Michael Walton: Hi everyone, this is Michael Walton here with Thomas Urano, who leads the portfolio management team at Sage, here with a mid-year update. Things have been changing so fast. I think it's very important to timestamp this conversation. It's July 7, at about 8am. I want to start by saying that we recognize how difficult this market environment has been, and we put this recording together just so you have a convenient way to listen. But let me emphasize, do not hesitate to reach out to your friends at Sage to talk specifics. We're always here to share our best thoughts and help out with any client conversations. I think as we look back at the first half of the year, I think it can be characterized by three things; one, rising and persistent inflation; two, a monetary response to meaningfully tightened conditions; and three, a significant retrenchment in financial assets and risk premiums across the board – duration, credit, equities. I would characterize this as the kitchen sink correction. It's everything in the kitchen sink, in the sense that you know, U.S. fixed income logged its worst start of the year ever, while U.S. equities had their worst first half since 1970. And there really haven't been too many places to hide. And listen, the goal of our conversation today is to tackle the key issues facing fixed income investors. This is complicated, a lot of these issues are interconnected. And we're really going to focus less on how we got here and how bad it is, but we really want to unravel the key issues in a way that gives you a sense of how to move forward. So Thomas, I thought it would be really good to start with our baseline playbook for the back half of the year. And so can you just give us the kind of high level talking points?
01:49
Thomas Urano: Yeah, sure, of course. So with rising recession risk, we think the Fed is likely going to slow the pace of rate hikes, or possibly even take a pause in the second half of the year. And that leads to a much more stable rate environment. In the second half, I think the biggest risk is going to be liquidity and credit risk premiums. We're managing those through sector allocations and issuer diversification within the portfolio structure. However, ultimately, these are going to become the biggest opportunities in the second half of the year. We're building up lots of dry powder to take advantage of what we think will be ultimately attractive risk premiums that will manifest in the second half. Ultimately, bond math is going to be working in our favor; we're seeing yields in the north of 4% range on intermediate core strategies, that's going to be able to carry the performance in the second half of this year. So our outlook for fixed income is pretty good for the second half.
02:40
Michael Walton: That's great, thanks. Alright, so let's, let's start with, the Fed, and they've worked to dramatically shift their policy to create much tighter financial conditions. And let's talk first about how this has manifested itself in capital markets.
02:58
Thomas Urano: So the Fed’s goal of tightening policy is working. It's working, we're seeing higher interest rates, rising credit premiums, and that is raising the cost of capital. And then we're also seeing softer lower liquidity conditions. And that's limiting new issue supply, new issue access. Ultimately, what does that mean? Companies when they come to market to borrow capital for capex or long-term investments are having limited access and a higher cost of capital, ultimately, kind of that brings down excessive credit use and spending.
03:34
Michael Walton: And how are the tighter financial conditions impacting or flowing through to economic data?
03:40
Thomas Urano: We're seeing that work as well. Again, if the if the Fed’s goal is to raise rates in order to slow the economy and that ultimately tries to combat or pull down inflation, then I would say it's starting to work. Economic data is coming in weaker than projected. The recent Citi Economic Surprise Index is reading near a decade low. The latest ISM Manufacturing survey is showing weakness across the board. And notably, sharp weakness in new orders out of that sub component. Bottom line is all central banks around the globe are in tightening mode simultaneously. And that's creating this global growth slowdown. And it's not just a domestic U.S. issue. It's global growth is slowing globally, right now, in this rotation from a slowdown to possible recession is happening around the world. And I think that that's where you can see, central bank policy is working in its goal to try and slow inflation.
04:36
Michael Walton: And let's talk about the consumer. You know, the consumer has been extremely resilient. But of late, they've really been feeling the impact of higher inflation. But now you layer in tighter financial conditions.
04:53
Thomas Urano: Yeah, so the consumer is in a very tough spot, right? Inflation is creating this demand destruction. You're seeing rising food costs, rising energy costs, rising housing costs. All that is squeezing the consumer’s disposable income, disposable spending dollars, right. And that ends up reducing the amount of money they get to spend on other goods and services. Savings rates are down, credit card balances are rising, cost of capital is higher in the form of mortgage rates for the consumer. Again, all that squeezing the consumer’s ability to spend, hopefully this is all showing through. Most recently, we got a number of updates from major retailers across the country, they all were guiding down on terms of sales and forward earnings. And they also all noted a substantial rise in inventories, which is indicative of consumer demand starting to wane.
05:41
Michael Walton: So it's a really good segue. So you know, policy is working to slow demand. But I think the bigger challenge on the inflation front is on the supply side.
05:52
Thomas Urano: Right. So supply is going to be the big challenge here. Obviously, supply constraints and logistics challenges on supply chains have been a contributor, a large contributor to the inflation problem that is outside the Fed’s control; geopolitics are outside the Fed’s control. So there are factors at work that may be counterproductive to this effort to slow inflation. But that's all supply-side driven and really not something that's going to be impacted by my monetary policy.
06:20
Michael Walton: Markets don't like uncertainty. And I feel like the thing we're all grappling with now is trying to understand the extent of the economic slowdown, is this going to be short and really sharp? Or is it going to be a longer, more protracted, maybe a more mild recession or slowdown?
