The Barbell Narrative for Fixed Income

We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to get his insights on the equity and bond markets, developments in the economy, the Fed’s next possible moves, the future of the electric grid, and opportunities in fixed income. We finished with a speed round of questions and a personal reflection.

Market Performance: Total Return

Let’s start with the markets. What happened in July and how has the tone shifted in early August?

In July, the S&P 500 Index was up a little over 1%. The S&P 500 Equal Weight Index saw some strength, up over 4%. The Russell 2000 Value Index had a great July, up 12%. So, you had a shift in market leadership in July. Then in early August, sentiment changed. Equities dropped anywhere from 5% to 10%, though the S&P is still up ~10% for the year. When I think about what happened, risk premiums were tight and the economy was doing fine, but things had been slowing. Traditional businesses were feeling the pinch of elevated financing costs while growth stocks had a huge rally.  While the economy is not going to shift in a day or two, sentiment seemed to. The jobs’ pillar was certainly something that the bulls hung onto. When we saw that cracking, I think it woke up risk.

10-Year Treasury Yields Remain Range Bound

We’ve been hearing about the unwinding of a global carry trade. What does the Japanese yen have to do with this market volatility?

Not too long ago, the Bank of Japan raised rates and essentially that increased the strength of the yen. This upsets a substantial carry trade, which is built on leverage. That appeared to exacerbate market volatility. The Nikkei was down 12% one day and then up 10% another day. That is significant volatility, and it resulted in a flight to safety. As a result, the 10-year Treasury dropped from 4.25% to the high threes. Last week, the Bank of Japan said it would not raise rates when markets are unstable, this appears to have a settling effect in the short-term. Equity markets are still up 10% for the year, and fixed income is also clipping an elevated coupon. In general, assets have been performing relatively well, but systemic leverage in this trade can result in wild swings.

Economic Dashboard: GDP, Inflation, Jobs, and Consumer Spending

What's the current data telling us about the economy?

For the past several months, we’ve been highlighting that the economy is slowing but still growing. The Atlanta Fed GDPNow is forecasting approximately 2.5% growth for the year, and consensus is ~1.5%. To me, that is a normalized GDP growth—what we saw before the pandemic. On the inflation side, we’ve seen it continuing to come down. I think we’ll crack 3% inflation in the near term on a year-over-year basis. Then there’s the recent jobs data, which has had an impact on the psyche of the markets. When you look at the jobs numbers for May, June and July, each month the numbers have been lower than last year. We’re seeing evidence of a weakening job market.

Fed Futures: Accelerating Timing of Rate Cuts (Expectations Increased to 3-4 Cuts in 2024)

Given the economic data, where do you think the Fed is on cutting interest rates?

The market is currently forecasting a greater than 70% chance for a 50-basis-point cut at the Fed’s September meeting and another 25-basis-point cut in November and December. Those cuts would total 1% and take us to a fed funds rate range of 4.25% to 4.50%. To me, a potential 50-basis-point cut in September will be what the market’s focused on. At that time, we’ll see if the Fed is going to be accommodative or stick to its data-dependent mindset.

Given the volatility we’ve been seeing this month, some are talking about an emergency fed funds rate cut. Do you think that’s realistic?

I don’t think so. Going back to 1987, there have been nine emergency rate cuts. When you look at the reasons why, for the ’87 crash and the bursting of the tech bubble, assets were down substantially—more than 25%. Sept. 11th and COVID each saw two emergency cuts. Those were exogenous shocks. It’s impossible to underwrite those elements. The remaining cuts pertained to financial system integrity, Long-Term Capital Management, the Russian crisis, and then twice before the Global Financial Crisis. From those, you can see the standard for the Fed to do an emergency cut is high. It’s possible, but I don’t think we’re anywhere near the economic or asset-pricing marks the Fed has used previously for emergency cuts.

Do you think an emergency rate cut would signal an all-clear to the markets or give the impression of the Fed’s behind the curve?

Assuming it’s not a shock, I think that would signal that the economy is dramatically weak, and the Fed’s behind the curve.

In recent years, problems with the electric grid have gotten more and more attention. What’s happening there?

Perhaps surprisingly, energy consumption has been relatively flat for more than two decades. I think that’s due in part to outsourcing manufacturing overseas. The U.S. as an industrial country has diminished in the 21st Century. This lack of demand growth is a big part of the reason there hasn’t been significant investment into the power grid.

