Macro Markets Podcast Episode 45: Macro and Market Outlook for 2024
Anne Walsh, CIO for Guggenheim Partners Investment Management, joins Macro Markets to discuss opportunities and risks in what promises to be an eventful 2024. A weakening economy, pivoting monetary policy, volatile geopolitics, and a presidential election form the backdrop that is tailor-made for active fixed-income management.
Jay Diamond: Hi, everybody. Happy New Year and welcome to Macro Markets with Guggenheim Investments, where we invite leaders from our investment team to offer their analysis of the investment landscape and the economic outlook. I'm Jay Diamond, Head of Thought Leadership for Guggenheim Investments, and I'll be hosting today. We are recording this episode on Wednesday, January 3rd, 2024. Now, even though we are only a couple of days into the New Year, I have full confidence in my forecast that 2024 will be offering up a lot of challenges for market participants. Investors have a lot of questions about how monetary policy may play out in the year ahead and what impact it could have on the markets, not to mention the potential for heightened volatility from geopolitical tensions around the world and an election here at home. Our guest today thinks a lot about these questions, and unlike most of us, also has to make portfolio allocation decisions for clients based on her answers. Anne Walsh is the CIO for Guggenheim Partners Investment Management and a managing partner for Guggenheim Partners, and she leads our team that is responsible for more than $218 billion in total assets on behalf of our clients. So welcome Anne and thanks for taking the time to kick off 2024 with us today.
Anne Walsh: Thanks, Jay, and Happy New Year to all of our podcast listeners today.
Jay Diamond: So Anne, we have so much to talk about as the year begins, but let's start with the commanding heights of Fed policy. How would you describe the Fed's overall posture right now?
Anne Walsh: They're really trying to be pretty careful in their narrative. I guess if I had to pick a word, I think the word might be “hopeful”, and I think they're hopeful that they've managed to engineer that soft landing that the market has already priced in. But I will tell you that the market has pretty much overreacted to the narrative from Jay Powell’s last press conference, and so I think we're looking at a pretty interesting early 2024 as the Fed continues to try and navigate the shifting economic data and to continue to navigate their way to that soft landing.
Jay Diamond: So as you said, the market seems convinced that the Fed has achieved this soft landing as elusive as it might be in history. Do you agree about the soft landing idea?
Anne Walsh: Well, we've been in the camp that we are slowly working our way toward a mild recession. I think that the Fed went ahead and pivoted, and I'll use that term of art to indicate a willingness to cut rates in advance of what market perception had been. As I mentioned, the market overreacted a bit to the messaging because the market still hasn't really priced in a mild recession. But let's look at some of the data and why the Fed engaged in the new narrative. Frankly, I think they got very concerned about the Beige Book results that came out in late November, and the data in the Beige Book indicated that the economy was slowing down much faster than some of the other headline numbers. For instance, inflation in the headline numbers still hasn't come down to their target of 2 percent, but if you look through the data to the surveys, you saw a very different picture. And the Fed was looking at that data in real time and what it was telling them, and so as a result, I think that they became more concerned than they had been before. Now, because the markets reacted so strongly to the messaging, financial conditions have now softened, if you will, made their task a lot easier. And so as a result, now they're trying to walk back some of that concern because, frankly, this easing of financial conditions offset some of the risks that they were perceiving that the market was starting to have. So, we could still see a lot go wrong at this point in time. The Fed is still seeing weakness in various parts of the economy. We ourselves are observing increases in corporate bankruptcies, credit card delinquencies, commercial real estate and small business activity. On the other side, because the markets have reacted so well and financial conditions have softened, this actually can help the story of growth, and so as a result, the Fed is continuing to hope that--and there's that word again, “hope”--that they can continue to engineer this soft landing. But again, I think there are more risks to the downside still because they're still engaged in quantitative tightening, and that's the reduction of the balance sheet, even though they've quite clearly paused rate hikes and are looking to actually lower rates at this particular time.
