Will the Fed Take Another Hike?

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

In June, Treasury yields rose, but equities and credit generated positive returns. What can we take away as we head into the second half of the year?

It’s been a surprising first half of the year. June was a solid month for the market, so let’s quickly go over some numbers. The S&P 500 Index was up 6.6% and year-to-date it’s up close to 17%. The tech-heavy Russell 1000 Growth Index was up about 7% in June and up almost 30% for the year. The Russell 2000 Value Index was up almost 8% in June, but year-to-date it’s up only about 2.5%. People are hearing that big tech is carrying the index levels and that seems to be the case.

What about fixed income?

The Bloomberg US Aggregate Bond Index (Agg) was down 36 basis points for June as yields rose year-to-date, it’s up about 2%. High-yield bonds were up about 1.7% during the month and year-to-date up over 5%. And bank loans were up over 2% in June and year to date up over 6%. If you have a balanced portfolio (60% S&P 500 and 40% Agg), you’d be up around 10%.

What stands out to you so far this year?

What’s amazing to me is that going into the year, the markets were certain on a recession and rates being lower. What we’ve seen are higher rates and a nice market rally.

Let’s talk Federal Reserve. Can you put last month’s rate-hike pause into perspective?

It’s interesting to look at the projections the central bank’s Federal Open Committee (FOMC) released after their June meeting: They raised GDP projections for 2023. They lowered unemployment projections. They raised fed funds rate projections. They increased inflation projections. This is a constructive view of the economy and growth.

The Fed also left room for one to two more hikes by year’s end when we thought the Fed would maybe hike one more time in May and be done. The Fed didn’t hike in June, which they stated, “allows the committee to assess additional information.” The Fed has been aggressive in hiking rates to this point, and now they’re sitting tight and seeing what happens. What we’re seeing from a projection standpoint is they’re more constructive than most people are on the economy and feel inflation’s going be more resilient.

Entering the month, the 2-year Treasury was at 3.9%. After the meeting, it jumped to 4.74%. Market expectations are now that rates are going to be higher for longer.

Do you agree with the Fed’s base case?

There is a 90% chance that the Fed hikes this month. And then there’s a 50-50 chance of a hike in the fourth quarter. The market is now expecting one hike is baked in and maybe two more. More of a change is the expectation that there will be no cuts in 2023. That’s a significant departure from the beginning of the second quarter when three cuts in 2023 were expected. Now, the markets are anticipating no cuts until mid-2024. The market was very dovish, but the Fed stuck to their guns. Now you’re seeing the Fed essentially proving their point, and the market now believes the Fed’s going to keep rates here.

Do I agree with this? I thought the market was too dovish before and now I feel the market’s becoming a little too hawkish on rates. I still think there will be enough data to show a reason to cut sooner than a year from now. But again, I’ll also say I’ve been wrong about this. We’ll see how the economic data plays out.

How are the markets digesting all this?

Let’s be honest. With the S&P 500 up 17% this year and rates increasing, I feel the markets are digesting it pretty well. But consumer spending is slowing, and inflation numbers are rolling over—there’s a lag there.

Let’s move on to the economy. What’s going on and where is it heading?

Let’s start with projections on Q2 earnings, according to Deutsche Bank. A modest decline in earnings is expected. And just to give some context, in the past two quarters, we’ve seen a decline of around 2% in earnings. Expectations are that tech earnings are going be higher, but energy’s going to be down substantially at -19%. Financial earnings are expected to be off 6%. And then defensive sectors and other cyclicals look to be down 3 to 4%.

Overall, earnings are expected to be down 7% in the second quarter, though, if you strip out the energy, earnings are expected to be down only around 2%, which is consistent with the past two quarters. So, market expectations on company earnings are weak, but if the expectations were more bearish, you could end up having a rally if earnings come in better than expected.

How are sectors performing?

According to Bank of America’s daily credit card spend data, spending per household is flat to slightly negative year-over-year. Relative to a year ago, 11 of 14 sub-sectors were flat to negative. The three sectors that were up are grocery up by about 2%, entertainment up 4%, and restaurants up 4%.

