«It’s Likely Going to Be a Fairly Hard Landing»
The risk of a severe recession is rising, financial markets are going crazy. Stephen Kane and Bryan Whalen, Co-Chief Investment Officers at US bond giant TCW, share what risk indicators they’re monitoring in today’s unpredictable environment and how they’re positioning their portfolio for an economic downturn.
Sentiment is approaching panic levels. Following last week’s interest rate decision by the Federal Reserve, a tremor is shaking global financial markets. The benchmark S&P 500 index fell to a new low on Thursday and has lost 24% since the beginning of the year. Meanwhile, bond yields are shooting up. The strong dollar is hitting the global economy with the force of a wrecking ball.
For Bryan Whalen and Stephen Kane, the risk of a severe economic downturn is high because of the Federal Reserve’s aggressive monetary policy. The two portfolio managers jointly took over as chief investment officers at TCW from Tad Rivelle earlier this year. The Los Angeles-based firm is one of the world’s largest active bond managers, with $220 billion assets under management.
In this in-depth interview with The Market/NZZ, which has been edited for clarity, Mr. Kane and Mr. Whalen discuss recent market developments, what indicators they’re watching to navigate today’s difficult environment, and where they spot investment opportunities despite the great uncertainty.
«It’s easy for Fed Chair Powell to be hawkish and to say that there will be pain for consumers and businesses today when there is no pain. But at some point, it’s going to be much more challenging to hold the line»: Bryan Whalen (left) and Stephen Kane.
Mr. Kane, Mr. Whalen, turbulence is increasing. Especially in the bond and foreign exchange markets, there have been considerable shocks in the past few days. How do you experience the current environment?
Mr. Kane: In the pandemic, we were all talking about how strange the world was at that point, being locked down, wearing masks, and the uncertainty about what’s going to happen. But as crazy as things were two years ago, we’re in a completely upside-down world today as well.
So what’s in store for the next few weeks and months?
Stephen Kane: First of all, the highly synchronized nature of what’s going on is noteworthy. It’s not just a US phenomenon. What’s happening with interest rates and the Fed is going on in almost every single developed country around the globe except for Japan and China. It’s pretty easy right now for central banks like the Fed and the ECB to say: Let’s go after inflation, let’s go hard! There is no trade-off. Unemployment is low, and almost everybody who wants a job can find one. So it’s not very difficult to be hawkish for the central bankers in the here and the now. That’s also why you’re seeing this uniformity within every central bank in terms of voting members, all of them wanting to attack inflation aggressively. But at some point, it will be more difficult for them. There will be trade-offs.
Recent developments in the UK have shown how quickly things can get out of control. How do you assess the situation in the USA?
Mr. Kane: It’s easy for Fed Chair Powell to be hawkish and to say that there will be pain for consumers and businesses today when there is no pain. But at some point, it’s going to be much more challenging to hold the line. I’m not saying the Fed won’t be able to stick to their plan to fight inflation, but there will be a dilemma as slack builds in the economy, people begin to lose their jobs and unemployment goes up. The other thing, which is sort of basic economics and monetary policy, is they are fighting hard against inflation using inflation itself as a measure of what they are doing. But we know that inflation lags the economy, which lags monetary policy itself. That means they’re driving with the rearview mirror, and they are probably going to overtighten.
What will the consequences be for the U.S. economy?
Bryan Whalen: We feel that we will get a pretty severe recession. The Fed will get the job done on inflation, but probably with a lot more economic pain than what is being discounted in the financial markets today. It’s remarkable, the FOMC’s economic projections indicate a rise in the unemployment rate to 4.6% for next year. There’s a presidential election cycle coming up, so it’s no small thing for them to say the unemployment rate is going to rise 0.9 percentage points from today. It shows an unusual amount of confidence from the Fed in terms of staying the course to put that out in the market. If the unemployment rate starts rising almost a full percentage point because people actually are losing their jobs, they will be able to say: «We said this was going to happen. This was part of the plan.»
According to the Fed’s forecast, the key interest rate is expected to rise rapidly from 3.25 to 4.5% by the end of the year. Is this realistic?
Mr. Kane: Who the heck knows how much tightening it’s going to take for the Fed to bring inflation down? The policy rate is just one aspect of how monetary policy works. It’s really financial conditions that have a huge impact; what’s going on in the equity market, what’s happening in the credit markets in terms of credit conditions, and how consumers and businesses react to all these types of factors - basically, the reaction function to higher rates. Given what we’re hearing from corporations in terms of margin pressure and input cost pressure, it’s been really surprising thus far. They’re revising down their forecast almost across the board, yet initial claims and the employment are staying very robust. Of course, employment tends to lag because after cutting capex and various other measures, the last thing companies do is start handing out pink slips. But it’s still surprising that the labor market hasn’t shown any real signs of weakness. Then again, by the time that happens, it’s already game over.