Jay Diamond: So the Fed, as you said, is hopeful, but they are hopeful that they're not going to get it wrong. Now, this brings to mind something that Ben Bernanke said a while ago, which is that expansions don't die of old age. They are murdered. So, what could possibly murder or derail where we are right now in the economy?
Anne Walsh: Well, I'm really focused on the money supply at this particular moment, and I mentioned quantitative tightening is still not done. You know, we have to realize in the larger context of where we have come from, the Fed has raised rates by 525 basis points over a very short window of time. In addition, they have also reduced their balance sheet from $9 trillion to just under $8 trillion. The combined effect is essentially the same as a Fed funds rate of 7 percent. As a result, financial conditions remain tight. From a monetary perspective. This could still cause pressure, particularly on the broader economy that is still interest sensitive, and in particular small and mid-sized businesses that are borrowing from banks at this point, or commercial real estate, which is facing a very significant maturity refinancing wall coming up in 2024 and 2025. These interest sensitive areas are not going to be benefited even by this loosening of financial conditions, because, frankly, the loosening of financial conditions isn't significant enough. This is an area of continued risk that the Fed is going to have to navigate, because I think this is an area where large companies are probably fine. They have access to capital and their capital costs are coming down as a result of financial conditions softening. And the Fed messaging, their willingness to cut rates. But these smaller borrowers, commercial real estate loan borrowers and frankly, small banks and mid-sized banks that loan to them, I think they're still in an area of higher risk, and it's very much elevated for that particular audience. So, I think the Fed still has to navigate pretty carefully at this particular point.
Jay Diamond: What's your take on the possible timing and depth of a recession?
Anne Walsh: Well, it's very hard to tell when a recession starts, except in the rearview mirror, but I believe that we could start to see indications of a recession beginning here even in the first quarter. There's enough evidence of slowing down in the broader economy to suggest that manufacturing is in a recession and the leading economic index peaked over 20 months ago. And so, we're still seeing a slowdown in that particular part of the market. Housing is still being affected by the elevated rates and housing construction could be affected and we could start to see that happen here as well. We also have to think about the timing. Generally speaking, 18-to-24 months after the Fed starts hiking is when you start to see the effect and when you could start to see or predict a recession, and that would put us very firmly in the first quarter. And additionally, we could also see because, and I'll go back to a point I'd made already before, and that is that the money supply is now negative. And historically, when the money supply turns negative, as it has, that's usually a precursor to a recession. And then also, of course, we've had this inverted yield curve and the inverted yield curve has been inverted for almost 300 days at this point in time. And given the fact that not only is it inverted for a length of time that is historically unprecedented, but it is also deeply inverted. And this usually predates a recession as well. So, we could start to see it happen here in the first quarter.
Jay Diamond: Anne, you've spoken before about something called a rolling recession. Talk to us a little bit about what that means and how it could play out.
Anne Walsh: A rolling recession is a concept that not every part of the economy is going to feel the effect of a recession, either at all or certainly to the same severity. And what we're really thinking about here is, is that there are particular parts of the economy that have already been in some form of a recession. If we look back to 2022, we had negative GDP impacting or being felt in the area of manufacturing, we had a bit of a tech winter over the summer of 2022, and we're definitely heading into a commercial real estate, in particular and office properties, cycle, and I think that that's going to be felt over the next number of months as well. So, what happens is it's a rather uneven impact on the economy. And I’ll go back to a point I made, which is that interest sensitive parts of the economy are being impacted first and most, and then they themselves will then feed into other parts of the economy. And right now, commercial real estate is one of those very, very interest sensitive areas that hadn't yet really started to feel the effect because those mortgage loans weren't being forced into a maturity refinancing. That's not the case now. In 2024 and 202, we're seeing about 80 percent of all commercial mortgage loans will have to be refinanced. That's a significant maturity wall that we're facing, and those borrowers are going to have to decide whether they can afford to pay those higher interest costs. And that's going to weigh on the Fed's mind also. And it's going to affect the small and mid-sized banks even more than what we felt, I think, in March. So that's what's really felt in terms of a rolling recession, is this unevenness or if you prefer, a bifurcation of the recessionary impact. And I'll go back to the other point, which is the larger borrowers that have access to capital will probably not feel the pain in the same way as those other parts of the economy will feel it.
