- While the Federal Open Market Committee (FOMC) forecasts need to be incorporated into any investment process, it’s important to remember that sometimes projections change or don’t come to fruition.
- While global supply disruptions are a veritable issue, it is important to remember that they are temporary and may even provide investors with opportunities in the credit markets.
- The Federal Reserve has indicated that its policies will be less accommodative in 2022 and has signaled the likelihood of interest rate hikes at their fastest pace since before the pandemic.
This month’s main article, Fixated on Forecasts, discusses the oft-changing projections by the FOMC and advocates for a measured approach to incorporating them into an investment strategy.
Also included are the following themes:
Fixated on Forecasts
Jeff Probst, CFA, Portfolio Manager
All too often market participants are fixated on forecasts, whether from sell-side research firms or government agencies. While forecasts are a valuable input into any investment process, it is important not to be overly reliant on these oft-changing projections.
Absent major shocks like COVID-19, forecasts are typically slow to change as new data is analyzed. The December 2021 Federal Open Market Committee (FOMC) meeting appears to be an exception, as FOMC members have made significant updates to their expectations. Throughout most of 2021, the message from the FOMC was that higher-than-normal inflation readings were “transitory” and there was little need to reduce monetary accommodation to combat it. As new data were incorporated into the individual FOMC member’s forecasts between their September and December Summary of Economic Projections, many members pivoted and substantially adjusted their federal funds rate forecasts higher. If anything, this illustrates why portfolio managers and investment strategies need to remain nimble.
Employment data continued to improve in the second half of 2021, and while job growth in some months was below consensus forecasts, inflation data continued to increase to multidecade highs. The components of inflation that were thought to be transitory have continued to affect inflation longer than anticipated. The following table illustrates the job creation and inflation trends during the second half of the year.
*Initial readings of data, excluding revisions
Federal Reserve Chair Jerome Powell adjusted his inflation forecasts after incorporating several new data points. Higher inflation figures were consistently dismissed as transitory until sustained, elevated readings could no longer be ignored. During a November Senate hearing, Powell alluded to his new forecast by stating it was time to retire the word “transitory” in the FOMC’s characterization of inflation. The pivot led to one of the largest Summary of Economic Projections changes to near-term fed funds rate forecasts in recent history. Of course, forecasts often change because of new information. While forecasts need to be incorporated into any investment process, it is important to remember that the FOMC’s forecasting track record is not as stellar as one might think. Looking back at the last rate hike/cut cycle illustrates that even the FOMC cannot always accurately predict rate hikes.
The table below shows annual forecasts by the Fed as of the prior year’s December FOMC meeting and the prior year-end market forecasts for the fed funds rate. For example, the forecast for 2015 is from the December 2014 FOMC meeting, and the market forecast figure is from the last day of 2014.
*Data based on fed funds futures
Source: Bloomberg, Federal Reserve
It’s not just the FOMC that swings and misses. Market-based projections have also been off but typically to a lesser degree. Thus, strictly following FOMC or market-based fed fund rate projections to manage investment strategies may lead to undesired outcomes in a portfolio. Coming out of the global financial crisis (GFC) of 2008, the FOMC forecasted four 25 basis point (bps) rate increases in 2015 and 2016 but only managed a single hike in each year. Forecasts were close in 2017 and 2018 but were severely off in 2019. Due to the pandemic, 2020 was an outlier year and should not be used to judge the accuracy of FOMC forecasts; however, it does provide a reminder that tail risks exist and can throw off even the best forecasts.
So, what’s the key takeaway? Investors may wonder if FOMC members are strictly making unbiased forecasts or if they have other motivations. Are they trying to instill confidence in the markets or project other monetary policy goals? For example, if the FOMC signals weakness in the economy, investors and consumers may react accordingly and make a dire forecast a reality. The FOMC needs to thread the needle; however, providing an accurate economic assessment without spooking the market could be a tricky balance to strike.
