Market Headwinds Offer Opportunity Tailwinds

_{The views contained herein are those of the presenters as of the date noted and are subject to change without notice. These views may differ from those of other T. Rowe Price Group companies and/or associates. This material is not  intended to be investment advice or a recommendation to take any particular investment action.}

Consensus Forecasts—Lower Growth, Higher Inflation

As of September 30, 2022

CPI is consumer price index. Inflation, average consumer prices.Sources: Bloomberg Finance L.P., Morgan Stanley.

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The macro outlook is not for the faint of heart, but that environment creates incredible opportunity.

- Andy McCormick, Head of Fixed Income and CIO

Economic Outlook—Current Investor Concerns

• Growth—Gross domestic product (GDP) forecasts keep going down, while consumer price index (CPI) forecasts keep going up. Growth predictions have been accurate, while inflation predictions have not.
  • Forward-looking Purchasing Managers’ Index (PMI) indicators in China have been improving
  • European and U.S. indicators continue to head south
  • Manufacturing and servicing PMIs are still pointing down but have not yet reached crisis level
  • TRP Outlook: We are forecasting that PMIs continue to remain weak
    ■ We feel the likelihood of a recession in Europe is 100% and in the U.S. is greater than 50%.

• Inflation—It is a rough story. Looking at the components of inflation:
  • Gas prices have risen significantly, while home prices have been soft and used car prices have come down
  • Core goods, especially food prices, remain hot (partly due to the food/fertilizer supply chain from Ukraine)
  • Energy costs are easier to deal with than food prices
  • In the services sector, rents remain stubbornly high
  • TRP Outlook: We feel inflation will slowly and grudgingly come down

• Interest Rates—The trick is to identify the terminal rate of fed funds
  • The market continues to build in additional rate hikes as inflation prints continue to come in higher than expected
  • The terminal rate is the only thing driving rates higher and continues to be the problem
    ■ Every time the terminal rate ratches higher, the probability of a recession goes up with it (represents an inverted curve)
    
  • A yield curve inversion of 50 basis points represents hedging against recession
    ■ A 50 basis points yield curve inversion doesn’t scare the Fed, while a 100 basis points inversion would
  • TRP Outlook: Until the end game of rising rates is seen, investors will remain skittish

• Liquidity—The systematic issues are possibly more terrifying than that of inflation and might require regulatory or legislative action to remedy
  • There have been recent bouts of illiquidity in the Treasury markets, which is not normal or healthy behavior and is akin to emerging markets rather than developed markets
  • The structural problem of the markets goes back to the Volker Rule, which came into effect in 2015
    ■ The Volker Rule curtailed dealers’ ability to warehouse and use balance sheet assets in trading
    ■ But this change in market structure was never tested as the Fed and others poured monies into the system. As a result, liquidity wasn’t an issue
    ■ Dealers have been using their balance sheets for passive exchange-traded fund trading because it’s profitable and done at an agreed-upon price at the end of the day
    ■ Today, this change in market structure is being tested by tighter monetary policy and the increased use of derivatives, which preserves cash on balance sheets
  • However, if you can use balance sheet assets when a counterparty needs to raise cash, those providers of liquidity can source opportunities
  • TRP Outlook: These market dynamics are not changing anytime soon, so the trick is to get on the right side of this illiquidity dynamic

• Do public credits still offer the liquidity they have traditionally?
  • The illiquidity premium has risen in public credits versus a decline in private credits
  • Some are worried while others are not: Where can I get paid for illiquidity?
  • Public market liquidity is worse than it used to be and can now be viewed as moment to moment and asset to asset specific
    ■ We need to better understand what environments work well for some assets and not for others
    ■ History may not be a guide moving forward

Inflation—A Global Challenge

As of September 30, 2022

Source: Bloomberg Finance L.P.

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U.S. Interest Rates—Rising Terminal Rate

As of September 30, 2022
Terminal rate expectations shifted higher post August CPI, September FOMC

Source: Bloomberg Finance L.P.

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Liquidity at Levels Comparable to March 2020

As of October 12, 2022

JPM Treasury Market Depth

Source: J.P. Morgan Chase.Information has been obtained from sources believed to be reliable, but J.P. Morgan does not warrantits completeness or accuracy. The index is used with permission. The index may not be copied, used, ordistributed without J.P. Morgan’s prior written approval. Copyright © 2022, J.P. Morgan Chase & Co. Allrights reserved.