When you look through to things that are down quite a bit and cooling quickly, gas is down 20%, which makes sense given just the drop in price of gasoline. Furniture and home improvement, which were substantially higher two years ago, are down 7 to 9%. Airlines spending has also come down since the spring. Consumer spending is cooling, and these indicators are reflecting a slowing economy. Yet we’re still seeing rates go up. I think there’s still a little bit of a disconnect right now between the economy and the markets.

Why do you think the economy’s been so resilient to date?

We had a lot of money go into the system at the start of the pandemic, and I think we’re still working through those excesses from 2020 and 2021. I think there’s a need for skilled and unskilled labor. Labor has been able to push back and get wages increased. The pendulum does seem to be moving a little bit away from that now.

But here’s another thing that one of our analysts did in looking deeper into the inflation numbers. Year-over-year, shelter contributed almost 300 basis points to the Consumer Price Index (CPI) number— and shelter makes up 35% of the CPI. So, shelter is the overwhelming contributor right now to CPI growth. But if you’re a homeowner, not a renter, the inflation number is actually lower because you have a fixed-rate mortgage and your cost of shelter hasn’t gone up substantially. So that may be another reason why the consumer is a little more resilient than most people predicted.

A related question: Where’s the recession that most folks thought would be here by now?

Going into this year, the market was certain that a recession would happen in the second half of this year. But right now, GDPNow—the Federal Reserve Bank of Atlanta’s model estimating GDP growth— has second quarter GDP growth at over 2%. That’s a decent number.

Because of COVID, we’ve had massive stimulus followed by massive inflation. And that led to aggressive hikes and the possibility of a recession. What we’ve seen is that everything has taken longer than most predicted. As I said earlier, expectations were for a 100% chance of a recession in the second half of this year. Now, it’s been pushed to maybe next year. I think one lesson for a lot of investors to reflect on is that the market rarely gives you what you expect. In January, if we said the S&P’s going to be up 17% and the 10-year Treasury’s going stay above 4% halfway through the year, that would have been completely against expectations.

Amid this, where do you see opportunities in fixed income?

Last July, the markets had gone through the worst first half of a year in a half-century. The S&P and credit got smoked. Bonds got smoked. But we said last July that now’s the time to step in. And from that point in time, the S&P’s up 20%, high yield’s up 9%, bank loans are up 10%, though the Agg is down 1% because rates have remained high.

When I look through to fixed income, the 10-year Treasury hit 4% in early July and investment-grade is over 5%. So, on the margin, I’d say that’s become a little more attractive. At the same time though, all this uncertainty around rates and the long end of the curve means to me that the bank-loan trade is sound. Loans have been the standout performer for the last year and a half, probably two years. Loans are up 6% this year. Because the Fed is getting more hawkish than people thought, the yield on loans is now 11%. You have an asset class that’s trading now at $94-$95, has defended well against inflation and is yielding 11%. I think there’s still value in that trade.

Conversely, as the belly of the curve moves higher, that makes duration a little more attractive. It’s a little more of a barbell. Meanwhile, high yield currently has a yield of about 9%. And I very much love the fact that we have yields now where, quote, “they should be.” Investment-grade is in mid-single digits. Leveraged finance is in the high single digits, low double digits. I feel you’re getting compensated for your risk in fixed income.

Until you get a sense of where rates will settle in, I would be judicious in employing assets in the midpart of the curve. I don’t think an entry point with the 10-year Treasury at 4% is a bad entry point for the belly of the curve.

Should we be concerned about defaults?

When you have a slowing economy, you have higher rates. What has that meant for defaults over the past 12 months? About 3% by dollar weighting. As relates to certain asset classes, upgrades are outpacing downgrades in high yield, yet downgrades are outpacing upgrades relative to when you look at the number of companies. That tells you larger companies are performing better than smaller companies and some of the private issues. On the loan side, there are more downgrades than upgrades.

