Podcast: Bond opportunities in a resilient US economy

Brian Levitt:

Welcome to the Greater Possibilities Podcast from Invesco, where we put concerns into context and opportunities into focus. I'm Brian Levitt.

Jodi Phillips:

And I'm Jodi Phillips. And today we have Matt Brill joining the podcast. Matt's a senior portfolio manager for Invesco Fixed Income, so we'll be covering all things bonds, especially where Matt sees opportunities for investors.

Brian Levitt:

And bonds have been coming. Very exciting.

Jodi Phillips:

Very exciting. Do you think too exciting?

Brian Levitt:

I guess investors have seen their share of rate volatility. They would probably prefer it to not be as exciting, but such is the world that we live in, we'll see what Matt thinks about it.

Jodi Phillips:

Such is the world. What do you make of it?

Brian Levitt:

Yeah, it's a little bit of a market trying to figure out where growth is going to be and what the expectations for the Fed will be. So you get these periods where conditions look too hot and the ten-year rate moves up. And then for a bit over the summer, I think people thought it was too cold and we saw the ten-year rate go down to 3.5%. And I don't know, I guess now we're not too hot, we're not too cold, just right I guess and the ten-year is sitting around 4% or so.

Jodi Phillips:

Not too hot, not too cold. I do have to say, as an aside, it's pretty remarkable to me that a 200 year old fairy tale about talking bears and lukewarm porridge has worked its way into our vocabulary to this extent when we're having these market conversations.

Brian Levitt:

Yeah, Goldilocks with the porridge, the sitting in the chair, the line. I've always-

Jodi Phillips:

4% yields.

Brian Levitt:

Yeah, everyone keeps talking about Goldilocks. I actually have no idea how that story ends. Is it a happy ending? Is it-

Jodi Phillips:

No.

Brian Levitt:

No. Everyone says Goldilocks. Shouldn't we know how the story ends?

Jodi Phillips:

Look, I mean, it's been a while. I think she escaped unscathed. I don't know. In my mind that's how it ends.

Brian Levitt:

Anyway, I don't even know what she was doing there in the first place. I mean, she's trying the porridge and beds of bears.

Jodi Phillips:

Okay. Okay. We're done. We're done. I'm stopping this no more. No more.

Brian Levitt:

I mean, shouldn't you be respectful of people's property? What's she doing there?

Jodi Phillips:

Well... All right, look, so you were talking about 4% yields if I recall correctly and those have not been a fairy tale for investors. There's been multiple opportunities to get yields at that level right?

Brian Levitt:

Yeah. It seems like every time we think investors have the chance to "lock in" a 4% yield, we return, not that there's anything magical about 4%, but it seems like people want four.

Jodi Phillips:

Yeah, no. And five years ago everyone was wondering how they got there, how they could get four.

Brian Levitt:

Right. 2019, how can I get 4%? I mean, I was just hearing it over and over again and that was just from my father, but I used to have to say to him, back then you would have to lend money to the Russian government. And I guess you don't have to do that anymore.

Jodi Phillips:

Well, on certain days you've been able to get it in US treasuries. So a different time it sounds like.

Brian Levitt:

Yeah, and I'm trying to remember actually if that Russian government comment is mine or if I stole it from Matt Brill. So I steal a lot of my comments and I'm sitting here thinking, well, we're about to bring Matt on. And I might've actually stolen the Russian government comment from him.

Jodi Phillips:

All right. Didn't you just say you have to be respectful of people's property? You clearly didn't read Goldilocks, did you?

Brian Levitt:

Well, we share in this industry.

Jodi Phillips:

No, back to you. You need to do your homework. Look, here's your chance to return credit where credit is due. We're going to bring on Matt. Matt Brill, thank you for joining us. Did Brian just steal from you? Yes or no?

Matt Brill:

Brian's allowed to use anything that promotes fixed income. So wherever you got it from, I don't really care.

Brian Levitt:

Yeah.

Jodi Phillips:

All right. Good.

Brian Levitt:

What's yours is mine. What's mine is yours. Correct? Matt, have you been surprised by the resilience of the US economy?

