing or, or transitioning, we do expect those minute meetings to suggest that, you know, they've done a lot of work, but there's still more work to do. But maybe they can take a slower pace of rate hikes.

Marc (10:27):

Yeah. And market participants will certainly be gauging that balance between hawkish and dovish commentary. And any comment that would indicate, you know, a pivot or a pause or deceleration in rate increases, which we are expecting, by the way,  will likely be somewhat helpful  for risky asset prices. Once again,  it's going to be your show here on credit conditions because, you know, I think what's interesting, and you tell me if you agree. I think you do. Credit conditions are actually looking pretty good.  That would  lead us to recommend for investors that, you know, the bond market is actually a good place to be now, , especially at rates at highs that we've seen and there's some income producing opportunities in the bond market. The first question we get is, okay, what about credit conditions? What are the balance sheets of U.S. corporations looking like, especially as we head into a recession? And that's what we're here to talk about, Lawrence. So, , so you guide me through some of these slides and tell me, as you walk through the credit conditions, tell me what are some of the high points on each one of these and what, and what the overall message is.

Lawrence (11:57):

Yep, for sure. So getting towards the end of third quarter earnings season. So we have gotten some updated balance sheet income statement type data. So what we're showing here is just how profitable these investment grade rated companies are, how profitable these high yield rated companies are. And we can look on, on the screen here, and metrics are still pretty elevated and, and pretty healthy in terms of profitability. Revenues are still pretty elevated. Operating income is still pretty elevated. And these are important metrics, we think, to that gauge the, the, the ability of these issuers to pay down debt if, if need be. So there's still a lot of revenue coming intothe , corporate issuers in aggregate. You know, there are going to be some, some winners, some losers, but in aggregate, you know, these profitability metrics look pretty healthy.

Lawrence (12:48):

If you want to go to the next slide I think importantly is that cash balances  still remain pretty healthy as well, and, and pretty elevated. So again, looking at these investment grade companies and these high yield companies, cash balances, yes, they've come down a little bit, but they were at record highs previously and still above averages in terms of, of cash balances. You know, we, we've talked about in other venues about how these corporate CFOs were very diligent in fortifying balance sheets by issuing debt and turning out their debt, which we'll talk about in just a second. But the cash balances that we've, that we see on these corporate balance sheets provide a lot of flexibility and a lot of financial strength in the event  of an economic slowdown. Now what we're looking at here is, you know, the all-important leverage ratio.

Lawrence (13:35):

So our corporate issuers over levered, do they too, do they have too much leverage on their, their balance sheets? And we would argue no. So if we look at things like net leverage, which is just total debt, minus that amount of cash that they have on, on their hands, and that's important because you know that cash can be used to pay off debt immediately. So that's why we look at net leverage. But if you look at net leverage for investment grade companies, which is the green line, and then you look at net leverage for high yield companies, which is the purple line, leverage ratios are still pretty good and, and still at or below historical averages. So despite the fact that there was a lot of issuance over the last couple years, leverage ratios are still pretty decent and still in pretty decent shape in aggregate.

Lawrence (14:18):

So we don't think these companies are over levered and, and with the profitability metrics that they have on hand and the cash that they have on balance sheets, credit conditions remain pretty favorable for, for both the high yield and the high grade, , companies. Now, we don't want to be overly Pollyann-ish here as, as well, we do understand that there are risks to corporate credit markets, particularly if the economy does enter into an economic slowdown or, or even a contraction. But downgrades have started to pick up, both on the high grade side and the high yield side. And this is natural. This is what we see every time the economy starts to slow down. We do see downgrades picking up and default activity picking up, but it's not out of the norm. And right now these ratios are still skewing positive in terms of the amount of upgrades relative to downgrades, particularly for the high grade companies. But we do expect a slight deterioration in these metrics if the economy does go into a recession and or contraction. But you know, right now, given the starting point that we're seeing for corporate balance sheets, corporate income statements, there's a lot of positive metrics that suggest to us that the credit conditions are pretty favorable still.

Marc (15:37):

And one of the reasons why they're favorable LG is they put in a lot of work during the post-COVID drop in interest rates and that's set  the stage for what has been relatively strong balance sheets across the board.

Lawrence (15:54):

That's absolutely right. I mean, you have to give kudos to corporate CFOs in aggregate, because again,  corporate issuance was elevated in, in 2019 and in in 2020, 2021, in an effort to term out debt, which means, you know, these companies issued a lot of debt at very low interest rates at longer maturities, so they don't have to access capital markets in the near term. And that's really, that's been a sticking point or, or even a tripping point for a lot of these companies in terms of downgrades and defaults. Say a high yield company has to, to roll over some existing debt, they can't get access to the capital markets, so, they end up defaulting on that debt. But what, what's happened over the last couple years, again,  these corporate CFOs have really termed out debt. Less than 10% of corporate debt outstanding needs to be rolled over over the next three years. And less than 6% of high yield debt needs to be rolled over over the next three years as well. So the, you know, the companies and, and these corporate CFOs have done a good job and, and they don't really have to access the capital markets anytime soon. Which would, you know, allow them, you know, at least a two to three year runway before we start to see some, some debt coming due that they have to, to pay off.