Mr. Whalen: If I could only pick one indicator to predict where the Fed Funds Rate peaks at and for how long it stays there, it wouldn’t be the unemployment rate. I would probably pick the Goldman Sachs Financial Conditions Index or high-yield spreads. Either one of those is going to tell me what’s really going on in the economy, and how these aggressive rate hikes will eventually impact growth and unemployment.
By now, it’s obvious that the Federal Reserve is willing to put up with a mild economic downturn in order to get inflation under control. Why do you think there will be a severe recession?
Mr. Kane: We’re seeing very aggressive monetary action over a short period of time, and then there are lags. In other words, the economy and the markets have not even fully felt the impact of the first few rate hikes yet. It’s happening very quickly, and it’s happening across the globe. And then, you layer in the other things that are going on: We have an energy shock, we have a war in Eastern Europe. Regarding the energy crisis and the impact on the economy, Europe is facing conditions that are a magnitude worse than in the US. Given that all these variables are moving very quickly, chances of settling into some sort of benignly cooling-off environment are pretty low. The degree of monetary moves suggests that it’s likely going to be a fairly hard landing.
Mr. Whalen: There are some tea leaves: The steep drop in consumer confidence and shifts in spending patterns, meaning substitutions for cheaper goods. When Dow Chemical and FedEx tell me we’re going into recession, I put my money on these organizations that literally touch the consumer and businesses.
With sporting goods manufacturer Nike, another blue-chip company just warned of problems. In addition, stress is increasing on the financial markets. How great is the risk of an accident?
Mr. Whalen: If you would make the case for a soft landing or a nice shallow recession - if there is such a thing - one of the facts you would point out is that the banking system is in a pretty healthy position in terms of its capital structure. It’s still highly regulated, and asset quality is pretty good. Sure, a lot of banks are hung with some LBO loans and commercial mortgage lending that they have to get off their books. But it’s not like before the financial crisis where capital levels and the asset quality put the system at risk. It’s a little surprising: Financial conditions have tightened, but we haven’t seen hedge funds blow up, or the collapse of a foreign bank or some middle-market mortgage lender. That’s not to say there aren’t some cracks. There probably will be some accidents here and there, but we feel pretty good about the core money center banks in the US.
And what about the real estate sector? The rapid rise in mortgage rates is putting more and more pressure on the US housing market. According to the latest data, the Case Shiller Home Price Index recently declined sequentially for the first time since 2012.
Mr. Kane: The housing market is in pretty good shape. Heading into recession, housing variables are turning negative, and prices should follow, of course. But in terms of the lending and the default activity, we expect the housing market to be much better than in the last recession.
Mr. Whalen: We will probably see a recession in terms of housing activity, but that most likely will not contribute to a recession in housing prices. Although we’re generally cautious, we’ve added risk in high-quality areas of the mortgage market. Some of the parts, even the non-agency mortgage market, look incredibly cheap. We have confidence when we look at the equity value the borrowers have in their home, and we still look at very conservative underwriting standards. The sector is fundamentally sound, and where we are buying in the capital structure there is plenty of cushion to absorb even a more modest downturn in the housing market. So two of the areas we like are counterintuitive to what you would expect in a recession: Banks in the corporate sector, and the housing market.
And which segments of the bond market would you advise against investing in?
Mr. Kane: Even though there are rainy clouds where we are heading from a broad economic standpoint, we are actually seeing opportunity. Our portfolio doesn’t look that pessimistic in terms of how we are allocating capital, because some high-quality areas of the market are paying you very well to take on the recession risk. As mentioned, these are areas of the corporate market, and higher quality, senior parts of the mortgage market. Where we don’t think the market is paying you well is high yield.
Why?
Mr. Kane: The high-yield market hasn’t really adjusted; spreads are still around 500 basis points. Every time you’ve looked at past periods of either financial stress or recessions, high-yield spreads are usually at least double where they are today. That’s why we are really careful in our allocations there. Emerging markets have re-priced a little bit more than US high-yield. But not enough in our opinion, given that they face even greater fundamental challenges than the US. De-globalization and the tightening of financial conditions tend to hurt EM much more than developed markets.
Emerging markets are particularly hard hit by the strong dollar. But they should benefit all the more if the dollar weakens in the wake of a recession in the U.S., shouldn’t they?
Mr. Kane: Yes. When monetary policy switches, and the market begins to anticipate it, basically you will see a lot of the mirror image of what we’re seeing today. You will see the dollar wrecking and the yield curve steepen. When that happens, we also think high-quality spreads in the agency mortgage market, and areas in the corporate bond market will begin to perform very well. You will see equities probably perform well too. So the key question is how long this cycle is going to go on.
