by Rick Rieder, CIO, Global Fixed Income, and Russell Brownback, Head of Global Macro, Fixed Income, Blackrock
- Why the U.S. economy continues to display polyurethane-like flexibility and resilience, despite encountering extraordinary shocks.
- How portfolios can also be built with flexibility and resilience in mind.
- Why high-quality fixed income assets are today a critical component of this more polyurethane-like portfolio.
Kitchen sponges, ski boots, luxury mattresses and nuclear submarine missile housings have something in common – they all contain polyurethane. In just over 80 years, polyurethane has gone from being undiscovered to one of the most widely used substances on Earth, largely due to some valuable characteristics: flexibility and adaptability, but also durability and strength. Its ability to be stretched, bent, stressed and flexed without breaking, while in fact returning to its original condition, is what makes it so chemically unique, yet widespread and useful in its application.
Likewise, a modern economy flexes, adjusts, and is more durable than many think – just like polyurethane. Over the last three years, the U.S. has led developed market economies in demonstrating an ability to bend under increasingly unpredictable conditions – from the global pandemic to war in Europe, and from heightened inflation to rampant layoffs – all without breaking. As a case in point, a 70-year trend away from volatile goods consumption and toward docile services consumption was hit by a violent reversion during the pandemic years, unwinding the last 30 years of that trend in just two years. Demand first swung toward goods, like household supplies and cars in 2021, before careening back to services, like restaurants and sports entertainment again in 2022, to the tune of double-digit economic growth rates (see Figure 1).
How has the economy been able to withstand dire predictions of doom, gloom and recession amidst these shocks? Putting it simply, apart from the initial shock in 2020, the labor market has been able to redistribute enough workers from where they have been in excess, to where they have been needed, keeping unemployment extremely low. A wealth boost in 2020-21 has allowed the growing share of workers aged 55+ to retire earlier, keeping enough open positions for those aged 25-54 to speedily recover their pre-pandemic participation. Simultaneously, sectors that “over-hired” during the pandemic, and are now going through layoffs (such as information technology, transportation and financial services), are being offset by sectors that lagged and are trying to catch up (such as health services and leisure and hospitality, as displayed in Figure 2).
To be sure, the process hasn’t been perfect, and continues to be in motion, yet this economic self-recalibration has been faster than any traditional economics textbook would have suggested. Indeed, with the ability to source jobs on multiple web platforms and social media, the labor market has become more liquid, price transparent, informationally symmetric and ultimately, much more flexible. There is a novel and tangible stickiness to employment strength in this business cycle that seems to defy policymakers’ attempts to slow it down by using age-old tools, like interest rates.
The truth is lower paying jobs are still recovering and are in need of help. Naturally, to attract workers, these jobs have seen the greatest increase in wages and share of job gains since 2021, whereas recent layoff announcements have been concentrated in the highest earnings sectors (tech and finance, for example). It is this kind of polyurethane-like flexibility that has allowed the labor market to stay so tight despite news that would appear to be to the contrary. This picture of today’s labor market is something that should be cultivated and preserved by the Federal Reserve (Fed), and other policymakers. To have lower paying jobs driving wage growth, while higher paying jobs bear the brunt of policy tightening, as corporate profit margins compress to absorb those higher wages, is unusual, and allows for a rebalancing of capital and labor as well as a narrowing of the income gap.
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Nonetheless, the economy isn’t immune to tighter policy – over the course of 2022 income growth slowed from an unsustainable 10% annual rate, to a simply “good,” and much less inflationary, 3% to 4% growth level. Not unexpectedly, retail sales have also slowed, starting 2022 by growing at about a 1% monthly pace, and ending the year at about a -1% pace. On a brighter note (at the very least for policymakers), and in sympathy with other leading indicators, inflation itself has slowed too. There are still some inflationary forces rolling through the system, most notably in shelter (which often displays a long lag), but in most major categories inflation is in the low single digits and poised to enter deflation. Incredibly, core inflation excluding shelter has posted a negative inflation reading for three consecutive months now (see Figure 3)!
Housing data and soft data (survey data) warrant monitoring as two potential canaries in the coal mine should the U.S. economy slow so much as to encounter a hard landing. When mortgage rates are well above wage growth and forward interest rates, as they are today, housing activity tends to fall (as it has been). Similarly, with some sentiment-based surveys falling as wage growth (and affordability) slows, one might expect hard data to follow. While these indicators warrant close watch, a lack of transactions in the housing market doesn’t necessarily translate into an all-out price collapse. In fact, some modest house price depreciation may help with consumers’ affordability challenges and with the Fed’s inflation target. At the same time, hard data has been resilient because actual spending has been much slower to turn down, both by consumers and by industry. Clearly, soft data appears to track sentiment better than it does output.
Can portfolios be as adaptive as the economy?
The marginal deceleration in the data has gained momentum, albeit from a generationally great level, an evolution that both policymakers and investors should be flexible enough to respect (global interest rate markets certainly seem to be doing so).
Over the last three years, successful investing has required a similar polyurethane-like flexibility as the economy. The long duration index has been both the best and worst performer in fixed income (returning 18% in 2020, but losing 29% in 2022), while the degree of an investor’s flexibility around energy and equity risk may have made or broken portfolios. Just comparing last January to this one is illustrative: in January of 2022 the Nasdaq index lost 8.5%, while in January of 2023 it has gained 11.2% (Bloomberg data as of January 27, 2023).