Marc (17:09):

So if I'm the average investor and I'm, I'm taking a look at, you know, my fixed income portfolio and given the rise in rates and given what's in front of us in terms perhaps some semblance of a modest recession, how should I think about my fixed income, you know, exposure, especially if I'm an income oriented investor?

Lawrence (17:37):

Yep. So we have seen yields across, most sectors move higher over the course of this year. It's been  a painful year for fixed income investors, but now that yields are, are higher and above levels that last seen since, you know, know before the global financial crisis, the income opportunities within fixed income have improved greatly, we think. And within the kind of core bond universe, which is, is the, the investment grade rated companies or issuers within the fixed income universe, those are your treasury securities, your agency mortgage back securities, your investment grade corporate securities. The investment grade landscape that only makes up about 25% of the index. So most of that, of, of the core bond index, for example, is, is going to be AAA rated treasuries or, or AAA rated agency mortgages. But given what we're seeing on the fundamental side for investment grade corporates, you know, they are riskier than treasuries of course, but we don't expect them to be the type  of catalyst for broad based selloffs in the core fixed income markets given the health  and the financial strength and flexibility for these companies that we're seeing currently.

Lawrence (18:42):

So we do think that there are a lot of good income opportunities, whether you're investing in treasury securities or investment grade corporate securities, or even agency mortgages. You can frankly build out  a nice income oriented portfolio that's yielding six to 8% without taking on a lot of risk. And we certainly couldn't have said, said that, you know, a year and two years ago.

Marc (19:03):

Yeah. And, and the, and the yield levels or the carry that's now available in fixed income really can, can offset or actually rather dramatically any kind of further increase in interest rates. I mean, I think maybe, you know, most people don't quite get that at this point. I mean, it's going to take an interest rate move higher of perhaps over a hundred basis points to really show in aggregate some negative returns perhaps in the bond market. So talk about the risk reward a little bit.

Lawrence (19:40):

Yeah, for sure. We certainly think the risk reward is, is more heavily weighted towards the positive returns now than what we've seen historically. Starting yields are a, a good kind of starting point for expected returns and, and they provide that, that kind of hurdle, that, that in a rising rate environment, you need to more than offset that those starting yields to generate negative returns. So to your point, we would need to see interest rates move hundred, 125 basis points higher just to offset what we're seeing currently in starting yields. And that's, I mean, we've seen some, some bears in the, in the, the treasury market. I haven't seen those bears call for another 125 basis point move higher in, in, in treasury yields. So we do think the risk reward is slanted towards positive returns over the next 12 to 16 months, just given where we are with starting yields. And the fact that any sort of pullback in treasury yields the potential for price appreciation has frankly has increased as well. So, I mean, it's been a long time since we've seen the possibility of a low double digit return out of core fixed income. But, you know, if yields drop by a percent, it's possible over the next 12 months. No guarantees of course.

Marc (20:51):

Yeah. And, and, and that's something that we want to make sure that we're kind of getting across to investors. I mean, we, we've had a difficult time in fixed income, no question. But those starting yields that you mentioned, you know, certainly provide some semblance of a, of a potential ballast against forward returns or certainly forward interest rate volatility. So, so we think bonds are actually a, a very, very good place to be. And, and we're going to guess that over the next 12 months they'll likely be a little bit more of a ballast versus that equity volatility that we've typically seen. So we're in a, we're in a better place in fixed income at this point. And, and if you are an income oriented investor that's been agonizing over where to get income over the last 10 or 15 years, well we think the bond market is really your answer at this point in time. So stocking away some of those income producing vehicles in the bond market will likely pay some dividends for years to come and, and in our view. So Lawrence, a great setup, a, a great view on credit conditions.  I appreciate you kind of joining me today and thank this audience  for joining us, talking a little bit about the Fed, a little bit about credit conditions. We hope you have a great Thanksgiving , and we'll see you back on the Market Signals podcast next week. Take care.

Corporate Credit Fundamentals Remain Healthy

In the latest LPL Market Signals podcast, LPL Director of Research and Chief Investment Officer Marc Zabicki and Fixed Income Strategist Lawrence Gillum discuss the recent Federal Reserve (Fed) “fedspeak”, expectations for the upcoming FOMC meeting minutes, and provide an update on the health of the corporate credit markets through the lens of corporate profitability and leverage ratios.

Markets Will be Focused on This Week’s FOMC Meeting Minutes

The economic calendar is light for this holiday week, so markets will likely be focused on the November Fed meeting minutes. While there have been a number of Fed speakers over the past few weeks, the potential for a surprise is always there. Nonetheless, the expectation is that Fed officials can proceed with smaller rate increases at subsequent meetings, while still acknowledging there is more work to be done to bring down inflationary pressures.

Corporate Fundamentals Should Remain Resilient in the Event of Economic Slowdown

Third quarter earnings season is wrapping up. So with updated financial statements, we think corporate credit fundamentals, including profitability ratios and cash balances on hand, remain in a strong position. Moreover, due to the increase in corporate debt issuance over the last few years that allowed corporate borrowers to term out debt (i.e. issue a lot of debt at low interest rates for long maturities), refinancing risks remain low.

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