What's Next After the Pause?

We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to get his insights on the Federal Reserve’s decision to pause rate hikes; the economy; consumer spending; and opportunities in fixed income. We finished with a speed round of questions and a personal reflection.

Let’s get right into it. After 10 increases, the Fed decided in June to pause interest-rate hikes. What do you think of the decision?

I think the decision to pause was warranted. Inflation has been rolling over, the economy is expected to slow, the Fed is still engaged in quantitative tightening (QT), and there remain pockets of weakness in the economy that could grow. While inflation has been stickier than most thought, given the level of rates, the upside to pausing outweighed the downside of hiking, in my opinion.

How would you frame the market’s reaction to the Fed’s pause?

Thus far, markets have digested the pause constructively. Longer-term rates have been rangebound, and risk assets have moved higher since the meeting.

How do you see the rest of the year playing out when it comes to interest rate hikes and the economy?

This has been difficult for many investors, including myself, to get correctly. Market expectations post meeting are for one to two more rate hikes and two to three cuts in 2024. This is substantially different than where the markets were earlier in the quarter, which was for two to three rate cuts in the second half of the year.

Is Fed rhetoric and market expectations in better alignment these days?

The short answer is yes. Last month, market expectations were for a pause in June and three to four cuts by the end of year. There was certainly a disconnect on what the market was baking in and what the Fed was saying. Today, expectations are for one more hike and maybe one cut this year. So Fed rhetoric and market expectations are lining up better. In fact, I’d say they’re more in line now than they’ve been in for a while.

Can you elaborate on where you see the economy headed?

Things are slowing down, but the consumer’s been resilient. It’s a narrative that’s been consistent with the past handful of recessions. Where do things sit from a consensus standpoint? GDP estimates for the second quarter are 0.5%, but they are -0.5% in the third quarter and -0.4% for the fourth quarter. But then forecasts are for three positive quarters in 2024.

From an inflation standpoint, the Consumer Price Index (CPI) is expected to be a little over 4% this quarter, then dropping to 3.5% in the third quarter and 3.2% in the fourth. Forecasts for next year are around 2.5%. When you think about it, the Feds want to bring down inflation to 2%—which is a low number not being forecasted—but yet markets are still expecting a rate cut.

If the Fed simply adds a little more flexibility and can be more accommodative as CPI gets to below 3%, then I think we can have an economy that rebounds into 2024.

What about consumer spending?

Using Bank of America daily credit card data, spending is flat-ish. It’s interesting to look at this relative to four years ago because we’re talking 2019, which means we have been through this COVID environment now for almost half a decade. Compared to four years ago, baseline spending is up about 25%.

Airlines, lodging, and entertainment are up about 15% relative to four years ago. Home improvement and online is much higher, at about 25%. One sector that is consistently lower is department stores, which has not recovered to the extent that other sectors have. Consumer spending has been resilient, but behavior has changed over the past four years.

Given everything that we have discussed, where do you see opportunities in fixed income?

I still remain constructive on general credit. The 10-year Treasury is at about 3.5%. If you look through to high-grade credit, yields are around 5%. Yields for high-yield bonds are nearly 9%. Yields for floating-rate loans are at about 10%. Default expectations are expected to be 3% to 4%, but we are seeing ranges start to deviate. The very bearish economists are projecting high single- or even low double-digit defaults. But the general consensus is around low- to mid-single digits on the default side, and I think that’s already baked into the credit markets.

Expectations are for a mild recession, not a severe one. That, to me, is attractive because the coupons can give you protection. One of the things that we have observed over the past few months is that most of the houses have come out and said, “Buy duration. Buy duration. Buy duration.” Essentially, they are saying, “Move out of bank loans.” And there have been bank-loan outflows for 39 of the past 40 weeks. So, we’ve had close to nine months of consistent outflows in the asset class because consensus was that rates were going to drop, so investors should put on more duration.

As I look today, loans are still the best performing fixed-income asset class year-to-date and the best performing asset class over the past six months relative to the Agg and high-yield bonds. I think a lesson there for investors is that timing fixed income markets is as, or more difficult than equity markets. I’m not talking the short end; I’m talking about the belly of the curve, the 10-year Treasury and out.

Extending duration to the Agg is about a six-year duration. If you sell bank loans and move to Agg based assets, you’re going to lose about 500 basis points of coupon. The primary way to pick that up is rates need to drop. That means rates need to drop about 75 basis points. And that’s to breakeven, assuming credit spreads hold. This means you’re expecting the 10-year Treasury to be below 3% by the end of the year. That’s a pretty big statement on the direction you think rates are going to go. I just think that is so difficult to time.

So far, investors have been wrong in moving out bank loans. I still see value in bank loans, but there’s an overwhelming narrative in place now to add duration. Could that narrative be correct going forward? Sure. There are reasons it could be correct, but at the same time, it doesn’t mean you exit out and move everything. I think the bank-loan asset class has been very underappreciated by investors, and that makes me even more constructive on it.

Now, let’s shift gears and move to the lightning round. On a scale of one to 10, how dangerous is AI?

Nine. Warren Buffet had a comment that 98% of AI is going to be good for humanity and 1% to 2% could destroy it, which makes it very dangerous.

What’s your biggest AI fear?

AI is not a creator of things; it’s an aggregator of things. I think about our kids. They’re using AI now to do homework and essays, but they’re not creating anything. I think confusing output for creation can dumb us down even more. AI can hurt us as a populace.

Biggest AI promise?

Productivity gain. If I can have a computer write emails and essays in seconds, that’s going to make productivity increase. My answer just tells you how complex I’m thinking in terms of AI’s potential. There are people using AI three and four derivatives beyond where I’m at. I’m just giving a very basic example on how productivity can be better.

Is a 7% mortgage rate the ceiling?

I hope so. There are folks reading this that probably have had an 8% mortgage—and maybe higher— back in the day. I feel like 7% should be the ceiling.

This year’s rainy season in California?

This has been a good thing. Being in California, it’s something we are especially attuned to. Just to give you a sense of perspective, one year ago today, 99% of the state was in some form of drought with 60% of the state in extreme drought. Today, 0% is in extreme drought, and only 4% is in a moderate drought.

How resilient is the labor market?

More resilient than most people thought, including myself.

Finally, how about a personal reflection?

June is the time for graduations, and I wanted to share my favorite part of a commencement speech that Amy Poehler gave at Harvard University in 2011. She said, “What I’ve discovered is that you can’t do it alone. Listen, say yes, live in the moment, make sure you play with people who have your back,”—that one I love—and “make big choices early and often.” I would only add to do some really fun things this summer.

Definitions:

One basis point is equal to 0.01%.

The Bloomberg US Aggregate Bond Index (Agg) is composed of investment-grade U.S. government bonds, investment-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 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.

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.

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.

Quantitative Tightening (QT) (or quantitative hiking) is a contractionary monetary policy applied by a central bank to decrease the amount of liquidity within the economy.

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