In this episode of Markets in Focus

No one thought 2022 would be easy, but the war in Ukraine, with its shocks to global energy and commodity markets, has made taming inflation even harder. James Camp, CFA, Managing Director of Fixed Income and Strategic Income at Eagle Asset Management, shares his perspective on credit and equity markets, the “creative destruction” rippling through the U.S. economy, and how the U.S. Federal Reserve doesn’t have any good choices, just “the lesser of many evils.”

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Transcript

Matt Orton:
Inflation has been top of mind for investors and consumers alike as well as the Federal Reserve, which has embarked on a more aggressive tightening campaign, but one that many have argued still might not be enough. Unfortunately, the withdrawal of historic monetary accommodation has coincided with the slowdown in economic growth, both here in the U.S. and abroad. And as a result, we've started to see a shift in the market narrative. Underlying concerns have now moved from a singular focus on inflation to also including a growth slowdown with recession probabilities increasing quickly over the past month or so. All of these dynamics have led to rapidly tightening financial conditions, widening credit spreads, and increased cross-asset volatility: Basically a cocktail of negative conditions for both equities and fixed income that has been playing out pretty spectacularly this spring. So how should investors navigate this changing narrative and where should you be looking for opportunities in a pretty confusing market environment?

To help answer these questions, I'm very happy to welcome back James Camp, who's the Managing Director of Fixed Income and Strategic Income at Eagle Asset Management.

This is Markets in Focus from Carillon Tower Advisers. I'm your host, Matt Orton. Join me and my colleagues as we discuss the latest trends in developments driving the markets. Visit us at marketsinfocuspodcast.com for additional episodes and insights. James, thanks for joining me again.

James Camp:
Matt, great to be with you.

Matt Orton:
So let's start things off on the subject of inflation. We've recently got some pretty ugly May inflation data, and I would say even worse inflation expectations data, and it's clear from all of that energy and food are a massive problem. But core inflation might be showing some signs of perhaps peaking. And going forward, what do you think drives inflationary pressures and what can the Fed really do to influence this?

James Camp:
Well, Matt, you lay out the scenario very well, and it is going to be a challenging period. We expected the first half of 2022 to be just this challenging, but we have exogenous events that have exacerbated it. Obviously the war in Ukraine, the energy issue, et cetera, as you mentioned. But the Federal Reserve at this moment really doesn't have any good choices. They have the lesser of many evils. And job one, two, and three in our opinion, is inflation and trying to get inflation under control. As we know, inflation is a massive regressive tax. It affects disproportionately those in lower and middle incomes as everyone pays the same amount for a loaf of bread or a gallon of gasoline. And it has now moved really front and center into the political landscape.

If you recall back in the fall of 2021, the president basically said inflation is the Federal Reserve's problem and they need to get a handle on it. Now, Chairman Powell was very slow on the uptick. He tried to hold on, I think, incorrectly, and he's being proven incorrect on the transitory narrative and inflation has taken a firm hold. To be sure, the May data was a bit jarring because many forecasters believe, because of a combination of base effects and other things, that we begin to see the peaking or at least the peaking process. So I think that singular data point was jarring and almost on a dime, it changed the narrative both at the Federal Reserve and in the public discourse.

Now, what can the Fed do? They control short-term interest rates, but through the transmission mechanism of aggregate financial conditions, they can make things very tight very quickly. And to exactly your point, that's what's happening. When we speak of credit conditions, it isn't just short-term interest rates. It is things like the spreads that corporations pay to issue a bond. It is the fact that many of the equity markets, the Nasdaq and now the S&P 500, are in correction, bear market, pick a title. And so equity issuance is down. So any company that is thinking about expansion, that is thinking about doing things for productivity enhancement, and needs to tap the capital markets, the vise just got very tight on all of that.

So over and above moving short-term interest rates, the entire landscape for the capital markets, just as you mentioned, has pivoted, it has tightened, it has gotten more difficult, and it has become a very bad backdrop for risk assets. On top of all of that, remember that when we have these periods of ultra-low interest rates, leverage creeps into the system. And part of this experience now is a lot of the speculative things sort of being wrung out. And we'll probably talk about that a little bit later, but to be sure inflation is an issue. It is late on the uptick from the Federal Reserve to get in front of this. We're going to have some front-loaded rate hikes through probably September, and then we're going to have to watch the data. But remember, this period was like no other in terms of our economic history. We had a recession largely of choice. Obviously not to be dismissive to the incredible medical suffering and the emergency that we had in healthcare in the pandemic, but we sent folks home and we stimulated. So we simultaneously crimped aggregate supply and pulled forward aggregate demand. So this result really should not be surprising.