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As active managers, we look forward to volatility in markets

• For 10 years, with volatility suppressed by central bank polices, prices barely changed due to tight spreads and low yields. This was a historical aberration.
• Uncertainty around future economic data and rates is exactly what is needed as it creates opportunities
  
• Volatile markets will reactivate the muscle memory needed to take advantage of dislocations
  • As an example, the recent gilt situation in the UK brings back the market dynamic of what investors can sell versus what they want to sell, leading to some interesting entry points
  • Some short-term opportunities are not always due to fundamental reasons but, rather, painful market disruptions

Is this the end of the 60/40 portfolio?

• For years, money pouring into the systems (i.e., central banks) masked problems and inflated asset prices
  • As money has been pulled out of the financial ecosystem, asset prices have gone down
  • This is an adjustment, not a permanent change
  • Many asset allocators would have said that the 60/40 portfolio was ending during the post-global financial crisis environment
    ■ The view was right, the journey was wrong…subtly
    ■ Economic growth was driven by liquidity versus inflation. This environment became perceived as “normal” when it really wasn’t.
    ■ We were starting to see normalization of fed funds before the pandemic, but never saw it play out
    ■ Is the Fed now going to pivot from being worried about inflation to being worried about growth?

• It shouldn’t be surprising that correlations break down during a stagflation environment due to unknowns, like a pandemic
  • We expect equity and fixed income correlations to revert back to negative
• Investors are being more thoughtful in hedging—diversifying their diversifiers beyond Treasuries
  • Portfolio construction: Don’t just think of high-quality bonds, think of other diversifiers

What’s Your Hedge?

As of September 30, 2022

Rolling 52-week correlation of the S&P 500 to Bloomberg U.S. Aggregate Bond Index

Source: Bloomberg Index Services Limited. Please see the Additional Disclosures page for moreinformation about this Bloomberg information.

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Looking Ahead to Investment Opportunities

• High Yield
  • Today’s high yield market is different from the high yield market of old
    ■ More than half of today’s high yield universe is composed of BB rated companies
  • Many companies are larger and, more substantial
    ■ Credits are very barbelled, offering opportunities at good value
    ■ The market refinanced itself, so there are limited maturities for the next two years, trending in higher quality
    ■ High yield is also attractive in emerging markets
    • Many emerging high yield companies have healthy balance sheets and attractive valuations
      • There is less debt accumulation, and underlying fundamentals look healthy
    • In many emerging market countries, GDP is running ahead of inflation as many countries raised rates quicker than developed     countries

• Emerging Markets, Ex-China
  • Chile, Colombia, Indonesia, Philippines, India, Qatar, and Saudi Arabia look attractive and are beneficiaries of healthy balance sheets
• They are at the shorter end of the yield curve with positive exposure to inflation (i.e., utility companies with inflation escalators, agriculture)
  • BB/BBB market segments contain considerable runway
    ■ We expect that low-single-digit/low-double-digit yield carry will convert into high-teens/low-twenties carry over the next few years

• The Securitized Markets
  • MBS
    ■ Relative cheapness and valuations are not about credit quality
    ■ Many municipalities are in better shape and are awash in cash, either from pandemic monies or from tax revenues, or both
  • CLOs
    ■ Allocation to private credit in a form that is regulatory and capital friendly
    • Top of capital structure with a little leverage
    • Clips a consistent coupon and has been a strong performer
    ■ For investments with a perceived remote loss potential, we believe that they have the potential for high returns

• Diversifying Into Private Credit? 
  • Earlier this year, the debate was on whether the illiquidity premium to lock up capital was worthwhile
  • The denominator effect is constraining interest in privates as investors are now over-allocated
  • However, the pricing of privates in the last six months has made it more attractive, on a select basis
• General Asset Allocation
  • The risk of unexpected inflation is worse-than-expected inflation
  • One benefit to a flat yield curve is to pick up similar yield by moving shorter and not thinking about LDI hedging
  • Consider high-quality bonds and leveraged loans
  • Consider short-term Treasury inflation protected securities (TIPS) over longer-term TIPS

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