Matt Brill:

Well, we have been. I mean, to be honest, we did expect a soft landing, but just the continued notion that there might be no landing at all has been a surprise. And what goes up must eventually come down. So we do believe that you will have a soft landing. In many ways we actually feel like you've already gotten it. To be honest, I feel like we've gotten a pretty good result so far and the economy is plugging along really, really well.

Brian Levitt:

So when you say we've already got it, you mean different parts of the economy have already slowed and maybe seem like they're picking up a little bit again?

Matt Brill:

Yeah, so there's really no end date right? So it's always we never know when the end to any of these things are, but for now, if you look around, what's happened is inflation is materially less than it was. So whether it's completely in check is still debatable, but overall, we're not looking at eight, 9% inflation like we saw back in 2022. You're around 2.5 to 3%, which isn't where the Fed wants it to be, but it's pretty darn close. Growth is pretty good. The Fed is not in a panic mode at all right now. So I'd say that you've gotten a lot of middle-of-the-fairway, middle-of-the-runway type activity, which is exactly what the Fed wanted.

Brian Levitt:

A golf analogy Jodi instead of a 200-year-old fairy tale analogy.

Jodi Phillips:

I'm on better territory with the fairy tales. I'm going to let golf go by, but I'm glad to hear the Fed's not in panic mode. We don't want anyone to be in panic mode. But what do you expect the Fed to do over the next year?

Matt Brill:

Yeah, so the way that we're describing the Fed is that they are cutting because they can — not because they have to. And so what we mean by that is they can because inflation has come down, they can because there are signs the economy is slowing, but they don't have to, meaning that they're not behind the curve and they're not in this panic mode that I just discussed. So overall, the economy is still good, they're ahead of the curve and they're cutting because they're very far from neutral.

And so we can debate all day what neutral is, but I don't think any of us think neutral is five and a quarter to five and a half, which is where they just were. So they needed to get away from a very restrictive policy closer to neutral. And in order to do that, our expectation is they'll cut in the November meeting, they'll cut again in December meeting just 25, though not in the big 50 that they did just last time. So 25, 25. And then next year they will do every other meeting 25 basis points. So that gets you about 150 basis points lower than you are today, which is in the low threes.

Brian Levitt:

And the low threes... Go ahead Jodi.

Jodi Phillips:

I was going to say, you said we could debate the neutral rate all day. We don't exactly have that kind of time, but I mean, what would be some of the points that would be underpinning that debate?

Matt Brill:

So go back pre-COVID back when Brian was trying to get 4% in any which way he could or his dad was actually...

Brian Levitt:

Russian government.

Matt Brill:

And lending to whatever EM or high yield company or country that could get you that when Fed funds was low. And if you recall, the Fed was hiking rates all through 2018 and then actually started to pivot in 2019 before COVID and they got to 2.25% in late 2018. That was their high point of Fed funds rate. And 2.25% was too restrictive for the economy. World has changed since then, but just put in perspective that was 2.25% and that was greater than neutral. That was restrictive. So how much have things changed since 2018, 2019? Well, quite a bit in terms of some of the things around tariffs, some of the things around de-globalization. There are some other strengths in the labor market that weren't there before. But overall, I think that there is an argument that maybe it's 3% or less, but to be conservative we would call it 3.5%. So just as kind of a high level conservative, meaning higher than it could be would be 3.5%, which we're still very, very far from.

Brian Levitt:

I get the sense that each time the rates move up and we have seen some days where rates have moved up quite a bit, I feel like I hear from investors saying this is the return of inflation where when I'm looking at it seems to me a bond market that's responding to pretty good real economic activity whether it's a payrolls number or a US retail sales number. So when you see those types of moves, do you have concern that it's inflation or are you comforted by the fact that it's growth and how do you know?

Matt Brill:

Well, they are often intertwined, inflation and growth, but you can have growth without inflation and we did for a number of years, but if you get too much growth, then inflation often kicks in. So anything in growth, two to 3% real growth can be okay, but you start getting above that, you're going to drag inflation with it generally. But overall, we would encourage... the market in general is going to be much better if there's growth than if there's not at all. So the worst combination is no growth and inflation.