As the market enters a new year, there are many scenarios that could alter the current forecast and the potential path to rate hikes. There is an extensive list of factors on investors’ radar, including current and future COVID variants, supply chain bottlenecks and inflation. In addition, the future composition of the FOMC is in flux. At year-end, President Biden had not yet nominated individuals to fill the three current or upcoming vacancies on the Board of Governors. The FOMC’s closely watched dot plot, which is produced four times a year and is used to signal its outlook for the path of interest rates, could be altered, depending on forecasts of new FOMC members. Just a few individual changes in the dots could move the median fed funds rate projections higher or lower.
Each dot in the dot plot represents an FOMC member’s estimate of the fed funds rate at the end of each period. These fed funds rate projections are estimated before the FOMC members meet. Following is the dot plot from the December 2021 meeting. The median dot for 2022 indicates that members forecasted three 25 bps rate hikes in 2022.
Source: Federal Reserve
As 2022 starts off with many crosscurrents and a wide array of forecasts to consider, we advocate for a measured approach to incorporating them into an investment strategy. We are, of course, watching the forecasts closely but are always prepared for any pivots. We believe that tailoring a sustainable investment program that fits each client’s unique risk profile can result in better outcomes as opposed to chasing ever-changing forecasts.
Credit Vista: Not spooked by supply chains
Nick Cisneros, Credit Research Associate
One of the most popular topics of macro commentary in 2021 was the supply chain crisis, which seemed to touch many aspects of our everyday lives. It is hard to nail down exactly what a supply chain crisis entails, but we will attempt to elaborate on the pain points we have observed and how they relate to credit fundamentals. While it is indisputable that global supply chains are in serious turmoil, credit quality in the investment-grade universe remains solid, and certain sectors have been able to take advantage of higher prices caused by supply chain dislocations. According to a recent article by the New York Fed, the Global Supply Chain Pressure Index (GSCPI) is more than four standard deviations above its mean since 1997, which demonstrates how much of an outlier the supply chain crisis is. Though this crisis is unusual, we believe it will ultimately prove to be temporary.
A perfect storm
During the pandemic, the two most important factors in the supply chain, shipping and input costs, experienced significant dislocation from historic norms. The next chart highlights data from the Institute of Supply Management (ISM), showing that elevated shipping costs are factoring into higher prices paid, while lower output caused by supply shortages are driving a backlog of orders.
Source: Institute of Supply Management
When thinking of inputs, semiconductor manufacturing is a prime example. Semiconductor manufacturers were hit with an unprecedented surge of demand, beyond pre-pandemic levels in late 2020. Meanwhile, supply potential was reduced significantly due to a pandemic lockdown in Taiwan, which accounts for more than 50% of the world’s semiconductor production. This created a supply/demand imbalance down the supply chain across multiple industries, most notably automotive manufacturing. Chips are a vital component in car production, especially as many automakers are rolling out their fully electric offerings. This imbalance between supply and demand caused auto prices — both new and used — to soar, as illustrated in the following chart.
Source: Bureau of Labor Statistics
But the story does not end with semiconductor supply. Shipping has been a culprit as well. The “Big Three” West Coast ports (Long Beach, Los Angeles and Oakland) have seen the number of ships waiting to dock and the average dwell time before docking rise drastically over the past year. As a result, shipping costs have skyrocketed, as port congestion and lack of space on container ships have created bidding wars to secure cargo space. Exacerbating matters, there has been a severe labor shortage in transporting goods once items have cleared ports. These factors have caused shipping to become more expensive and less efficient, driving the supply chain crisis.
The global supply chain has been a massive logistical headache for over a year. Input components are being battered by extraordinary demand levels, while supply is still lagging below pre-pandemic levels. Shipping issues have created an expensive bottleneck where space is limited by port infrastructure, and labor challenges persist even after cargo comes off the ship.
