Please ensure Javascript is enabled for purposes of website accessibility Navigating Rates and Inflation - Janus Henderson Investors

Navigating Rates and Inflation

John Lloyd

John Lloyd

Lead, Multi-Sector Credit Strategies | Portfolio Manager


John Kerschner, CFA

John Kerschner, CFA

Head of US Securitised Products | Portfolio Manager


Jessica Leoncini

Jessica Leoncini

Head of Fixed Income CPM Management


27 Jan 2022

John Lloyd, Co-Head of Global Credit Research and John Kerschner, Head of US Securitized Products, provide some thoughts on the Fixed Income markets and dive into one of our portfolio solutions that we believe is suited for this environment.

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Navigating Inflation and Rising Interest Rates

Thanks, Jessica and thank you everybody for joining us late on a Friday. And congratulations to everyone on this call for surviving, which what I will say is going to be the highest inflation print that any of us will see for the rest of our careers. And you may say, “Whoa you know, inflation is high.” It 6.8% this morning, but it continues to seemingly go up. The reason why I think this will be the peak is for two main reasons. One is oil and energy prices have continued down. I haven’t seen that at my local gas station. I’m still paying close to $4.50 for premium gas and like I said that has not gone down. But oil prices themselves have gone down from about $85 a barrel to $71 a barrel and that decrease in oil prices has yet to be reflected in the CPI numbers but will do so next month.

Additionally, what a lot of people don’t realize is that housing prices are starting to go down. And in fact, the month-on-month increases in housing prices nationally have been cut in half from about 1.85 back this past summer to .96 right now. And so for an annualized number, you could just take that .96 and multiply it by 12 and you would see we’re still at very high levels in home price appreciation, but home price appreciation has come down a lot and we believe it will continue to do so and so that will feed into the CPI numbers as well. So that being all said, inflation still seems relatively high and bond yields surprisingly enough, actually seem relatively low. 10-Year Treasury is still below 150 basis points. It tapped out earlier this year at about 175 basis points and the 5-Year Treasuries only about 125 basis points. So you may ask, “John you know, why is that? Why do we have close to 7% inflation even if this is the top and yet bond yields are so much lower which translate into a negative really of which is just taking the bond yield out the headline bond yield and subtracting the inflation rate?”

And the real reason for that is very simple, is that bond yields or bond prices don’t necessarily react only to inflation. They react to what the Fed is going to do with the Fed funds rate. Now we have a Federal Reserve meeting coming up next week. At that time, we do think that the Fed will cause an increased rate of taper of its buying of mortgage-backed and Treasury securities. The taper of people don’t realize as part of quantitative easing for that started in March of 2020. The Fed increased these types of securities, agency mortgages and treasuries onto its balance sheet. It has bought those since that time and as of last month, it started decreasing the amount of buying it was doing every month. That does not mean that it’s selling out of its balance sheet, it just means it is buying less each and each month.

Now we believe next month, it will even increase the rate of that taper so that by somewhere around March of 2022, it will no longer be buying any of these securities at all. Again, it won’t be selling, just won’t be buying and so that its balance sheet, this graph’s a little bit old here because it shows you know, the line going up into the right. It actually will be leveling off. Why is that important? Because the Fed has explicitly said it does not want to raise interest rates until it’s done with the taper. So that’s why we think that the Fed will be increasingly amount of taper so that sometime mid next year, it can start raising interest rates.

Now you might say, “Whoa, that’s you know, very important when the Fed starts raising interest rates, usually that means that stocks have issues and also that bond yields go up and if people that have taken a bond class know if of bond yields are going up bond prices are going down.” Well what is more interesting is what’s actually priced into the market as far as Fed rate hikes. And currently only about three hikes this year and then three more hikes next year are priced in. So that would get the Fed funds to about 150 basis points. Now, what you’re seeing here on the slide is the FOMC dot plot projection. We actually think the market has it right. The dot plots have it wrong as in too high and that the Fed will raise rates in 2020 to two or three times make sense to us, but that the Fed funds rate this time around, will not get any higher than probably about 150 basis points. And the reason why we think that is simply because last time when the Fed raised interest rates, yes it got up to 250 basis points, but they probably went too far too fast. Anybody that remembers December 2018, the stock market had a very tough time simply because the market was telling the Fed, “You’ve raised rates too far. It’s time to cut them,” which they subsequently did. We think this time the economy’s actually in an even worse place and so by the time the Fed gets to 150 basis points on the Fed funds rate plus or minus, that the market will be signaling that’s enough. And that is why that rates 5-Year at 125, 10-Year just under 150 are where they are.

