PM Exchange: Credit Markets During a “Growth Recession” (September 22, 2022)

Michael Buchanan: [00:00:02] Welcome, everyone. I'm Michael Buchanan. I'm the Deputy Chief Investment Officer at Western Asset. Thanks for taking the time to join us today for our quarterly portfolio manager exchange webcast. Joining me today, I have portfolio manager John Bellows who's going to share a lot of good macro insights, obviously a lot to unpack with respect to macro conditions. And then Head of Global Investment-Grade Portfolio Management and Portfolio Manager Ryan Brist. This year, 2022 has certainly been one for the record books for fixed-income investors and not in a good way. The combination of dramatically higher rates during the first part of the year, followed by widening credit spreads more recently, has translated into an unprecedented drawdown for fixed-income investors. And if you see the slide that hopefully we're going to put up here in a second, it right there.

Michael Buchanan: [00:01:07] Really is pretty a pretty amazing slide. What this shows is the history of the Fixed-Income Aggregate Index and shows the path of total return in each year. And you can see where 2022 is. It really stands out as being just a significant departure from anything we've seen before. So I think it really does put the magnitude of what we've witnessed in 2022 in perspective. That combination of higher rates, wider spreads. So now as we're, as inflation is proving to be stubbornly persistent and the prospects appear to be narrowing somewhat for the Fed to engineer a soft landing, credit fundamentals are actually telling us a somewhat different story. And in the face of this daunting macro environment, our view on credit remains relatively constructive. And although inflation, it's pretty obvious, remains a key driver of the Fed's hawkish bias, we feel confident that overall inflation will begin to show some signs of rolling over. And I think John will comment more on that. Today we're going to share our latest insights on the credit cycle, inflation, Fed policy, corporate fundamentals and what we believe is the most most likely path forward for fixed-income investors. We're going to explore some of the best opportunities we're seeing in today's fixed-income market as as well as where we see concerns. As always, we've designed this session to be a free-flowing conversation among Western Asset's thought leaders. And at the end of the discussion, there's going to be time for a brief question and answer session. We've already received a number of really good questions, and we're certainly going to do our best to go through as many of those as possible. So with that, let's get started. And I think probably the easiest place to start, John, is yesterday's FOMC meeting. Your reaction to that and maybe the outlook for policy going forward, if that's changed at all?

John Bellows: [00:03:11] Yeah. Thanks, Mike. You know, let me start by saying thanks for having me on your on your webcast today. You know, obviously a moment of a lot of volatility and uncertainty and certainly appreciate the opportunity to share our view with with you and with clients. With regard to yesterday's FOMC meeting, I'd make three points. The first is on the forecast. The Fed puts out the dots. You know, I think this was the part that the market really latched onto or focused on. It was a bit hawkish relative to expectations. The dots are now showing a peak funds rate that's a little bit higher than it was previously and showing less growth. And so I think people put those two together and put together a narrative of a hawkish Fed. My own view is we should be kind of cautious and really putting too much weight on the dots. I think the dots have had a very poor track record in actually anticipating what the Fed's going to do. You know, it's been true this year. We've seen meaningful revisions every quarter in the dots, but it's also been true going back a number of years. You know, in previous times, the dots overestimated where the Fed ended up. So the Fed's been no more successful than anybody else in forecasting interest rates or inflation or growth. And so I don't see why that should change now. So I wouldn't put as much weight on the dots as perhaps others did.