Jay Diamond: So, the Fed has always seen economic damage as a collateral effect of its primary fight, which has been the fight against inflation, and since the recent peak, not 9.1 percent year-over- year and June of last year, CPI inflation has dropped significantly to around 3.3 percent in November and on a three month and six month annualized, it's actually closer to two. So it's still high, but it does appear that Fed is well on its way to reaching its 2 percent target. Now, do you think that they will be able to sustain this trajectory? What do you think the outlook is for inflation and therefore its interest rate policy?
Anne Walsh: Well, we were early on in believing that the level of inflation was going to decline precipitously, and we believe it's going to continue to decline from here, that they will, in fact, achieve that 2 percent target of inflation in PCE, which is their preferred measure of inflation. We believe that there's also some disruption, if you will, in the calculation of some of the measures of inflation, in particular to the response levels to service being substantially less than in years past. And this high frequency economic data, I think is as a result rather backward-looking, and that if we were to look at current data from other sources, for example, particularly an owner equivalent rent, where the level of inflation there continues to be very, very elevated relative to say, for example, goods. The price of goods has come down significantly and that includes commodity prices, where those levels within rents and owner equivalent rent remain highly elevated still, and we think that that is misleading. And because it is backward-looking, we believe that it will decline rather rapidly from here, and again, get us back into the level that the Fed projects to be able to sustain a 2 percent inflation level. Additionally, I mentioned money supply. Money supply being so negative is a precursor of an economic slowdown, but it also is a predictor of the level of inflation. After all, one of the reasons I think we got inflation post-COVID was because we had such significant fiscal and monetary stimulus that came into the system and as a result, we saw inflation spike. Now, it reversed course. Money supply is down globally. And so as a result, we are seeing a global phenomenon of disinflation. Now, the real question is do we get deflation? And in some parts of the economy, we certainly could start to see actual price declines, which is deflation. In those areas, for example, like used cars, we're starting to see that: actual price declines. And the question is, do we return to price levels from before COVID? Maybe not, but certainly well within that 2 percent level that the Fed and other global central banks have targeted as their level of tolerance for inflation.
Jay Diamond: Often overlooked in the monetary policy toolkit is the Fed's balance sheet manipulation, which we've talked about in the past year. As you know, it's down by about $1 trillion in balance sheet and more to go. You talked a little bit about money supply, but what's the impact of the Fed's balance sheet activity been on markets and do you believe it will continue?
Anne Walsh: This is an area that's little understood, but it is an area of elevated risk right now. Quantitative tightening, when coupled with heavy Treasury issuance, has led to a spike in what we would refer to as an uncertainty premium in Treasury yields. All other factors being equal, it has increased borrowing costs. And it continues: the Treasury is continuing to have to issue more Treasuries to cover the increased cost of interest to the government. And of course, we've seen an incredible spike in the debt levels of the US Treasury. But also, what we can see and expect to see is a spillover into the market from a liquidity perspective. In addition to the $1 trillion of balance sheet reduction by the Fed, we've also seen globally central banks reduce the global liquidity now to a global amount of about $5 trillion. This incredibly significant amount of liquidity has now left the system. It takes a while for the full effect of liquidity to drain out of the system and for those effects to be felt. For example, RRP usage at the Fed started 2023 at over $2 trillion. Now it's less than $800 billion, and the more it drains out of the system, combined with continued Q.T., quantitative tightening that's going on through the reduction of the balance sheet plus the Treasury issuance ahead will start to weigh on bank reserves. Banks aren't going to be able to provide liquidity if they themselves don't have any, and as bank reserves decline, liquidity risk in the financial markets will increase. As I said, this is a very technical and little understood phenomenon, but we could start to see a liquidity problem really bite by the end of the first quarter and frankly, probably by the end of February if it continues at this trajectory. That means that there could be a liquidity event similar to what occurred in September of 2019, which caused the Fed at that time to have to pivot significantly from their tightening to begin loosening right away because the Fed can't really stomach a liquidity crisis that could evolve. So, this is an area of risk that we're watching very closely.