So what does this mean for you and your portfolio? Rates may go up some from here, but we don’t think it will be substantial. Maybe rates go up to 175, worst case maybe 2%, but we don’t, we do not foresee a 2% or a 2-1/2%, 3% tenure or anything like that. Now I will pass on to John Lloyd to talk a little bit more about this portfolio.

Thanks, John. So hopefully with that overview, you get an idea of why this Multi-Sector Income Fund that we co-manage, might make sense for your portfolio. I think right now, income is very important to a lot of people and this is a portfolio where again, we’re using our best ideas in fixed income. And the way we do that is by using a large amount of diversification within the portfolio in all these different fixed income asset classes you see below. And so you might say, “Well, that all sounds great but you know, where are you seeing opportunities?” Maybe if you’re watching CNBC or reading the Wall Street Journal, you might hear how spreads are very tight, that you know, given all the Fed’s support to this economy, that there isn’t much opportunity out there and really, it’s just the opposite from what we’re seeing on a day-to-day basis when we’re getting involved in and looking at individual issues in the bond market.

I won’t go through all these sectors because it would just take too long, but let me just point out as far as CMBS is one of our favorite sectors. CMBS stands for Commercial Mortgage-Backed Securities, so the big sub sectors of CMBS are office, retail, lodging, multifamily warehouse or industrial, self-storage, etc. It’s pretty much all commercial real estate out there. One of the nice things about CMBS which a lot of people don’t realize, is a lot of these loans are made on a floating rate basis instead of a fixed coupon which will get hurt if interest rates rise. Hurt, meaning the bond price will go down because the coupon is fixed. On a floating rate security, that interest that we get or that coupon we get, tends to change every month. So if the Fed raises interest rates, that means that our coupon on the security will go up in tandem and so that’s obviously advantageous in this type of environment where we think the Fed is going to start raising rates.

Secondly, you might say, “Well, I’ve heard a lot of bad things about malls and retail and maybe even about lodging because business travel is going down and maybe even about office,” right? Because so few people are going back to the office on a full-time basis. What does that mean for long-term trends of office? All these things are true and it’s a very, very small part of our portfolio, any of those sub sectors. What we really like is multifamily and industrial. That makes up probably about two-thirds of our CMBS portfolio. And the reason we like multifamily is bottom line, we’re just not building enough shelter in this country, particularly of affordable nature and that’s really where multifamily comes in. And so if you look at the trends on multifamily, the amount of occupancy is at near all-time highs, rent increases are going up around the country. It’s just a very solid time to be a multifamily or an apartment landlord. And the reason why is because people are very concerned about shelter and they’re optimizing their shelter and again, we’re just not building enough multifamily. I don’t know of others have had this experience but where I live in Boulder, Colorado, they continue to try to build more multifamily properties and there’s a lot of nimbyism that stands for “not in my backyard,” meaning the developers have to go through all sorts of hoops to try to get these properties built. It takes years upon years and a lot of these communities just tend to shut down construction because they’re worried about traffic and you know, pollution and noise and all those things. So we’re just you know, we don’t have time to dig into the numbers, but we’re just not building enough multifamily properties out there. And because of that, the fundamentals of that sector are strong.