John Bellows: [00:04:30] The second point that I would make was with regard to the message in the press conference. Here, I thought Powell has been pretty clear recently. He's adopted a very succinct, short message. Inflation's too high for the Fed. They're going to bring it down. That's it. That's that's really what he's saying. He said the same thing multiple times and really didn't add much to that basic message yesterday. If anything, I thought yesterday he was perhaps a little bit more pessimistic than necessary. He didn't really talk about any progress having been made on inflation when I think the reality is, is we're in a pretty different spot than we were, say, three months ago when they started doing 75 basis point hikes. If you think back to where we were in June and think about how things have changed, it seems that most things have actually changed in the right direction. Inflation expectations are quite a bit lower than they were in June. You're actually seeing pretty surprising levels on inflation expectations, both in the TIPS market and in surveys. Surveys have inflation expectations at their lowest level in 18 months. It's a big change from where we were in June. Similarly, on commodity prices, you know, this was a concern in June when they started doing 75 basis point hikes. He was worried about oil prices. He was worried about gasoline, worried about the flow through of headline inflation to core, all that's turned around. You know, we went from oil at $120 a barrel to, you know, in the low $80s today. Similarly, copper is down 25%. You know, it's a big change. And again, not something he's talking about. We're seeing kind of the other side of some of the Covid supply shocks. You know, this is something he actually did mention yesterday. Supply chains look better. Labor supply is picking up. You know, that's a big change from where we were three months ago. And the final thing and I know we're going to get into this more with the focus on growth, but the final thing is they've been hiking rates and that appears to have a pretty noticeable impact on the economy. Growth's at zero this year, housing market's in contraction again, something that's changed a lot and not something he focused on. So, you know, in the second with regard to the message, Powell's message is very short. You inflation is too high and they're going to bring it down. But I actually think there's a lot of positives or progress being made on inflation that he's not talking about. And as a consequence, I think he's actually a little bit more pessimistic than he needs to be.

John Bellows: [00:06:50] My third point on the Fed yesterday is: what's next? So the Fed forecasts and everything in the messaging still is consistent with the Fed pausing their rate hikes at some point. It actually appears that that point could be in the next two to three meetings. They're pretty close to the point where they want to pause rate hikes. That's still appears to be the plan. You know, the one thing on this that I think is important is when asked about the criteria for pausing rate hikes, the one thing he said was that he wants to see real rates be positive across the curve, but we're already there. You know, real rates are positive across the curve. That's a big change from where we were earlier in the year. Two-year. real rates are at 2%; positive 2%. So, you know, when you think about how are we going to get to this pause, the one criteria he's giving you has already been met. So I think we're relatively close, you know, two or three more meetings and we'll be there. And obviously that will be determined by the inflation data. But I think that's the direction.

John Bellows: [00:07:51] So let me just sum up the dots. Got all the attention. I think we should be cautious putting too much weight on the Fed's forecasts. They haven't been any more successful than anybody else in forecasting inflation or policy, so I treat that with caution. Two, with regard to the message, Powell was succinct. Inflation is too high. It needs to come down. But I actually think he's a little bit too pessimistic. I think there's actually been quite a bit of progress that he's not talking about. And then three: what's next? I think what's next is at some point in the next two to three meetings, we are going to see a pause. And I think it's important that the one criterion for that has actually already been met.

Michael Buchanan: [00:08:26] Okay. Thanks, John. Some good takeaways there for sure. You know, you mentioned growth at or approaching zero. I think we all know zero is pretty darn close to recessionary territory. So, Ryan, you know, this this next question and I know we've talked a lot about it, but, you know, one, what was the response by credit markets yesterday to the FOMC and probably more to the meat of the question here, how much of a recession do we feel is already priced in to current spreads, current current valuations, if you will? So, Ryan, I'll hand it to you for that question.