Mr. Whalen: When you look at where the world is today, there are so many reasons to like the dollar, and it’s all reflected in the value of the dollar. It’s all in there. And, every time something is at an all-time high, you should be hearing from us that it’s probably time to start trimming, to start moving in the other direction. That’s not to say the dollar can’t strengthen a little bit more, but it has certainly run the majority of its course.
So when will the «pivot» come, the big turnaround in monetary policy?
Mr. Whalen: We know, but we can’t tell you. Now seriously: I don’t have a time frame, but as I said earlier, it’s all about the financial conditions, because the US economy is so tied to asset prices and valuations. So when the stock market and high-yield spreads crack, and crack hard, that will be it. The Fed may not come out that day or that week. But you will start to see the yield curve put in more of a traditional kind of bull steepener, as the markets start to anticipate both the timing and the magnitude of the rate cut.
Stock markets in the USA fell to a new low this week. Spreads on high-yield bonds, on the other hand, are still below the high they reached in early July. Why?
Mr. Kane: Some of the things that are supporting the market are good technicals like the lack of supply. Basically, there hasn’t been hardly any issuance this year. We’re in this period where high-yield companies are able to not tap the market, but that can only last so long, since they need to roll their debt. What’s more, energy is a big component of the high-yield market, and the energy sector has been well supported fundamentally in terms of cash flows. But generally speaking, even if defaults go up only from around 1% to 3% - which would be a very benign environment - it’s hard to imagine that high-yield spreads won’t widen significantly when financial conditions continue to tighten and the economy is slowing down.
So where are the biggest weaknesses in the junk bond market?
Mr. Kane: Some of the companies that are percolating are the ones that are disproportionately impacted by the pandemic like AMC. We’ve already seen two defaults in the movie theater business. American Airlines has a high probability of defaulting. That’s a very levered airline, and we don’t expect air travel, particularly on the business side, to come back in any way. In the cruise lines area, a few names are likely going to get hit as well. Furthermore, the retail washout has been ongoing for a while, and there will be a few defaults more for sure.
We are hearing more and more warnings that liquidity is drying up in the bond markets, even in the US treasury market. How serious is the situation? Do you notice this in your day-to-day business?
Mr. Whalen: Liquidity is incredibly shallow. It’s like when somebody is diving into a pool and the water is only about ten inches deep. We’re seeing things moving around, but in the treasury market and the agency mortgage market, anytime you really try to move some size, liquidity is just not there. It’s been incredibly poor, and it will only get worse. In this context, we generally think the market underestimates the impact of quantitative tightening because investors can’t wrap their heads around it. Some estimates suggest that the impact of QT - basically getting the Fed’s balance sheet down under 30% relative to GDP - should be the equivalent of about 75 basis points of rate hikes. But we will see.
How high do you rate the risk of a liquidity squeeze?
Mr. Whalen: Because of regulations like Dodd-Frank and Basel III, we could have an interesting environment in the capital markets where liquidity is so bad that the Fed has to continue tightening on one hand in regard of the Fed Funds Rate because of inflation, and on the other hand providing the market with some sort of these 13(3) facilities to keep the plumbing of the financial system working. In other words, they could actually be pushing on one hand and pulling on the other, which could be quite interesting.
As you mentioned at the beginning, interest rates are rising not only in the U.S. but basically around the globe, especially in Europe. Could this lead to a new edition of the debt crisis?
Mr. Kane: That’s a tough call. It comes down to the strength of the unity of the Eurozone and the EU in general. During periods of crises like today, the unity usually is pretty strong, and that’s been the case so far. Yet, we do distinguish between some of the periphery countries. For instance, Italy we’re not comfortable with. Just like Greece years ago, their debt is not sustainable absent a backstop by the broader EU. So you’re playing a little bit of a game of chicken. In effect, you’re betting on the EU bailing out Italy. We’re not comfortable with that risk. But to some degree we trade Ireland, Portugal and Spain. At times, we’re long and then a little bit short, depending on where spreads are. We do see that as an opportunity. For instance, we’ve added a little bit of Portugal’s debt in the last few days.
Mr. Whalen: Given the lack of clarity on the ECB’s anti-fragmentation tool, the energy crisis, and the dark winter that’s coming on in Europe – no pun intended - a stagflation scenario is certainly in the cards. Against this backdrop, there is a lot of room for Italian spreads over Bunds to move up. You can have a belief that Europe will stick together, even in the peripherals, but that doesn’t mean you’re not going to have hundreds of basis points of spread widening from today, and who knows where that spread eventually ends up.
Any final thoughts you’d like to share?
Mr. Kane: In most of our careers, we had these long economic cycles where things played out barely, although you had a financial crisis and other shocks. Given the volatility created by the pandemic and the policy responses, we’re in an environment where we are seeing that this cycle is going to be very quick. We saw a sharp contraction, a big recovery, and now we’re likely going to see economic volatility in addition to the interest rate volatility.
