Credit market dynamics and the case for a soft landing

Rick Raczkowski, Portfolio Manager, Relative Return Team, Loomis, Sayles & Company

How do you expect the easing cycle to unfold from here?

Yeah, the Fed certainly started its easing cycle with a bang with a 50-basis point cut. And we think that this signals that the Fed really thinks that inflation is under control and is now shifting to the employment side of its dual mandate.

We're not expecting any additional 50-basis point cuts in the near term. And in fact, Fed Chair Powell has pushed back on this idea by saying the Fed is in no rush to start an aggressive easing cycle.

So what will we be watching? Well, of course, the monthly inflation reports; consumer price index; the PCE, which is the Fed's preferred measure. And in particular, we're going to be looking at the housing component. Housing has been one of the biggest drivers of inflation in this cycle. Now, we've been encouraged by some of the real time rent data which has been coming down, and that flows through the inflation gauges with a lag. So we'll be looking to see that these real-time rent measures continue to come down and don't re-accelerate.

As far as the economy, it's going to be all about the labor markets. And we saw that with a strong September employment report. That caused the market to really reassess its expectations for Fed easing through the rest of the year.

Where are we in the credit cycle?

We believe we're in the late expansion phase of the credit cycle. The economy remains healthy and corporate and consumer balance sheets are in good shape. However, we think the best may be behind us. We're still feeling the lagged effects of prior Fed hiking, and that's starting to show up in some stress among lower income consumers and small businesses.

That said, we're not expecting a downturn anytime soon. Our base case is for a soft landing, where the economy slows but does not fall into a recession and inflation comes down fast enough for the Fed to continue its easing cycle. We do think, though, that the risks are tilted toward the downside, more toward slower growth, slower inflation, and a Fed that has to be more aggressive rather than a hotter economy, faster inflation, and a Fed that's on pause or starts to reconsider maybe hiking again.

Our base case of a soft landing should be supportive for risk markets, but we don't believe that credit markets in general and spread markets are fully compensating investors for the potential risks that are out there, in terms of where the credit cycle could evolve to.

How are you currently thinking about duration?

We think duration makes sense in the current environment. For example, duration works in our base case of a soft landing, where inflation comes down and the Fed continues to ease. And duration also works in more negative scenarios of a downturn or a growth scare.

Now, duration won't work in a situation where inflation is rising and the Fed begins to pause its monetary policy. However, we put a relatively low probability on that scenario.

As far as curve positioning, we think the best opportunities are in the 5 to 10-year area of the curve. We think this offers good yield and also enough duration to provide a buffer against more negative economic scenarios.

Where are you currently seeing opportunity?

There's always opportunities in fixed income markets and we're finding them in a few places now. As we talked about, we think duration has good risk reward in the current environment. Credit markets, broadly speaking, we think are fair value at best. Technicals and fundamentals of credit markets remain strong. We just don't think the current level of spreads, which are quite narrow, are fully compensating investors for the range of outcomes that we expect for the credit cycle.

That said, we are finding opportunities. In high yield, for example, we're finding opportunities in some shorter duration high yield. In investment-grade credit although spreads are tight, we're finding some opportunities in financials. In securitized markets, we like CLOs. We think here, you're getting a good combination of yield and some potential protection against rising rates.

We also like certain securitized credit markets such as autos, equipment rentals, and aircraft leasing. Here again, we're staying up in quality, but we're picking up yield over generic investment grade corporates.

Globally, we're also finding opportunities in some foreign currency markets in Latin America, such as Uruguay, Mexico, and Brazil, where we're getting 9% to 10% yields on government bonds there. And we think those positions should continue to benefit from global central bank easing, as well as recent stimulus measures by the Chinese government.