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With elevated volatility in fixed income markets and the potential for an imminent Fed easing cycle, we sat down with Andrew Szczurowski, CFA and Brian Shaw, CFA from the portfolio management team of the Eaton Vance Strategic Income Fund to get their thoughts on the macro environment and to learn where they're currently finding attractive investment opportunities today.
Macro Environment and Fed Policy Expectations
There has been much debate about whether the Fed is behind the curve or not with regards to cutting rates given the economic data - what are your expectations for the Fed and what should investors be paying attention to?
It's important to remember that monetary policy works with long and variable lags, and we are just now starting to feel the impact of the last of the Fed's hikes last July. We believe too many people are focused on today (things are fine in the economy at the moment), and not paying enough attention to what's coming. The lagging impact of rate hikes will continue to pressure the economy at a time when the Fed is seeking to lessen the economic drag of tight policy.
When thinking about whether or not the Fed is behind the curve, investors should consider that since the Fed's last hike (July 2023), the Core Personal Consumption Expenditures Price Index (PCE) has fallen from 4.3% to 2.6%, meaning that in real terms, the Fed's policy has tightened by 170 bps despite a noticeable slowing in the labor market. And that's just interest rate policy - since 2022 the Fed's balance sheet has shrunk from roughly $8.5 trillion to around $6.8 trillion at present, which represents even more tightening. Cutting rates will be intended to return to a more neutral state, as opposed to a restrictive state.
Consumption and policy rate trends
Source: Bloomberg. As of 8/31/24.
The other question on investors' minds is where this cutting cycle will end. While the neutral rate certainly may be higher than the 2.5% pre-pandemic rate, we're also confident it hasn't jumped to 4.5%-5% post-pandemic. Keep in mind that most of the time monetary policy is spent above or below the neutral rate, not on it. Therefore, now that inflation is back under control, if the economy continues to slow, the Fed is likely to cut below neutral in order to stimulate growth once again.
As inflation has come down, the Fed will likely shift more of its focus to the jobs market. Which data points are you following most closely and what are they telling you?
The two most important data releases for the labor market are the unemployment rate and nonfarm payrolls, and both are becoming a concern for the Fed. To be sure, unemployment is still low at 4.3%, but at the precipice of the pandemic in February 2020, it stood at only 3.5%. More concerning is the fact that the unemployment rate has risen by 0.9 percentage points since its lows in 2023, and the recent acceleration we've seen has historically foreshadowed even higher unemployment ahead.
The payroll data, on the other hand, was looking quite healthy...until very recently when the Bureau of Labor Statistics announced downward revisions to the jobs figures for the 12-month period ending March 2024. Post-revisions, the economy has added 158k jobs per month. This figure isn't disastrous, but it is likely below the level necessary to maintain full employment, which some estimates consider to be up to 200k jobs per month due to high levels of immigration and improving labor force participation.
Beyond unemployment and payrolls, some of the less-scrutinized labor market data indicates even more concern. For example, a composite of 19 labor market indicators, including hard data like initial jobless claims and surveys like ISM manufacturing employment, has recently fallen to its lowest level (ex-pandemic) since 2012.
Labor market now "less tight"
Source: Macrobond. As of 8/31/24.
This supports Powell's commentary at the August Jackson Hole summit, which characterized the labor market as "less tight" than before the pandemic, and we believe this to be ample evidence for him to begin cutting rates.
One pocket of strength in the economy has been the consumer, and we've seen consumer spending in the U.S. remain quite strong - do you expect that to continue or are there areas of concern on the horizon?
It is true that the consumer has been quite resilient, yet we're beginning to see some signs of weakness from both a macro and a micro perspective.
At the macro level, we estimate that the level of excess savings, which peaked at $1.7 trillion in 2021, has fallen to -$1 trillion today as consumers have largely spent the savings that had been built up over the pandemic. Because of the higher cost of living that consumers have been forced to contend with, household savings rates are well-below the pre-COVID average. As past savings have been depleted and current savings are low, delinquencies are beginning to pick up in both automotive and credit card loans.
Rising delinquencies
Source: Macrobond. As of 4/30/24.
At the micro level, there are also signs of softening. For example, Target has recently announced price cuts on over 5,000 goods; McDonald's is bringing back the $5 value menu for customers; and restaurant traffic in the U.S. and Europe is slowing considerably as more consumers are shifting to dining at home.
As noted above, the economic data remains OK at the moment, but the direction of the data is what's raising caution flags for us, and this is why our current portfolio positioning is on the more conservative end of our multisector fixed income strategy's historical range.
Stay tuned for Part 2 of our blog series, in which we will share some thoughts on sector allocation and duration positioning within today's fixed income market environment.
Learn more about the Eaton Vance Strategic Income Fund, including how to access the fund prospectus here.
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