Jay Diamond: The plumbing of the bond market is certainly something that's not well understood. So the RRP is the Reverse Repurchase Facility that the Fed runs. And it's really, if you think about it broadly, it's the grease in the wheels of the bond market, and if there's less of it, that's how liquidity starts to dry up. Is that a good way to describe it?
Anne Walsh: That is exactly the way to describe this potential effect.
Jay Diamond: Given everything we've talked about and then we'll wrap up our Fed discussion. Do you think the Fed hikes are over? When do you think the Fed will begin cutting rates? I know what the market thinks. And what kind of macro and market events do you that you'll be looking for about the timing of Fed cuts?
Anne Walsh: I believe that the Fed is done hiking rates. However, that doesn't mean that they are done with quantitative tightening. As mentioned, they are still reducing the balance sheet, and as long as there's a perception that that there is liquidity in the system, I think they're going to continue that initiative. However, as was mentioned, we could see a liquidity event and that will finally put a stop to quantitative tightening, and it would immediately cause the Fed to lower rates. Without that, we still anticipate the first rate cut to happen by the end of the first quarter. And we were early in that assessment and expectation. Now the market has priced in a first rate cut by then as well. Historically, in a recession, the Fed's trajectory was to reduce rates by about 175 to 200 basis points. The consensus view is for five rate cuts next year. Our view is for seven rate cuts next year. And as a result, we think that bond prices will start to increase and yields will be coming down, significantly, particularly on the long end as well, because as inflation drops, that brings the long end rates down. And of course, the Fed will be bringing rates down on the short end to address market conditions, which we anticipate will get less liquid by the end of the first quarter.
Jay Diamond: Turning toward the bond markets and investing. What is your outlook for the credit cycle as we head into 2024?
Anne Walsh: So we think that the period of delinquencies has begun to increase, and defaults along with those delinquencies. The high-yield level of defaults have increased, albeit from a very low level of less than 1 percent, but they've increased to 4 percent in 2023. And our expectations, along with those predicted by Moody's, in a normal recessionary cycle, could suggest that defaults could rise above 5 percent. Large corporate bankruptcies are actually right now running about the same as in 2020. However, smaller company bankruptcies have started to rise significantly, along with individual consumer delinquencies on credit cards. So, we are starting to see a credit cycle begin both at the consumer level and also at the corporate level. Now, the good news for the corporate story is that corporations, particularly those that are in the large category and in the capital markets, have come into this recessionary cycle that we're projecting with a strong tailwind. And these particular companies have been able to pass along their higher costs, their margins have been protected. Their story is a pretty good one. that's not necessarily the case for the small and midsize companies in the U.S. that make up about 50 percent of U.S. GDP. So, we have a nice tailwind for large companies coming into this cycle. so that's why we don't anticipate defaults rising significantly above the 5 percent level as you might have expected in prior recessionary cycles. this is going to feel a little bit differently and this bifurcation in credit is going to be something to watch. And we're very thoughtful of with regard to it going into this cycle.
Jay Diamond: What is the range of outcomes that Guggenheim Investments is positioning its portfolios for? And how are you accomplishing that given the different opportunities and relative values available in the market?