So I think people can live with growth and 3% inflation. Now again, that's higher than the Fed wants, but it's not a particular situation that people were fearful of back in 2022, which was stagflation, and they were thinking, "Oh God, we can't get inflation under control and there's actually going to be a recession. This is the worst combo." So for us as credit investors, we don't just buy treasuries, but credit investors, it's better for corporations if there's growth and they can actually inflate their way out of a lot of their debt. But overall, we think that the economy is slowing in both in terms of inflation, we're calling it a disinflationary environment, not a deflationary environment, but a disinflationary environment, which basically means inflation is still happening, but at a lesser extent and your growth is still positive. Atlanta GDP now is still around 3%. So again, as you stated earlier, this economy continues to be way more resilient than anybody thought, but I am not seeing inflationary trends pick up. It's just not slowing as fast as the Fed wants it to.

Jodi Phillips:

Excellent. Well, I definitely want to talk about some of the particular opportunities that you're seeing. Brian, should we dive into that or is there anything else we want to establish higher level first?

Brian Levitt:

No, I want to dive in. I mean, investors want to know if growth is too strong and the Fed isn't going to lower rates. Should I just hide out in cash?

Matt Brill:

Well, cash has been a great place to be for a lot of this, but I think if you look at where we are now, I think the journal had an article recently just that money market funds are now... the 5% money market funds are no longer there. So you're in the high fours but still pretty attractive on a historical basis and still have generally an inverted yield curve of at least overnight rates versus out the curve. So cash looks better on an all-in yield basis, but the question is are you renting it and how long are you going to be able to get it for? So reinvestment risk we do think is real. I think what people will be surprised to know is that if you look back over the last year, fixed income returns are in the double digits. So everybody was waiting for the Fed to cut before they enter the market, but yet you've just had 10%+ type returns in the ag as well as corporate credit markets.

So a lot of it has already started to happen and it's kind of the market running ahead of expectations or running ahead of the actual reality of the Fed cutting. So I think the Fed is going to be on a path to cutting and whether or not they're going super fast or just kind of snail pace, the high point I'm pretty sure has already been hit. So the numbers that you got, 5%+ are gone. Are you going to stop at 2%, 3% or 4%? We don't know. But I think along the way you are served to start stepping out the curve, again, if you like this 4% for back all these years, we were looking to get 4% for so long, we've been saying if you like it for six weeks, you ought to like it for six years.

Brian Levitt:

I thought that was my line.

Matt Brill:

[inaudible 00:12:07] for six years.

Brian Levitt:

I thought that... So I'm not sure which one. I probably stole that line from you. I've been using it all year as well.

Matt Brill:

Good lines are to be shared.

Brian Levitt:

Jodi, did you see how happy Matt looked when he was talking about double digit bond returns?

Jodi Phillips:

I did.

Brian Levitt:

Don't tell his children. They're going to expect a very nice holiday season.

Matt Brill:

Taylor Swift End of Eras tour. It's a bull market for bonds, but not quite. We still have some wood to chop. The pain was pretty bad back in 2022 for sure.

Brian Levitt:

That's true. That's true.

Jodi Phillips:

Well, let's go around to some more specific sectors. Let's start with investment grade credit, kind of your opinion of the fundamentals there at the moment and any potential concerns you might see.

Matt Brill:

Yeah, so if you look at yields and investment grade credit, they still look very attractive. But if you look at what we call spreads or the additional compensation you get over treasuries or risk-free securities, they're on the lower end, which means that there is not a lot of fear out there right now. The market is believing that the fundamentals are good and the technicals are extremely strong. So you've got yields of corporate credit, investment grade credit above 5%, right around 5%, but going to call it slightly above 5%. Supply is light, so companies have not been issuing a lot of debt. We're not seeing a ton of M&A activity yet, and corporations are not levering up their balance sheets to take advantage of these lower rates that they have now versus a year ago because they're still relatively punitive and earnings are way better than expectations. So we've been seeing kind of a, I was going to say it, the Goldilocks environment for investment credit.

Brian Levitt:

Right down the fair-

Matt Brill:

The term we're actually using... Goldilocks isn't good enough honestly, and I hate to say it, but it's Platinumlocks is actually where we are, so things are very, very good from a fundamental standpoint. The supply is light and the demand is incredibly strong. So demand is coming domestically from institutional investors, it's coming internationally from Asian as well as European investors. And then the new entrant to the party is the retail investor. So the retail investor has generally sat it out in cash and we and others are finally convincing them maybe step out the curve and we're starting to see retail inflow. So there's just a wave of money coming to investment grade credit, which is overall very supportive. And as long as you don't have fundamental issues, we continue to believe this will do very well.