Ryan Brist: [00:09:05] Thanks, Mike. Hello, everybody. Hey, John. It's funny, I guess I was going to say that credit market response, you know, first blush, clearly market reaction was negative for risky assets yesterday. And it's funny, we were talking on the trading desk this morning. We came in and we saw the IG credit index was actually marked to tighter from yesterday. We were shaking our heads a little bit and and the team that's like closer in the weeds to the market every day, I think they said, hey, yesterday morning, coming into the meeting, spreads were 3 to 5 tighter. And there was a little bit of an adrenaline build around the meeting. Of course, there's high anticipation, these last three meetings that maybe there was some notion around less large rate hikes in the future. And clearly they didn't get it. So we saw at the end of the day, negativity and risky assets. Higher front-end yield, spreads were wider. Stock prices were down two and one half percent from the highs. Liquidity was pretty low after the meeting. And it was at the end of the day. So I think there's a little bit of lag on that index. If you talk to the high-yield desk, I think things were firmly 15 to 20 wide or and kind of a messy market. I heard John talk about Fed and he's like 10 levels deeper on the Fed than I am. For me, I think it's surreal to hear the Fed Chairman refer to future economic pain and all the references to pain. No painless way to get inflation down, you know, as a non-Fed person, as a credit person, it's almost alarming to hear two consecutive meetings. And I also think that he was really firm in saying my message has not changed and I stand by what I said before. And so I think that was that was that was a little bit alarming to the to the risky markets.

Ryan Brist: [00:10:59] You talked about recession, Mike. You know, I think that's always a hard one. Credit spreads, IG credit spreads are about 45 wider this year. So I think I consider it like a hard leak this year, but I don't think credit spreads are pricing in a real recession here. You know, there's a bunch of models you can look at. You can look at default probability models or you can look at market implied volatility models on the street. And a couple of different ones are probably saying that about 20% to 25%. We're pricing in about 20% to 25% chance of a recession or we're going into a recession here. You got to keep those in mind when you're when you're thinking about the market and you're trying to put numbers around things. My gut-feel point of view is that if the economy takes the path of a real recession, a garden variety recession, or even a more severe recession, you know, we're going to clearly go wider from here. Credit index at 130. We always say kind of garden variety recession or real hard times are in that 200 to 250 range. If you're a believer that markets have the ability to overshoot themselves, you know, at 200, maybe we can go wider so. Hard leak here in 2022. But clearly not pricing in a recession at these levels. And I'd say this too, John and I were talking about this yesterday on the desk. He just said, like if stock's down 21%, IG credit spreads only 45 wider. And so I'd argue first from that first graph you showed us, Mike, you know, like, hey, terrible risk numbers. But on a relative basis, it seems like up in the capital structure companies, IG spreads have held up reasonably well in this real rout of a market here. So, you know, some probability of a recession. But clearly, we're going to go wider if we take that path.

Michael Buchanan: [00:12:57] All right. Thanks, Ryan. So, John, now on to you. So from Ryan's perspective, we've got despite some underperformance in both investment-grade corporate credit and high-yield, we have the potential to get worse or go wider if we do, in fact, slip into a recession, be it a mild recession or something more severe. I guess I'm going to ask you on your outlook for both growth and inflation and maybe tie that back to what Ryan was referencing.