Some good news
At first glance it would seem these supply chain problems, which have led to higher prices and inventory issues, are bad for credit. Typically, higher costs associated with a shortage of inputs and shipping congestion lead to contracting margins, which, in turn, can lead to lower profitability and cash flow. However, the supply chain issues have been neutral on credit, with some sectors even seeing meaningful credit improvements.
How can that be possible? While supply chain problems have led to lower volumes of finished goods, it has also given companies more leeway to raise prices. Demand is still at record levels in the retail and commercial industries, and the limited supply of finished goods allows these companies to improve margins by passing on price increases to consumers.
Our earlier example of automotive manufacturers underscores this point, as automakers had an exceptional year on the back of record car prices. The credit impact was evidenced by agency upgrades and a positive outlook on the entire sector. The underlying credit of asset-backed securities (ABS) has improved in a similar fashion, with auto and farm equipment ABS benefiting from stronger pricing power amid record demand, while shipping container and railcar ABS have had their credit bolstered by the unusual shipping dynamics and pricing.
The bottom line
We note these higher prices have led to higher revenues, as volume has stayed flat to slightly lower. This benefits credit metrics for corporate issuers who carry higher debt loads as their margins improve, leading to higher EBITDA, which is the denominator in leverage calculations. This is one of the reasons we are not overly concerned about the ongoing supply chain disruptions.
We still believe these supply chain problems are likely to persist for some time in 2022, but there are signs that point to an ultimate easing of this situation. Issuers that have benefited from these shortages will continue to do so in the near term. Demand for goods is currently so strong that an easement of supply problems will likely act as a tailwind to these issuers and increase volumes at current high prices.
Trading Vista: The Fed gets serious
Hiroshi Ikemoto, Senior Fixed Income Trader
The year ended with a bang in the bond market as the Fed, in one of its more hawkish FOMC meetings in quite some time, stated unequivocally that it will intensify the battle against inflation. Not only did Chair Powell all but banish the word “transitory” when referring to inflation, but the FOMC also accelerated the pace at which it would pivot away from its extremely accommodative policies. The “taper” is now being conducted more aggressively, and the Fed has signaled the likelihood of interest rate hikes earlier and at a faster pace than previously indicated. The market is now pricing in three one-quarter-point increases to the federal funds rate in 2022, with the consensus being that June will see the first tightening. As a result, the front-end Treasury curve backed up with two-year benchmark yields going from 0.55% to 0.73% at the end of 2021, while the one-year T-bill rose from 0.24% to 0.38% during the same period.
In the corporate bond market — as traditionally occurs during year-end — many, if not all, dealers lighten their books for accounting purposes, and this past December was no different. Inventories became harder to source and caused credit spreads to tighten against benchmarks. Even with this spread tightening, all-in corporate bond yields were still higher than in November, reflecting the strong demand and higher benchmark rates for corporate credit. The commercial paper market was very quiet, especially in the last two weeks of December, as most major issuers were well-funded going into the new year. Bonds were also difficult to source in the secondary market, as dealers were reluctant to hold inventory in a fast-moving rate environment, since nobody wants to be stuck with a large losing position at year-end.
After almost two years since the Fed first cut rates in response to the pandemic, the tide has turned, and 2022 looks to be an exciting one in the bond market. With rates on the rise, we expect to have ample opportunities and flexibility to select securities across the curve, which, in turn, will allow us to build our target duration and allocations to fit clients’ specific needs and risk tolerances. As ever, we remain committed to prudently managing interest rate risk, credit risk and all other facets of this dynamic environment.
|Treasury Rates:||Total Returns:|
|3-Month||0.03%||ICE BofA 3-Month Treasury||0.01%|
|6-Month||0.18%||ICE BofA 6-Month Treasury||0.01%|
|1-Year||0.38%||ICE BofA 12-Month Treasury||-0.11%|
Source: Bloomberg, Silicon Valley Bank as of 12/31/21