Growth in U.S. Power Demand Driven by Data Centers

Do you see demand increasing?

This is what has changed. Forecasts are for an annual 2.5% increase through 2030. Why the greater need for power? The predominant contributor to the increased demand is data centers, and this is largely part of the AI boom. Next are electric vehicles. That’s the fundamental change that is occurring over the next decade.

Increases in U.S. Residential Electricity Costs Outpace Inflation

Power costs have been outpacing inflation, but demand has been flat over the years. Why is that?

The Consumer Price Index (CPI) is up in general 30% over the past 10 years—annualized it’s a little less than 3%. But the cost of air-conditioning is up about 43% over the same period—a 13% difference. In practical terms, the average electric bill in 2020 was around $500; today it’s more than $700. What’s caused the rise in prices? Natural disasters and resulting insurance costs have played a role. We also have an aging power grid, which means efficiency is declining and capital expenditures are rising.

We have a growing demand for electricity and an aging infrastructure. What kind of money are we talking about to modernize the grid?

In the 2010s, capital expenditures hovered around $100 billion annually. In the next couple of years, that figure is estimated to rise to $200 billion. But the reality is even by doubling infrastructure investments is not going to move the needle much on supplying power. So, we have to make a choice: Either we put significantly more money into our power grid or we’ll continue to see prices rise at a faster pace than inflation. We have medicine to take. Make the investment now or be worse later.

Fixed-Income Yields and Year-to-Date Returns

Let's shift gears and talk bonds. Where do you see opportunities in fixed income?

We’ve been consistent on the barbell narrative, focusing on two asset classes: investment-grade corporate bonds and bank loans. Essentially, when rates are elevated, duration is more attractive and vice versa. We now sit in the high threes on the 10-year Treasury, and bank-loan coupons are still 9 to 10%, but we are still seeing outflows in the latter.

Let’s think about bank loans over the next two years. Assume the Fed cuts interest rates six or seven times. That would mean, on average, SOFR will give you around 4 to 4.5% rather than the 5%. Spreads are not at historical tights like other asset classes. So, I think it’s reasonable that we could see 8 to 9% bank-loan coupons over the next two years. Investment-grade bonds are yielding 5% now, and I think for that asset class to return 8% over the next two years, rates need to come down. That means the 10-year Treasury would need to be inside of 3%. In my opinion, the duration trade has been highlighted by a lot of asset managers over the past year and a half, and we finally saw yields fall 40 to 50 basis points this past month. Technically at this point, even though duration has helped substantially over the past month, I’m neutral on it now as the market has reacted dramatically. High yield has performed well, but I still am very much a fan of investment-grade corporate bonds coupled with bank loans.

Now it’s time for the lightning round. First one, WTI oil prices: over or under $75 at the end of the year?

Under. I think a weakening economy is going to push it lower.

Houthis.

When you look at their tactics, they’re using a new brand of guerrilla warfare. Previously, you had small groups of soldiers disrupting larger groups. Now it’s done with technology. Drones cause so much damage, but they’re also so inexpensive. It isn’t worth our warships shooting them down with expensive missiles. It’s a new tactic we are going to have to live with for now.

Biden to Harris.

Biden handing off the nomination to someone needed to be done. I’ll just say it’s needed, and the presidential election got a lot more interesting.

Berkshire Hathaway selling Apple.

The issue is if you’re a company like Apple that’s built on innovation, share buybacks are not a good signal. It’s a financial signal, not an innovation signal. And I’m not going to argue with Warren Buffett. He’s the wizard.

Stranded astronauts.

I hope and expect them to get back and would put my money on SpaceX to figure out a way to get them back home. The real tragedy is it’s another misstep for Boeing, an iconic American company and the only major commercial-airlines manufacturer in North America. I think where Boeing went off course was to have Wall Street run this company, which put “financial engineers” in charge. When a company’s public, that’s what we have tended to do. Boeing needs to have real engineers with a voice. This is about the integrity of engineering. What you’re seeing is misstep after misstep caused by Wall Street types running the company.

Summer blockbuster: "Deadpool."

I laughed for most of the movie. It is not a family movie, but I loved it.

Favorite Olympic moments.

I enjoyed Simone Biles, and I love how the women’s gymnastics team members support each other. That’s been a pleasure to watch. It was also super cool to watch internet sensation Stephen Nederoscki or “pommel horse guy.”

Let’s close with a personal reflection.