Secondly, industrial. I think what we’ve all, what we know is that we’ve all been ordering more and more things online since this COVID outbreak. What’s even more interesting is there a lot of people that had probably never ordered anything online in their life and they were forced to because of COVID. And that’s really where all these well, where lot of the supply chain issues are coming from, just when you had that incremental demand for online ordering and what that meant for shipping and what that meant for intermodal transportation, shipping to trucking to rails, what that meant for distribution. Our system is just overloaded right now. That will mitigate itself over time. But right now, you cannot build industrial properties fast enough for the Amazons, the Walmarts, the Targets of the world. And what’s even more interesting is let’s just say you go to rural Pennsylvania where a lot of these warehouses had been built because they’re close enough to the big city centers of DC and New York, those communities have had up to here with all the truck traffic and whatnot from these warehouse facilities. And they’re saying, “We don’t want any more of those.” So even in locations where you think it would make a lot of sense to put these industrial properties, developers are having a harder time finding space for them. And so what they’re resorting to is building infill locations in places like Brooklyn and Queens outside New York City, and they’re having to make them two story like two level, incredibly expensive to do that because you got to build bigger ramps and more reinforcements of the floor plates. But that’s what they’re willing to do in order to keep these industrial properties closer to their end user. Again, demand is way over supply and so we love that sector.

And then a final sector we really love is what we call Life Science Office. This is Big Pharma lab space and so it’s a very niche sector but yes, you can go out and buy CMBS deals that are backed by this. There are nodes of these areas throughout the country. A big one is in Cambridge, Northern Virginia, Austin, San Diego, parts in Silicon Valley. These companies, Big Pharma, want to be close to the big universities, close to the educated workforce. What’s really interesting about these, you can’t just take old office that have been emptied out because all the people are working from home and re-outfit them to Life Science Office because it takes special HVAC, special venting. Again, special reinforced floor plates for all the heavy equipment that’s in there. And what’s probably the best thing about this is obviously, you cannot do world class cutting edge research in your spare bedroom. So these places, 100% of the workers are back in the office and doing the work that’s keeping us safe from things like COVID. So those are just a sub sector of the things we’re finding.

Jess, I think we turn it back to you now and see if we have any questions for the last five minutes?

Yes, I love this question. Again yes, it’s astute. One of my old professors from business school which is a long time in my rearview mirror, but a guy by the name of Campbell Harvey at Duke University, he actually made his name by investigating this very topic where how the inverted U-curve of all the economic indicators we have out there and literally there are tens of thousands, that this is the best one for projecting and forecasting a downturn in the economy and what happens, right? A lot of people say, “Well you know, you have a growth spurt and a recovery and that eventually dies of old age and then we go because of the business cycle, we go into recession. And real evidence proves that not to be true. What really happens is that we have growth, things like inflation heat up, we come to full employment, the Fed decides to start raising rates and you know, there’s this old adage that recovery’s going do not die of old age, that the Federal Reserve just ends up murdering them. And that’s kind of what happens, right. And we saw that last time. People forget, but the Fed was actually cutting rates going into COVID. Like I mentioned back in December ’18, the market got very anxious because it was basically telling the Fed to stop raising rates and yet in December ’18, they raised rates one more time. We came back in January and it was a completely different message from the Fed. They said they had done enough and that they were reversing their stance and then they ended up cutting rates soon thereafter.

So what I would tell you, yes, continue to look at the yield curve. The yield curve is very flat for this stage of the recovery. It’s quite flat and the Fed hasn’t even started raising rates yet. That’s because the markets pricing that in. I would say that if the Fed raises rates again more than a few times in ’22 and we get to where the Fed funds gets to about 100 to 150 basis points, I would expect at that point, the 5-Year and 10-Year Treasury to be in the same range. So that would be almost a completely flat yield curve, that that is when you would be concerned about a recession. I would not be surprised if the Fed continues to raise rates that we have a recession maybe late 2023 or early 2024. Obviously, my crystal ball does didn’t go out that far, but I do think the yield curve is a great forecaster for what’s going to happen in the economy. I don’t think we’re there yet. We’re still probably going to have something like 4% growth next year, GDP growth. But by the end of next year, we’ll be down closer to 2% and so I would hope that the Fed would then stop raising rates and would probably just kind of let this, let the economy see what it was going to do from there.

John Lloyd

John Lloyd

Lead, Multi-Sector Credit Strategies | Portfolio Manager


John Kerschner, CFA

John Kerschner, CFA

Head of US Securitised Products | Portfolio Manager


Jessica Leoncini

Jessica Leoncini

Head of Fixed Income CPM Management


27 Jan 2022

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