Anne Walsh: We found that fixed income yields are really quite attractive, and we've been maintaining our exposure across any number of the sectors that are available for diversification purposes. But we've had an up in credit quality tilt and with investment grade corporate bond yields still above 5 percent, that's very attractive relative to 3.5 percent in the years leading up to COVID. And even in categories that frankly, we had not been investing in because they were so rich prior to now or really prior to last year even, that included agency mortgage-backed securities, which offer very attractive spreads right now. And rate volatility has driven quite a bit of the pricing there, and we believe that as rates come down, this is an asset category within the investment-grade universe that's going to perform very, very well. Asset-backed securities and structured credit continues to maintain its place in our portfolios because spreads are not as tight as they are in corporate bonds in the investment-grade space. They offer attractive yields and most of them are based off of a floating rate base index, and so as a result, their yields are even more attractive because of the inverted yield curve. Our exposures have to historically depended upon client demands and strategies, but throughout all of our portfolios, we've tended to be tilted defensively and we're maintaining our dry powder so that we can invest to take advantage of opportunities as we go forward as the fixed income markets really react to the changing backdrop of a slowing economy, lowered inflation and as a result, bond returns should be very strong given that particular backdrop.
Jay Diamond: And how are you thinking about duration positioning at this point?
Anne Walsh: As we went all the way up to 5 percent on the 10-year, we got as long as we could within our objectives in duration. As we moved back down to where we are now, around the 4 percent level on the 10-year, we're a bit long on duration, but not as long as we were. We're not at maximum length, but we do believe that as the 10-year is likely to continue its trajectory, although markets don't move in straight lines, we believe that the 10-ear will continue to retreat towards the 3.5 percent level as we go through this cycle. That still leaves a lot of return and that slightly longer benchmark duration will be maintained in place until we get down to about that 3.5 percent level and then we would return to a neutral position.
Jay Diamond: Before we let you go, we still have a lot left on the table to talk about. So, if it's okay with you, let's do a little bit of a lightning round where I'll mention a topic and you can give me a quick answer on how you're processing this in the context of portfolio management. We'll start with geopolitics. How do you manage for the market risk and possible impact about things such as the War in Ukraine and the Israel-Hamas war?
Anne Walsh: Markets do a pretty poor job of pricing in geopolitical risk, but what I can say is that as an investor, it's incumbent upon us to expect that it creates volatility. Certainly, Middle East conflict is having an impact on oil prices, which could have an impact on inflation, particularly if oil prices spike. It is complicating the U.S. election cycle, which we are in, and frankly, the U.S. elections are going to create their own backdrop of volatility and impact on the markets as we go from one primary to another. And we watched this election unfold this year, and that could have an impact both on the U.S. dollar as well as on commodity prices like gold and silver, which, by the way, could be benefited in a period of time of volatility. We are really paying a lot of attention to geopolitics. It's one of our Macro Themes that we're looking out for 2024 as well, taking it into account in our decision making.
Jay Diamond: Okay. And how about the equity market outlook?
Anne Walsh: The equity market has been very strong, as we know, in 2023. But, as we enter into a recession year, a time frame, these recessionary risks tend to weigh on corporate earnings and corporate earnings outlooks. And I think that that's likely to continue to have a disproportionate effect on smaller companies relative to larger ones. And I think that's the way we're going to see stock market behavior. continued bifurcation of the two markets, that being those leading companies that are going to probably continue to perform well and those that aren't going to be able to perform as well or pass along costs or revenues are going to decline in a recessionary backdrop. So, I think that equities will also suffer from the effect of continued quantitative tightening if in fact the Fed does not pivot as quickly as they might otherwise. And so, I think equities are overvalued, but it is really a tale of two markets within the equity space.
Jay Diamond: You mentioned this before, but I want to ask you directly: the potential impact on the markets of the presidential election this year.
