Week of January 2, 2023
Dec Mullarkey, CFA , Managing Director, Investment Strategy and Asset Allocation
Feverishly waiting to read meeting minutes sounds like you desperately need a hobby. But when it’s the U.S. Federal Reserve revealing what happened “in the room” in early December, it’s a little more forgivable. The behind-the-scenes update hit squarely at the difference between the Fed’s intent and market expectations. The minutes forcefully reiterated that no Federal Open Market Committee member thinks a rate cut is likely this year. And if markets continue to think so, it will complicate the Fed’s job and perhaps force an overshoot and a deeper downturn.
That seemed like a somber warning, but markets didn’t change their rate cut outlook. The Fed’s fear is that if it cuts too early, a second wave of inflation could ensue. A painful episode like that happened in the 1970s and no Fed member wants to repeat that.
Meanwhile markets have their own ideas. This week, European inflation unexpectedly cooled. While still early, this is encouraging and promotes the view that central banks have already done a lot, and perhaps all that’s needed is time to let the current level of rates marinate through the economy.
In terms of recession alerts one reliable indicator has been continuing jobless claims. When their rolling average exceeds the low from a lookback period by a certain threshold, it signals that a setback is on its way. And that signal is flashing red right now even as job openings remain high. So, markets seem to be concluding that the Fed may have done enough and that any more tightening will need to be rolled back once the central bank pauses.
Source: U.S. Federal Reserve, Bloomberg, 2023.
Richard Familetti, CFA , Chief Investment Officer, U.S. Total Return Fixed Income?
It is more than tempting to start a new year with predictions. We see a ton of predictions from Wall Street analysts on every topic from inflation to interest rates to equity prices. The problem is they’re all different (or all the same) and often wrong. So, what can we do with all these predictions, including our own views? The fact is, it is very difficult to make predictions accurately on a sustainable basis, so instead we focus on two things: the information that leads us to what we suspect may happen and the current price of securities. Our observations about the current environment and the observations of Wall Street analysts become useful in understanding where there is value in credit markets. This makes the information that leads to a prediction more useful than the prediction itself. The good thing about using the information we know is that we’re not predicting.
Corporate credit spreads suggest a relatively benign environment for the economy, inflation and earnings, meaning they appear somewhat rich to what we’re seeing in real time. Margins are beginning to weaken and earnings expectations are dropping. Although the technical picture is positive, that can change quickly. As a result, we are more cautious on corporate credit at these spread levels and favor Treasury bonds. The lone exception is structured credit. Structured credit spreads are exceptionally wide versus comparably rated corporate counterparts, based on historical averages.
In structured credit, we see the technical picture as negative and the fundamentals to be mixed, but most bonds are structured well to protect against underlying asset deterioration, making valuations attractive. As a result, we favor the sector broadly and are searching for opportunities by picking through the bonds that have underperformed.
Andrew Kleeman , Senior Managing Director, Head of Corporate Private Placements
Is it back to the future? The increase in financial sector issuance gets a lot of attention for driving investment grade (IG) private credit volume since April 2020, attention that is well deserved. The sector accounted for approximately 40% of market issuance in 2022, maybe down slightly from 2021 but up from the low 20% in 2019, which was pre-pandemic. While overall market issuance in 2022 will not be as robust as 2021, the financial sector will anchor that volume. But it is increased cross-border issuance, delayed fundings and the ability to issue in various currencies that drove IG private credit market volume in 2022. All of these attributes of the private credit market are not new, and have underpinned the attractiveness of the market for many years. While there are new or different investment themes that can drive a market every year, or even for a few years, sometimes it’s the fundamentals that are most important.
Source: Private Placement Monitor, 2023.
John Bichajian III, CFA , Senior Director, Derivatives & Quantitative Strategy
Out-of-the-money equity put options continue to screen cheaply relative to out-of-the money calls, due to significant demand for upside exposure in all the major North American indices. Traders continue to buy options that expire shortly after the Consumer Price Index print on January 12, with the equity market implying a +/- 2% move for that date.
Same-day options exploded in popularity in 2022, with approximately half of all equity index and ETF options traded in December 2022 expiring within 24 hours of purchase.
The significant demand for these short-dated out-of-the-money call options exposes dealers to upside market risk, which they often “delta hedge” by buying the underlying asset, which in turn can push the underlying price even higher, leading to a self-reinforcing cycle and higher realized market volatility.?While weak liquidity and economic uncertainty are clearly contributing to the influx of large daily swings in equities, the booming popularity of short-dated options is playing an increasingly important role.
Source: Bloomberg, 2023.
Market insights are based on individual portfolio manager opinions and market observations. These are observations only and are not intended to provide specific financial, tax, investment, insurance, legal or accounting advice and should not be relied upon and does not?constitute a specific offer to buy and/or sell securities, insurance or investment services. Investors should consult with their professional advisors before acting upon any information posted here.
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