I believe the market’s already pricing in defaults to rise. There’s enough of a narrative about defaults going up and inflation staying sticky to scare investors into staying under invested. I think that’s been a big mistake for investors. Yes, defaults are expected to go to about 5%, but that’s already baked in. In the event we have defaults go to high single digits, that’s different. Let’s see.

Now let’s shift gears and move to the lightning round. First phrase: European Central Bank interest rate hikes.

They’ve been aggressive. Historically, Europeans— anchored by the Germans—are uber-scared of inflation. Whereas our central bank over the past decade has been more concerned with disinflation and been more accommodative between the two fears, Germans tend to be more scared of inflation. They’d rather be more aggressive in this situation.

Reasons for continued job growth.

I think the COVID shutdown caused a lot of baby boomers to rethink when they were going to retire. Many things shifted such as work from home and meetings over Zoom. I think a lot of Boomers looked at all this and said, “That’s not what I signed up for.” So, you had more people retiring than normally.

Conversely, with regard to millennials, there’s still a disconnect and an adjustment needed in the workforce for the jobs and skills we need versus what we’re willing to accept as a workforce. That allows labor a little more leverage than it’s had over the past decade plus.

Housing market.

That’s another one that’s been resilient. The 10-year Treasury hit 4% in early July, which means mortgage rates are going to go up. But the housing market continues to be strong, just not as screaming hot as it was a year ago. I think the homebuilders have done a better job at managing inventory. And for sellers, the last thing to drop is the price, so you’re seeing houses stay on the market longer. More inventory is coming, but so far housing prices have been more resilient than most had predicted.

Future of malls.

Oh, they have to look different. Just walk through a shopping mall and try and pick five stores that you feel very comfortable will be around in 10 years. I think that’s hard to do. What happens to the space? I think you’re going to see more mixed use. You might see more medical come into play, you could see more groceries, you could see the condos or apartments. But I don’t think the malls will look the same going forward.

Commercial real estate.

Industrial seems to be doing just fine, but office side is awful and uncertain. And that’s a secular issue. Work-from-home to me is one of the biggest shifts caused by the pandemic. I just think it’s super tough.

Will San Francisco come back?

Hope it does, but I think tougher decisions need to be made.

Royal Caribbean Cruises’ new “Icon and the Seas” mega-ship, which is scheduled to set sail in January.

Let me give you a sense of its size. “The Titanic” was 50,000 gross tons. The "Icon of the Seas” is going to be 250,000 gross tons. It can hold 7,500 people, is 1,200 feet long—longer than an aircraft carrier—has 20 decks, and a world-class waterpark with six huge slides. It’s one of the most anticipated rollouts ever in the cruise ship industry in a long time.

Summer travel.

Cooling off, but it’s still pretty robust, especially with the strength of the dollar. A lot of travelers from the U.S. are going international given how strong the dollar is.

All right, last one. The Los Angeles Angels’ Shohei Ohtani is having one of the best seasons ever. He leads his team in every offensive and pitching category. Is he the best baseball player in history?

I’m an Angel fan. To me, Mike Trout has been the best player in a generation. But Shohei may be the best player in a century. He even leads the Angels in stolen bases. If he continues this through the rest of the season, this year has to be one of the best years for a player in baseball history. But it’s too early to call Shohei the best to ever play the game. If he continues to do this for the next seven, eight years, then that argument can be made.

Let’s close with a personal reflection.

Okay, we are halfway through the year, so I recently dug up my New Year’s resolutions to see how I’m doing, and I’m way behind.

Did you write them down?

I did. Actually, 10 of my friends got together and wrote down things we each wanted to accomplish this year. So far, two of them fulfilled theirs, and I’m not close on mine. The first half of the year rolled through quickly, and the second half will probably seem to go by even faster. I’d suggest folks take a look at the New Year’s resolutions they made—and I view those as promises you’ve made to yourself— and see how you’re doing. So many times we’re less inclined to fulfill those promises than the promises we make to others.

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.

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