This week our summer interns will be concluding their time with us. They’ve been with us for about 8 weeks, and it’s been a pleasure. They’re excited to be here. They’re eager to learn. They’re motivated to do the work. They took pride in their output, and they had great energy. All of this made me think: While we may be past the intern phase of our lives, may we always have the spirit of an intern.

Definitions

10-year Treasury yield is the interest rate the U.S. government pays to borrow money for a decade.

Accommodative monetary policy is when central banks expand the money supply to boost the economy.

The Atlanta Fed GDPNow is a running estimate of real GDP growth based on available economic data for the current measured quarter.

Bank loans (or floating-rate loans) are financial instruments that pay a variable or floating interest rate. A floating rate fund invests in bonds and debt instruments whose interest payments fluctuate with an underlying interest rate level.

The Bank of Japan (BOJ) is the Japanese central bank, which is responsible for issuing and handling currency and treasury securities, implementing monetary policy, maintaining the stability of the Japanese financial system, and providing settling and clearing services.

The barbell investment strategy often used in fixed-income portfolios, with the portfolio split between long-term bonds and short-term bonds.

Basis points, otherwise known as bps or bips, are a unit of measure used in finance to describe the percentage change in the value or rate of a financial instrument. One basis point is equivalent to 0.01% (1/100th of a percent) or 0.0001 in decimal form.

The Bloomberg US Aggregate Bond Index (Agg) is composed of investment-grade U.S. government bonds, invest-ment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds.

The Bloomberg US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government-related bond markets.

Carry trades involve borrowing at low cost in one currency to achieve higher returns from investments in another currency.

The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living.

A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity.

Duration is often used to measure a bond’s or fund’s sensitivity to interest rates. The longer a fund’s duration, the more sensitive it is to interest-rate risk. The shorter a fund’s duration, the less sensitive it is to interest-rate risk.

The effective yield is the return on a bond that has its interest payments (or coupons) reinvested at the same rate by the bondholder.

The federal funds rate is the target interest rate range set by the Federal Reserve’s Federal Open Market Committee (FOMC).

Gross Domestic Product (GDP) is the total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period.

High-yield bonds are debt securities, also known as junk bonds, that are issued by corporations.

Investment grade refers to the quality of a company's credit. To be considered an investment grade issue, the company must be rated at 'BBB' or higher by Standard and Poor's or Moody's.

Leverage refers to using debt (borrowed funds) to amplify returns from an investment or project.

The Nikkei is Japan's leading stock index comprised of the country's top 225 blue-chip stocks.

The nominal Gross Domestic Product (GDP) growth rate compares the year-over-year (or quarterly) change in a country’s economic output to measure how fast an economy is growing. Real GDP is GDP adjusted for inflation.

The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-value ratios and higher forecasted growth values.

The Russell 2000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell1000 companies with lower price-to-book ratios and lower expected growth values.

The S&P 500 Index is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.

The S&P 500 Equal Weight Index is the equal-weight version of the widely used S&P 500 Index, which is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.

Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.

Spread is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, represented by treasury bonds. Spread income refers to the additional income from this difference.

U.S. Treasuries represent the Bloomberg US Treasury Index, which is made up of U.S. government bonds of various durations.

West Texas Intermediate is one of the main three benchmarks in oil pricing, along with Brent and Dubai Crude.

Volatility is a statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security.

Yield is the income returned on an investment, such as the interest received from holding a security.

Yield-to-worst is the lowest potential yield that can be received on a bond without the issuer defaulting.

‍

Any performance data quoted represent past performance, which does not guarantee future results. Index performance is not indicative of any fund’s performance. Indexes are unmanaged and it is not possible to invest directly in an index. For current standardized performance of the funds, please visit www.AristotleFunds.com.

The views expressed are as of the publication date and are presented for informational purposes only. These views should not be considered as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment or market. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant.

Investors should consider a fund’s investment goal, risk, charges and expenses carefully before investing. The prospectus contains this and other information about the fund and can be obtained at www.AristotleFunds.com. It should be read carefully before investing.

A full list of holdings can be found at www.aristotlefunds.com and are subject to risk and to change at anytime. Any discussion of individual companies is not intended as a recommendation to buy, hold or sell securities issued by those companies.

Investing involves risk. Principal loss is possible.

Aristotle Funds and Foreside Financial Services, LLC are not affiliated with Pacific Life Fund Advisors LLC.

Foreside Financial Services, LLC, distributor.