06:41
Thomas Urano: Right, if you think about this growth slowdown and/or recession in terms of severity, the notion of a very sharp, a very short but sharp recession, we believe would trigger the Fed to likely reverse course, even turn around and start providing support to the markets, not in the sense to drive market prices up but to support market functionality. However, our base case is more for a mild and drawn out recession, right? Growth slows, maybe slows low-single-digit, sub-1% growth, maybe negative a quarter or two. But in a more drawn out scenario, where we have this mild recession that goes on, I think the Fed is more than happy to let it run its course. And in that scenario, from a performance standpoint, portfolio standpoint, performance is going to be driven by yield again. We won't be looking for price gains from falling yields, we'll be looking for that income in the portfolio to really drive performance.
07:39
Michael Walton: Got it. And listen, as bond managers, I feel like we're wired to solve for the worst-case scenario first in the form of defaults and then find ways to earn money for our clients. And, you know, if our if our base case is that policy is working and growth is slowing, signs point to inflation moderating, what are the risks to that view?
08:03
Thomas Urano: The risk is that you get the exact opposite. The risk is that this growth slowdown runs its course in short order. And in the second half of this year, global economies turn around and start re-accelerating, growth starts re-accelerating again. In that scenario, inflation is going to be pressured to stay elevated, and central banks, the Fed the ECB, all central banks are going to have to re-engage and almost double down their efforts to raise rates to try and cause the slowdown.
08:32
Michael Walton: And let's go back to the playbook you mentioned and if you will kind of relate it to specific positioning, what's happening within our portfolios, as you think about the second half of the year. So you mentioned a more stable rate environment. At the at the start of the year, interest rate markets were pricing in a fed funds rate of 82 basis points at the end of this year. Fast forward to 6/30, and markets are discounting a 333 basis point fed funds rate by the end of 2022. Talk about rates and how you know how that view of more stable rate environments playing out in the positioning of our portfolios.
09:12
Thomas Urano: Yeah, I think markets have digested the bulk of their expected rate hikes out of the Fed. Futures markets priced up, as you said, almost 3 and 3/8-type yield level from fed funds. I think the risk is that the Fed stopped short of that. But in that environment, the reason we think rates are going to be stable in the second half is because most of this pricing is already built into the market, no need to price the Fed even further beyond that.
09:38
Michael Walton: So you mentioned the biggest risk is liquidity risk and credit premiums. And at the start of the year, investment grade corporate bond spreads were 92 basis points over with a yield of around 2.3. As of 6/30, the spread had widened out to 155 for the IG corporate bond index, but the all-in yield is 470. Talk about how we're positioning for both liquidity risk and credit premium.
10:07
Thomas Urano: Yeah, so on the credit side, we are seeing that repricing of investment grade credit risk right now, right. And I think that's a function of Fed policy being effective, causing a slowdown. And now credit investors are beginning to worry about either downgrade or default risk. And in that scenario, you're seeing the investment grade market and the high yield market increase risk premiums. So that move from 92 basis points on the investment grade corporate market to 155, that's a good start. But I think there's more to go on that front, there's a bit more weakness you need. However, as we get to the high hundreds, maybe the 175 level, a little wider than that possibly, investment grade credit historically begins looking very attractive at those levels. To that end, what we want to do within our portfolio structures, maintain some dry powder and try and onboard some risk premiums and sectors or issuers where we have high confidence and be able to onboard a very cheap risk premium into the portfolio. And that will be a driver of performance for us.
11:09
Michael Walton: And let's talk diversification. Our President Bob Smith correctly identified the kind of biggest issue in the first half of the year and what was ultimately a Black Swan. A very, very rare and unlikely occurrence is the breakdown of correlations between stocks and bonds. You know, that kind of played its way through most of the first half of the year, but over the last month or so, we've started to see a return to more normal behavior.
11:41
Thomas Urano: Yeah, so in the first half of this year, what we saw was that as the Fed is engaged in this monetary policy to slow the economy, it had to reprice rates higher, and then also derate equity valuations lower. All of that is a scenario where you saw bond performance, negative stock performance. And again, that historical unusual correlation. I think as we're nearing the end or the possibility that the Fed takes a pause and that recession risk is rising and that their policy is working, we've just recently noticed this correlation between stocks and bonds revert back to a normal level, meaning we did see yields fall, we did see Treasuries rally, in a scenario where equities pulled back, as we saw more and more data about the economy slowing. So I think as we get into the second half, if the Fed does pause, then we can revert back to those normal correlations between stocks and bonds.
12:33
Michael Walton: Alright, so Thomas, let's end on a high note and talk income and yield. You mentioned the higher overall level of yields being a key to our playbook to have positive returns in the back half of the year. So you know, you obviously have much more income to kind of work through volatility, but talk this out.
12:50
Thomas Urano: Yeah, income has always been the predominant driver of performance, like historically over a cycle income is about 85% of performance in a fixed income portfolio. And to that end, with yields in the north of 4% range, we think it sets up a nice income cushion, a baseline to generate income over the second half of the year. In addition, we expect to see yields more range bound and maybe a little bit of price volatility associated with credit risk. But ultimately, portfolio yields likely range bound, that sets a scenario where we can generate performance out of the income component, and that will be sufficient income there to end to justify any fluctuations in terms of yield and/or price.
13:31
Michael Walton: I love bond math, letting bond math do its thing. And the other point I would make is maybe just the importance of having active management in times like this, you know, a manager like Sage that can onboard risk premiums, but take advantage of high value credits and let them be a meaningful part of the portfolio to add performance above and beyond what is structurally available in the bond market today. I want to thank everybody for your time today. I mentioned this earlier, but you know, we certainly hope this was helpful, but please don't hesitate to reach out to your friends at Sage if you'd like to talk any of this out. Thanks so much.
14:12
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