Anne Walsh: Well, I think there's two potential effects. One is the Fed doesn't normally like to have or be accused at least of impacting US elections. And so, they're going to want to engage in policy that's well set and well-defined ahead of time so as to, quote unquote, not impact the election. However, the politicians also realize that incumbents do not win reelection in a period of recession, and so they're going to want to try and influence the Fed to lower rates and to avoid any kind of recession. And so, policy outlooks can be really quite uncertain in this particular environment. We could expect some volatility in the currency markets, particularly to the dollar and in commodity prices from geopolitics. There's also the messaging by each of the parties, particularly on international trade relations with China being one very strong example. Foreign markets will also be impacted by the US elections. So, the concentric circles of impact here can be far and wide. And so again, we're looking for it to create volatility within the year and we could see markets gyrate quite significantly over the course of this calendar year.
Jay Diamond: So, Anne, you mentioned before, our macro themes we actually are publishing shortly. It might be out by the time people listen to this podcast, the Macro Themes for 2024. Are there any of them that you'd like to mention right now to conclude our call?
Anne Walsh: Absolutely. To reflect again on a few of the thoughts, there's a lot of bifurcation. We're going to see different kinds of effects on the economy. We're going to see effects from continued tightening Fed policy on small and mid-sized companies more, we're going to see an impact in the real estate market, as was mentioned, and geopolitics and the election cycle. But some real positives, too, and that will be technological innovation and competition transforming our economy, particularly in the area of artificial intelligence and its effect on productivity as a strong positive. But we have to get through a recessionary cycle, I think, to really see the real market benefits of that, and Fed policy is going to continue to dominate the story in 2024. The good news is, as a fixed income investor, I think this will be a very strong year for fixed income returns and for the opportunity sets that we see available to us. As I like to say, out of chaos comes opportunity and we will see that in 2024.
Jay Diamond: Well, thank you very much, Anne. Before I let you go, any other last words for our listeners who have been kind enough to tune in today?
Anne Walsh: Well, just to thank everybody for your time and attention today, and we look forward to serving all of you in 2024.
Jay Diamond: Well, thank you again and for your time and your insight. I look forward to checking in with you again in 2024 and see how all this is playing out. And thanks to all of you who have joined us for our podcast. If you like what you are hearing, these ratings, five stars and if you have any questions for Anne Walsh or any of our other podcast guests, please send them to macromarkets@guggenheiminvestments.com and we will do our best to answer them on a future episode, or offline. I'm Jay Diamond, and we look forward to gathering again for the next episode of Macro Markets with Guggenheim Investments. In the meantime, for more of our thought leadership, guggenheiminvestments.com/perspectives. So long.
Important Notices and Disclosures
Investing involves risk, including the possible loss of principal.
Stock markets can be volatile. Investments in securities of small and medium capitalization companies may involve greater risk of loss and more abrupt fluctuations in market price than investments in larger companies. Investments in fixed-income instruments are subject to the possibility that interest rates could rise, causing their values to decline. High yield and unrated debt securities are at a greater risk of default than investment grade bonds and may be less liquid, which may increase volatility. Investors in asset-backed securities, including mortgage-backed securities and collateralized loan obligations (“CLOs”), generally receive payments that are part interest and part return of principal. These payments may vary based on the rate loans are repaid. Some asset-backed securities may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity and valuation risk. CLOs bear similar risks to investing in loans directly, such as credit, interest rate, counterparty, prepayment, liquidity, and valuation risks. Loans are often below investment grade, may be unrated, and typically offer a fixed or floating interest rate.
Investors in asset-backed securities ("ABS"), including mortgage-backed securities ("MBS"), and collateralized loan obligations (“CLOs”), generally receive payments that are part interest and part return of principal. These payments may vary based on the rate loans are repaid. Some asset-backed securities may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity and valuation risk. CLOs bear similar risks to investing in loans directly, such as credit, interest rate, counterparty, prepayment, liquidity, and valuation risks. Loans are often below investment grade, may be unrated, and typically offer a fixed or floating interest rate.
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