Brian Levitt:

I think all that money's coming in from you telling people not to rent money markets all year. They're finally listening to you. Matt, is it-

Matt Brill:

We've tried.

Brian Levitt:

Is it possible? I mean when we think about spreads, there's two sides of that. Is it possible that just... it means the risk-free rate is too high?

Matt Brill:

Well, the risk-free rate of the US, you could argue that the US balance sheet is maybe not as good as something like Apple, but at the end of the day we don't make that argument. But the risk-free rate in the US is elevated on concerns of maybe not getting this inflation under control. It's also elevated because of budget deficits. And so corporations are issuing less debt. However, countries are issuing more debt. So the technicals are less positive in the risk-free rate or the government rates, treasuries basically rather than corporate. So that's why we prefer corporate credit and other asset classes, but we prefer high yield investment grade as well as emerging market corporate debt over sovereign treasury debt right now because the technicals are that much better and the overall fundamentals we think are better just because these corporations have done a better job with their balance sheets than the governments have.

Jodi Phillips:

Let's talk a little bit more about high yield you just mentioned. Your thoughts on that at the moment, in your opinion, is it worth the risk?

Matt Brill:

So in a no-landing environment, and again, we don't believe that if you can stay... you have to come down at some point or at least at least even out. And so in an no-landing environment, high yield just absolutely crushes it because the growth is tremendous. And if you have an unlocking of potential growth in the US potentially through what Trump is describing his policy as, that would generally be good for high yield. However, we'll get to the politics later, but in any environment where growth is doing well, high yield is fine. High yield doesn't do well when you enter recession. So if you can eliminate the tail risk of a recession, which I think the Fed has done by telling you that they have your back and there's basically a Fed put there, I like high yield and actually you're seeing a significant amount of upgrades relative to downgrades in high yield.

It's been in the range of anywhere from two to four times depending on what you look at, two upgrades to every downgrade and in some instances it's been as high as four upgrades to every downgrade into high yield versus high investment grade going into high yield, so into investment grade. So the wind is at your back from a upgrade standpoint, yields in high yield, you can easily get 6%+ in high quality, the highest quality double B rated high yield, but you could get 7% quite easily as well in high yield. So overall the yields are positive and as long as you don't see a recession, high yield is going to do well. And our base case is a very low tail risk for the economy of entering a recession. So a no landing or a soft landing are good for high yield and that's how we're skewing the portfolio.

Brian Levitt:

Let's keep moving around the world. I want to talk about emerging markets. I know that we can add emerging markets to a core plus portfolio. I think the thesis that most had gone with was that the Federal Reserve was going to lower rates, bringing the rate differential between the US and the rest of the world to a narrower place, which should weaken the dollar, which would be supportive for investors to go overseas, own the bonds, take advantage of the currency exposure. Has that story changed?

Matt Brill:

Well, it's certainly been delayed just by the resilience of the US economy. So if the Fed cut because they are behind the curve, or even if the Fed just cuts because inflation just drops off a cliff and growth is okay, generally that would be bad for the US dollar. If the Fed's cutting like crazy whether they have to or because they can, that would be bad for the US dollar. If the Fed has to stay a little bit more elevated or a slower pace just because the resiliency of the US economy, that's generally strong dollar and that's not always good for EM local currency, it could be actually okay for EM corporations though, because at the end of the day, if the US economy is doing well, you would expect the derivative to be foreign economies doing well also. So it can be a difference of FX and things like that.

But in terms of really bad things happening to EM, not likely to happen if the US economy is doing well. Really bad things happen to the EM economy if the US is in a recession and people in the US are not buying goods. So overall I think there's little tail risk in EM. However, what are the opportunities? China is a very difficult one just given the volatility people have seen there. The Chinese property companies had a lot of losses for US investors. They didn't have them for local investors, which is kind of interesting, but overall you see a lot of stimulus coming out China. So if that's done appropriately and effectively, China could be a real opportunity from an emerging market debt standpoint. The other area, you have to talk about oil if you're going to talk about EM because it's such a large... any EM in general is very bifurcated.

