Gravity Exists


Expect More Volatility as the Fed Shifts from QE to QT

April 18, 2022

Andrzej Skiba is the Head of US Fixed Income for RBC Global Asset Management. Skiba joined RBC following the bank’s 2010 acquisition of BlueBay Asset Management, where he headed the Developed Markets team. Gravity Exists asked Skiba how inflationary pressure affects the fixed income and credit markets broadly and how he recommends allocators adjust risk.

While the debate over whether the US has reached “peak inflation” continues, all recent data indicates that sustained price pressure is here to stay for the near term. How do you see inflation playing out for investors in the coming quarters?

We agree that inflation is the key theme to watch in the near to medium term in the US. We see inflation impacting markets in several ways.

Monetary policy is the obvious one. The longer we experience inflation levels elevated far beyond the Fed’s goal of ‘inflation averaging 2 percent over time,’ the more aggressive the Fed’s actions need to be. Following the recent rate hike in March, the market expects another 200 basis points of rate hikes before the end of the year and another 50 basis points in 2023. Combined with balance sheet reduction at an indicated pace of $95bn per month, this level of policy tightening is likely to cap the extent to which risk assets can rally from here.

Federal Reserve officials have been explicit in the past, suggesting that lower asset prices are a natural result of tightening financial conditions unless the extent of the risk asset correction creates a demand shock for consumers. So the ‘Fed Put’ might be at a much lower point of valuation than was previously the case when the central bank pursued accommodative monetary policy.

And how do you see that playing out for C earnings?

Corporates face wage and input cost pressures across a broad range of industries. So far, shrinking profit margins haven’t dramatically impacted credit valuations as most companies were at least partially successful in passing through cost increases to consumers. However, we’re getting to a point when consumers might balk at ever-increasing prices and opt to purchase less or defer expenditures until their earnings catch up with inflation. Markets will be far less forgiving of a scenario where inflationary pressures impair outlook future revenue and demand for goods wanes. Cyclicals and discretionary goods companies are most vulnerable in this respect. We expect major sector rotation away from those segments of the economy would ensue were the inflation outlook to worsen further.

How are you approaching portfolio positioning to manage risk should these scenarios play out?

In terms of fixed income portfolio adjustments, we would recommend investors shorten the duration of their portfolios. You can achieve that in several ways.

With US High Yield at yields close to 7 percent, a duration of approximately four years should work well in this environment. Away from rate-sensitive, BB-rated bonds and deep cyclical credits, we see value in the asset class, especially compared to a much longer duration investment grade universe. With defaults close to zero and recession not yet on our doorstep, we see good opportunities within the space.

The leveraged loan market has the benefit of short-duration, floating rate instruments, which will pay you more as the Fed continues to hike rates. While name selection is key, due to aggressive leveraging transactions being financed in the loan market these days, the universe offers yields of approximately 5%.

Unconstrained/flexible fixed income — portfolios without a reference benchmark such as the US Aggregate Index — will enjoy the benefit of investing at a time of increased volatility without the pain that higher bond yields inflict on investor total returns. Increased asset dispersion should create plentiful opportunities for active managers to generate alpha.

Within securitized credit — whether in asset-backed markets or the mortgage-backed universe — there are plenty of instruments with short duration and high levels of credit enhancement, i.e., improved ability to withstand losses in adverse conditions. While the Fed might be selling mortgages soon, investors should not lose sight of the fact that the securitized universe offers a variety of alternatives to traditional low-spread, long-duration agency MBS securities.

This environment also calls for fixed-income investors to use a wider toolkit of instruments to protect their clients’ capital. Interest rate hedges and credit protection (CDS indices) are some of the tools that can allow you to keep exposure to high-conviction holdings while steering you through the bouts of volatility likely to persist as we move from the QE to QT era.

RBC’s Andrzej counsels credit investors to expand their horizons to fight inflation.

Andrzej SkibaRBC’s Andrzej counsels credit investors to expand their horizons to fight inflation.