While the market may be getting ahead of itself by forecasting policy easing later this year, we think this is less about predicting what the Fed will do rather than a desire to put piles of cash to work locking in yields that are well above 20-year averages. If wages, inflation and growth are all bending back to normalcy, ultimately policy likely also reverts to normal too. Portfolios could start flexing back toward more interest rate exposure than has been heretofore comfortable, particularly with high quality income-producing assets that would likely benefit from a simple return to normalization, and benefit a lot if the economy goes into recession, but lose less than riskier assets if inflation ends up being more resilient than expected, requiring further policy tightening. It certainly feels as though many of the durable, protective characteristics that make polyurethane the material of choice in mattresses and missile insulation are also making fixed income our asset class of choice in portfolios today.
At the current level of yields in fixed income, investors should hope for a boring year in interest rates – one in which they earn their carry. A boring year should naturally be accompanied by a decline in volatility, perhaps with the notable exception of Japan, where a change in yield curve control could be disruptive. Nonetheless, with yields near multi-decade highs even after accounting for inflation expectations, there is substantial margin of safety in fixed income markets to withstand a variety of shocks (see Figure 4)
Last month we described the Fed’s policy rate path as akin to a ski lift – creating a lot of vertical on the other side. The market has already anticipated a peak and a turn in interest rates, perhaps prematurely, but the fact remains that a substantial real yield is coming from the risk-free rate, especially in the front-end of the curve. High quality yield is available without as much volatility as elsewhere, and without much credit, duration, or illiquidity risk – hence a lower probability of loss (relative to that volatility, as displayed in Figure 5).
While assets in fixed income have climbed the proverbial interest rate mountain (even if they haven’t quite reached their peak), U.S. equities do not seem to have done the same. To be sure, a lower rate environment, accompanied by a decline in interest rate volatility, is often a great environment for owning equities. However, without having done as much of the valuation heavy lifting, it is hard to argue that portfolios should take more risk in equities than in fixed income, when similar returns could be generated in the latter asset class, with a lower probability of loss (see Figure 5 and Figure 6).
Within fixed income, lower quality junk bonds yield just 1.5 times as much as their investment grade (IG) counterparts. As recently as 2021, the IG yield could be tripled by moving into the high yield (HY) space. Considering that the cash flows backing the debt of IG companies are dramatically less volatile than those in the high yield universe, the relatively small risk premium that high yield commands may not reflect enough risk. Further, there is not much dispersion in IG (a good thing in times of stress); whereas, in HY there is a significant amount of dispersion, suggesting more volatility in the range of outcomes (including default) during the eventuality of a more serious downturn. Indeed, portfolio polyurethane resides in the higher quality end of the fixed income spectrum today.
Outside the U.S., as global inflation pressures begin to subside alongside warmer weather, higher inventories, and consequently lower global gas prices, the case for a slowing of rate hikes (and ultimately, and eventual rate-pivot) is building. Euro and U.K. IG, along with the front-end of rate curves, seem like hubs around which to anchor portfolios, given their historically elevated yields, and similarly low probability of loss as analogous assets in the U.S. The U.S. dollar may provide an additional tailwind. In a slowing economy, the USD is unlikely to strengthen further and may even weaken. The sovereign bonds of IG-rated countries like Spain, for example, offer the same yield as U.S. high yield when converted back to dollars! This provides investors an opportunity to upgrade portfolios and diversify internationally without giving up any income (see Figure 7).
The Polyurethane Portfolio
The flexible investor ought to know when to scale back into fixed income (FI), assuming they were able to avoid it in 2021-22. While yields in low quality FI look attractive on an absolute level, it is high quality FI that looks more compelling from a total return perspective – comparable not just to low quality FI, but also to equities. For example, Agency mortgage-backed securities (MBS) typify what we think is the investment environment for 2023, being a high-quality yield that is inherently short volatility. The asset class is currently in the 96th percentile of yield over the past 10 years. So, if MBS simply recovered to the 80th percentile of yield over the next year, it would translate to a 10% total return, more than the yield on U.S. HY, and in line with the average return in the S&P 500 over the last 30 years (Sources: Bloomberg and BlackRock, data as of January 23, 2023).
Quality yield, such as that in MBS, in an environment of possibly lower rate volatility in a slowing economy offers higher return potential than in prior years, less beta, plenty of liquidity, and, not unlike a polyurethane sponge, the ability for a portfolio to flex around what could be a long period of restrictive interest rates, while preserving its “shape,” in terms of principal and carry. This is a unique window in time to orient portfolios around lower risk assets that can deliver a solid yield with a fraction of that volatility.
Eventually, should riskier financial assets become less correlated with interest rates, as U.S. dollar strength wanes, and as volatility (including equity vol) subsides, it would make sense for investors to lean out of cash and back into more carry, and some higher levels of beta. While equity valuations in the U.S. are not incredibly compelling, the prices of call options have declined enough to afford investors the ability to capture some upside without having to spend exorbitant amounts of premium, and with a defined potential loss. Equities outside the U.S. do, in fact, have better looking valuations, with the same additional tailwind as their fixed income counterparts of the dollar looking like it has passed its cycle peak (see Figure 8). While non-U.S. economies are generally less flexible, in 2023 they have the potential for more stable returns given a more stable (or weaker) dollar, and a potentially large growth engine out of China given the abandonment of the zero Covid policy and its ensuing release of pent-up demand.
In portfolios today, it is possible to have a large allocation that seeks the return potential of high-quality income, while simultaneously accumulating assets down the capital stack that have more convexity, particularly in an environment where rate vol is coming down and central banks are nearing the end of their respective hiking cycles. A decent return could potentially be achieved with high quality assets alone. However, for investors that have a higher return target, and a higher tolerance for volatility, the polyurethane-like flexibility offered by high-quality fixed income can mean venturing down the capital stack and beyond the U.S. for additional beta risk, anchored and enabled by that generous allocation to quality income at home.