Matt Orton:
Yeah. James, I had a pretty bleak picture in some respects. And the one person I definitely wouldn't want to be right now is Jay Powell. It's interesting, because in his messaging to investors he's having to contend not only with all of those issues that you've laid out, but also what I would say is a pretty unprecedented panel of former Federal Open Market Committee (FOMC) members who are just squawking from the sidelines. They're in the media practically every single day. And on top of that, you've got a heightened political environment heading into an election year. So do you think that this plays into the ultimate Fed reaction function because they are supposed to be independent and does it create the potential for a policy mistake?

James Camp:
You're a kind person. I think you're a little more generous to Chairman Powell than I might be. But fair enough, he has a very difficult hand. But in large measure, some is self-dealt. This is an issue that I think was a reasonable thing to anticipate. I look at ex-Fed governors a little bit differently. I think there's a little more candor that comes out of them to be sure it does put pressure on the existing Fed members, and I'm quite certain it's not comfortable, but there's a little more candor that oftentimes it comes out of the Fed. But to the conversation about political pressure, if you will, you'll make no mistake: This Federal Reserve, really since the post-financial crisis, has had reaction functions that in my opinion have been different than the dual mandate of maximum employment and stability of prices. It has been a largely a market animal. What I will tell you today, Matt, is that reaction function to support markets when they have a hiccup has absolutely been thrown out the window and it has been overtaken by the need to get inflation under control.

If you remember, Chairman Powell in 2018 was talking about “all systems go,” the economy on all cylinders. We need to tighten. The 10-year was at about the level it's at today. Stock market corrects in December and the Fed stands down. The difference now is we are in a regime change. That's the comment that we've been making for a while now on my team, is that this is different. This is reflation. This is inflation. The tools and the things that the Federal Reserve needs to do are going to have to be targeted on price stability first and foremost, and the market reactions are going to take a backseat at least for the time being.

So to be sure, there's a lot of conversation about what the Fed should be doing. There is clearly the need to get the inflation narrative under control, both from the Federal Reserve and from the body politic. I think it is probably for this go-round at least in this cycle, a losing proposition by our measures. Even if we were to hold inflation at zero month after month after month, we are early into 2023 before we even get to a 4% price deflator or CPI level.

So all of that being said, this can be productive. In other words, when we have low interest rates, we have speculation, we have some financial activity that is non-productive or suboptimal. These moments sort of reorient the capital markets to quality, to value, to companies that are embarking on good pricing and good capital expenditures, good productivity-enhancing activities. So as painful and as disruptive as it is, the status quo up until this moment wasn't going to hold. The simple idea that we could have checks being sent, stimulus to infinity, and 0% funding costs was not going to work. And I think inflation is that natural economic governor that says, "Hey, folks. Wait a minute. Let's level this out." And that's the transition that we're going through right now.

Matt Orton:
Yeah. I think that's a great way to explain it, James. And you mentioned something. You mentioned regime change. And I think that's important to contextualize some of the pretty dramatic moves that we've seen this year. Credit spreads have widened considerably, financial conditions are tightening at an exponential rate. And all of that is feeding into this negative growth narrative that's depressing the market. Is there anything that is especially concerning you specifically within credit right now because that is so important to the ultimate health of equities in the economy?

James Camp:
Well, actually we're quite heartened by the fact that credit spreads are widening because by our way of looking at things, in most of corporate America – we're talking about the spaces that we're active in: the double B, the triple B, and up – corporate balance sheets are in very, very good shape. We're not uncomfortable certainly with anything that we might invest in on behalf of our clients in terms of our credit metrics and what we see going forward, but a more relaxed pricing to me is indicative of a couple things. One, as you mentioned financial conditions are tightening, but there's also this moment of self-fulfilling de-leveraging that happens in the capital markets. If you think about the worst bond market to start the year that we've had in 30, 40 years in terms of total rate of return price movement, the yields have gone up, the spreads have gone wider, both have conspired to make corporate bonds in particular, have a very rocky start to start the year. There is a lot of passive investment that self-liquidates. It has redemptions, it has things that they have to sell. So liquidity in the credit markets is very poor. That does not mean credit quality is very poor.

To be sure, you have to be selective. I think you can focus on the higher-quality investment-grade or the higher quality in the high-yield area for yield, but these yield ratios or these yield spreads combined with the fact that the 10-year Treasury, the five-year Treasury have all moved significantly higher are starting to get to points where, actuarily speaking, or even for total return investors, you're starting to hit those draw-down targets that many of our clients are looking at for long-term rates of return. So to be sure, a slowdown is going to put problems on certain credits. If we do have a recession, we are going to have companies struggle to refund; higher rates beget more challenges because companies have to roll debt. And that's why it is so incredibly important to know what you own in terms of your portfolio, especially in the debt markets.

Matt Orton:
Yeah. I'm glad you brought that up, James, because I think that's an important point that investors are being more discerning. That there's still appetite, but selectivity has increased. So are there any specific opportunities that you and your team are finding right now in the markets or that you're hearing clients might be interested in?