You can't just paint it with a broad brush, but EM cannot be discussed without talking about oil. And just a few weeks ago, there was a lot of discussion of whether the Saudis would go for market share rather than price within the oil markets. And if they were to do that, basically they're saying they're going to flood the market with oil and drive the oil prices down. If they do that, that's not great for any commodity-rich EM country because the Saudis can win that game at the end of the day. That's probably the biggest risk out there is what do they do with oil prices and do they try to, I don't want to say manipulate it, but just drive it and basically break away from OPEC in that regard.

Brian Levitt:

Jodi, my biggest takeaway from all of this is that I'm now going to steal Platinumlocks.

Jodi Phillips:

Yeah, I knew it. When I hear you say that, I'm going to know.I'm going to know where it came from.

Brian Levitt:

Well, you and our millions of listeners, but there'll still be other people around the globe that will not have known where I got that from.

Jodi Phillips:

That's right. Absolutely. Matt, are there any areas, sectors, places of opportunity that you're watching that we neglected to ask you about?

Matt Brill:

Yeah, so the two hot spots have been commercial real estate and retail. And commercial real estate we've actually seen a huge turnaround and CMBS has done quite well. There've been opportunities and office reach that we've taken advantage of. And when I say that people just fall out of their chair and say, "Oh my God, I can't believe you're buying anything in there." This has been going back a year. And if you look at some of these REIT stocks, which we don't own, but this is representative of the activity, a lot of the office REITs have done incredible. I mean they've basically doubled plus in the last 12 months. And you see things like Amazon telling people to go back to work, there's a huge push for this and the high quality or the highest... the best buildings basically are being leased and there is activity there.

Anything else? No. So you got to pick your spots there, but I would say the fear that we saw a year ago, for several years really, but really a year ago it was really getting a lot of people concerned that it could even spill over to the banks. We're not seeing that. And in fact the banks this week, you saw the bank earnings and Morgan Stanley actually said, "We're going to reserve less for our commercial real estate loans than we had before, reserve less for the losses because we don't think these losses are going to come." And that's the first time we've seen anybody do that since COVID in any material size. So basically no one's declaring victory there, but I do think at the end of the day, the worst is probably behind you in course real estate, which creates opportunities. Again, these are small opportunities, these are not major themes in the portfolio, but I just think it's good.

If you have eliminate one tail risk after another, generally it's good for the overall markets and course real estate has a lower tail risk of the day before. And then the other one is retail. And I think everybody was so concerned that we were going to hit this recession. We've called it the most anticipated recession and most forecasted recession in history. That never happened. And we had retail sales this week and they were fantastic. And you keep being amazed by people going out and spending, but guess what? If they have a job, they're going to spend and if you don't believe the US is going to go into recession, you don't believe that the job losses are going to be material. And in fact, we're still generating 150 to 200,000 jobs a month, people are going to spend. So I actually think that's an undervalued area of the market and mainly because of fear that's been there for so long, but the valuations are a lot better there than they are in other portions of the market. So I think retail could be an interesting play from here.

Brian Levitt:

And I am the living anecdote of all of that. The commute from New Jersey to New York City, as I always say now up to about 80 minutes and about 20 minutes to get a rice bowl at lunch. So I am the living anecdote of all of this. Matt, thank you so much, so informative, so great to have you on the show. You've always been such a great guest to bring on and a friend to the Greater Possibilities Podcast. So thank you.

Matt Brill:

Thank you guys.

Jodi Phillips:

Great. All right, Brian, that wraps it up once more. Tell our listeners where they can get more insights from you.

Brian Levitt:

Yeah, please visit invesco.com/brianlevitt to read my latest commentaries. And of course you can follow me on LinkedIn and on X at Brian Levitt.

Jodi Phillips:

And if he starts tweeting about Platinumlocks, you heard it here first.

Brian Levitt:

I already did.

Jodi Phillips:

All right.

Brian Levitt:

While we were recording.

Jodi Phillips:

All right. Thanks for listening.

Brian Levitt:

Good one.

Jodi Phillips:

All right.

Matt Brill:

All right.