James Camp:
Well, the most important thing is the intermediate part of the Treasury curve has moved well in anticipation of the Federal Reserve. So from a duration standpoint, you don't have to take a lot of interest rate risk to capture the majority, if not even more because of the way the yield curve is configured of the yield that is available in the Treasury market. We are finding a lot of generous yields, not only in the Treasury market, in selective corporate credit, and particularly in the municipal bond market, which I know we're going to talk a little bit about, but that has provided a great deal of opportunity. Not because any municipality's credit has gone under or even gone down. In fact, COVID in the stimulus sort of paradoxically has made municipal credit actually quite good, but we've had these mark-to-market phenomena because of liquidity de-leveraging and rate movements that have actually opened up windows of very good opportunity, particularly for tax-free investors.

On the equity side, the dividend stream is coming into favor. The growth rates are still very good, particularly in our portfolios. The yield advantage is less than it was relative to bonds. And that's why we make some tactical asset allocation choices. But I think quality and I think the return of some sort of economic return in the form of a cash flow, be it a coupon payment, or an interest payment, or a dividend payment, a dividend growth payment, is going to be something clients are really going to want to know that is there, that is growing, that is compounding. And the more aspirational sides of the capital markets, the more pure growth, momentum growth necessarily fall out of favor when rates go higher and they also become more vulnerable. Again, I can't overstate how much financial leverage creeps into the market in sort of a stealth fashion when rates are very, very low. And many of these areas that are equity-rich, but cash flow-poor are selling and de-leveraging as the funding costs and the market corrections happen simultaneously.

Matt Orton:
All great points. So I do want to dive into municipals because you mentioned that. And so you had mentioned that munis had been hit pretty hard this year. And I think they've had 20 consecutive weeks or more of outflows. And like you said, we're starting to see a rebound. Crossover buyers are starting to enter the space. You mentioned a couple of opportunities. Do you think the rebound in municipals can and is likely to continue in this sort of market environment?

James Camp:
Yeah. Matt, thank you for that. And in fact, your 20 consecutive weeks, I think maybe actually 23, maybe 24, we did have a very good month in May in the municipal bond market. We are setting up for a seasonal period of strength in July because of some redemptions in cash flow payments into products. The simple truth of the municipal market is it's highly retail. And the retail investor, the individual investor oftentimes lacking really good counsel, which is why it's so important for our advisory channel and the work that they do, will often do something counter to their best interests when rates move particularly higher. You can almost watch the flow of funds moving coincidentally through history with rates moving higher and higher.

So what you see is a self-fulfilling mechanism where the passive vehicles, the mutual funds, you wake up with what I call the parenthesis effect. You see a mark-to-market quarter down and folks hear this narrative of higher rates, higher rates, got to get out and ultimately puts a lot of selling pressure into the market. And so what that begets for separate account managers is really good buying opportunities. Now, you have to be patient. Will the municipal market snaps back or recovers all the losses in the next month, two or three? Perhaps not. But on a tax-equivalent basis, the yields that are being offered in the municipal market for credit that is actually improved over the last couple years, are historically very generous. We tell people dollar-cost averaging is always an evergreen idea. Use the separate account platform, if you can, to own individual bonds, or even if you're using a bond trading desk like we have to populate your own portfolios, all very, very good options, but these are the kind of yields, if you think about, Matt, just two years ago, two or a quarter years ago, we had a 10-year Treasury at 0.4 basis points. We are getting taxable equivalent yields and munis in excessive 5% now. So it's kind of good news, bad news in the rate market. Sure, the mark-to-market over the last quarter has been challenging. Most municipal bond products or either laddered portfolios or active management will have a portfolio that is not simply bulleted or terming in five or 10 years. It has cash flows and terms that roll throughout the period. And interestingly, if you do the math over a long period of time, and let's call it 10 years or 20 years if you're a retiree with a long hopeful lifespan, that reinvestment rate is actually better than had we had a slow move higher in interest rates that we sort of had to rip the bandaid off moment because all of the opportunity set on a go forward basis just got that much more generous.

Matt Orton:
I think that's a great point for all of our listeners to bear in mind. It’s just the opportunities that are created as a result of what we're seeing happen in the market. I want to touch on before I kind of ask you one final question on the big R word, recession. But before we get there, I want to touch on credit one more time because I think credit and equities are so intertwined and I'm sure many of our listeners are invested in both asset classes, but I've posited that in order to see the lows in equities, you have to see credit spreads at least stop tightening or the pace of the highs in credit spreads or widening stop. Do you think we're there? Do you think there's still more to go? How do you think about that going forward?

James Camp:
Well, there's two things to the credit spread conversation and the recession conversation that I think will follow. We're nowhere near where triple-B spreads would need to be, to be a recessionary indicator, though I have some concerns about a slowdown and perhaps that we will have even a mild recession. The Federal Reserve is in full demand destruction mode. There's no elegant way to say that. They have one option right now and that's the slow aggregate demand to get the inflation back under control to let supply chain get back up to where consumption is.

There's a few ways that can happen. One is we rotate. We rotate from consuming things to consuming experiences, and there's some evidence that that's happening. But I do think corporate bond spreads widen and I think all risk assets stay vulnerable here. I don't think they become unhinged because I don't think underlying credit quality is the real issue here. I think it's a liquidity de-leveraging phenomenon. So I think you're absolutely right that there's an inner relationship, an intimate interrelationship. I've been doing credit conditions, corporate bond spreads in the equity markets, and I don't think we've seen the absolute wides on investment-grade or high-yield credit. I think we're approaching that. I think we're at sort of peak risk-off, if you will, sentiment in the market right now. I think we're probably not going to get corporate bond spreads to recessionary levels over the next quarter or two.

Matt Orton:
Now, thank you for that, James. Sentiment like you had mentioned, peak risk-off sentiment, I think you definitely can see that with the worst University of Michigan Consumer Sentiment Survey since the metric started in March of 1978. So worse than the Global Financial Crisis (GFC), worse than the COVID lows. So let's use that to transition to the discussion of recession. Looking at the market and just listening to the news on a daily basis, it seems like it's almost a foregone conclusion that a soft lending is off the table and we're heading for some sort of recession. Do you think a soft landing is achievable? And do we need to throw the economy into a recession to really put the inflation genie back into the bottle?

James Camp:
Well, Matt, I'm of the belief that inflation is one of the most punishing things that you can overlay on an economy. I think that's been proven through economic history. And I do think the Fed has to break something and I do think that they have begun that. You've seen massive wealth destruction, if you will, in some of the more speculative-type investments, quote unquote. And I think the Federal Reserve has presented a case that they get it now, that they are going to be more aggressive and perhaps even overshoot. And when they do that, you know recessions don't necessarily come because of time or just chalking off the calendar. They often happen because policies overshoot. And I think we're at that moment where that's highly likely, because this fever needs to be broken. But what I will tell you, Matt, is it would not surprise me that if we are in mid-2023 and the economy still is muddling along, maybe we touch a mild recession, these policies, this spring that we're loading up with these hikes that are going to continue could be unwound very quickly.

It has always been my assumption in my sort of thesis that COVID compressed time economically. It may have expanded time in all of our lives. It felt like Groundhog Day, day after day, but from an economic perspective, it compressed time. We had the fastest drawdown in history. We had the most rapid response in history. We then had the biggest demand supply imbalance and inflation spike since the '80s. And I think what we're going to see going forward – and I think this is where I'll answer your recession question – what does the labor market look like? When I talked about 2021, I said inflation will be the story. It will either show up or it won't. And that sounds sort of tongue in cheek, but my premise was it necessarily has to show up because if it doesn't, we are going to continue down an economic policy path that to me was completely unconstructive for wealth creation and taking care of folks. And that is things like MMT (modern monetary theory) and QE (quantitative easing) to infinity. But what the story is now is we have 11 million jobs open, we have 5 million unemployed.

We have mismatches all over the economy. This is a moment of creative destruction that happens in economies, where we retrain, we redeploy, we rethink. We rethink how we engage with our labor force, we rethink how we work. And COVID has compressed all of that narrative from maybe a five-, 10-year phenomena to two years. So we're dealing with all of this simultaneously. And maybe I'll be a little more forgiving than I should be to policy makers. This is not easy, but I do know the American economy is incredibly resilient. I know capital expenditures are accelerating. We have productivity gains that will follow. I know that the consumption is rotating to more experiential things away from stuff, and that will help the inflation, but I do watch the labor markets because so many of those signals are so confounding and so confusing and I think that's just indicative of the moment.

So I might argue that, yes, Mr. Powell has a very hard job. I think people that are in the HR world and people that are hiring managers and people that have to manage this incredible sociological transition, this is going to be a real test and those that do it well are going to thrive and those that stumble are going to have trouble with margins, they're going to have trouble with keeping talent, and all of that. So I think that, from a real fundamentals of the economy, that's the story that's most interesting going forward.

Matt Orton:
James, I don't think that could be better said. And I think that's an excellent place to leave the discussion since where we're running out of time. But thank you so much. I think this was really engaging and great perspective for all of our listeners. So thank you. And we'll definitely have you back for a follow up to see where we go. And thank you to all of our listeners for tuning in as always. And until next time, take care.

Thanks for listening to Markets in Focus from Carillon Tower Advisers. Please find additional episodes and market insights at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple podcasts, Spotify, or your favorite podcast app. Until next time, I'm Matt Orton.