John Bellows: [00:13:34] Let me start with growth. There's there's no question we've already seen a big change in the environment. Last year in 2021, we had 6% year-over-year growth. You know, very easy fiscal policy, very, very easy monetary policy. You know, all of that is turned on a dime. We've seen just a spectacular retraction of the policy support and growth has kind of responded as well. So we had very, very strong growth for six quarters through the end of last year. And this year, growth is going to be zero. And that's just a big change. I mean, it's be challenging to go back and find another period where you went from a 6% growth year to a 0% growth year, which is where we're at. So a lot of this growth slowdown has already happened. In terms of where do we go from here, the one sector that we'd really highlight would be housing. For all the commentary about how the economy is challenging and it's difficult to understand, which I think is all right, you know, there are some kind of fundamental things that remain the same, which is housing is the part of the economy that responds first and responds the most to Fed hikes. You know, housing is an interest rate sensitive asset or part of the economy. We've seen a lot of interest rate increases and housing is responding. You know, you see in Q2, housing activity contracted by 25% relative to Q1 and it could be down another 25% in Q3. So housing is kind of the outlier here. The big kind of news, it is responding and that could put some real downward pressure on GDP going forward. So on growth, we've already seen a big contraction. The environment today is very different than where we were 12 months ago. Probably more of that to come, especially on housing, as the material increase in interest rates are going to put downward pressure on both activity and and I'll get to prices. So growth has changed and we think bias downward given the given the impact on housing. With regards to inflation, you know, I guess a few points. So first of all, from a very kind of high level perspective, I think it's important to emphasize just how much everything has changed. Again, we went through a period of very easy fiscal monetary policy supported by good growth that then led to very high inflation. And that's where we have been. But going forward, you know, you have to think about what's happening now. And what's happening now is kind of the inverse of all that. We've seen a tightening in financial conditions. We've seen a tightening in Fed policy. Money supply, just to choose one, M2 was growing at 25% last year, year-over-year. Right now, M2 growth is close to zero. That's a big change. And so from a very, very kind of high level macro perspective suggests we're going to see a very different inflation outcome going forward. I do think, though, that you need to be even more specific about that. You need kind of drill into the details and the components here. And I think those two are pretty favorable. You know, we've seen a big change in durable goods consumption, which I think has put downward pressure on durable goods prices. Housing I mentioned, very sharp contraction in housing activity, I think likely to lead to at least a flattening out of house prices, if not some declines nationally in house prices, we're starting to see that in certain markets. And the one thing that that that hasn't happened but I think could is some suffering in the labor market. We've gone through a period where GDP growth has been zero and we've hired 3 million workers. Everybody will tell you the labor market is incredibly robust. It's unlikely, though, that it's going to remain robust if we continue in these very low growth levels. So that's the one thing that I would say on a forward-looking basis.

John Bellows: [00:17:23] And then the final thing I'll just put in here on on inflation is I mentioned earlier all the progress and the change since June. And I think that matters. I think that matters for both headline inflation. And I think it matters for core inflation, the stability of inflation expectations, the downward pressure on commodity prices, obviously some risks around the world contributing to that, kind of getting past this Covid shock. I think all of those are are still to come in terms of their downward pressure on inflation.

John Bellows: [00:17:53] So let me just sum up on growth. We've already seen a very big change, very good growth last year, going to zero this year down. Downside risks to that, especially coming from housing, which we're seeing very, very sharp contractions. On inflation, I think inflation eventually is going to follow that big change in both the policy and the and the growth landscape. I think the details are actually supportive of that moderation in inflation, on goods prices coming down, on housing prices coming down, inflation expectations are anchored and we'll see when that happens. But I think very clearly right now, both the growth and the inflation dynamics point to something that's much different than what we've had.

Michael Buchanan: [00:18:38] Okay. Thanks, John. I want to talk about credit fundamentals. This is something that is obviously near and dear to both Ryan and myself. Our teams, we spend a lot of time, a lot of effort on understanding what corporate fundamentals look like today, and probably even more importantly, how those should evolve going forward. And I think what's interesting now, when you look at credit fundamentals, if we are in fact heading for a recession, you're not necessarily seeing the decay or the evidence of that decay within corporate credit. It would be unique. I'm not saying it's impossible, but it would be unique for a period where we're about to enter a recession. And Ryan, I guess you know what I want to talk about? I want to look at fundamentals, get your views on that. But if the Fed seems to acknowledge that we're going to feel pain, that doesn't necessarily signal a soft landing. So, you know, I guess my question to you is, let's talk about how fundamentals look today and then maybe how those might evolve or shift or change if we are, in fact, moving away from the soft landing scenario to a hard landing.

Ryan Brist: [00:19:58] Yep. You know that graph there? I can't totally see it, but I think I know it like the back of my hand. And I was just going to say starting point, Mike and you know, starting point, like when we look at industrial companies or companies in the S&P 500, large-base companies, the starting point kind of was in what I call the amazing category. And we came into the earth. You know, I was quizzed, our clients that say: was 2021 a tough comp or an easy comp? And I say revenues were at all-time highs, earnings were at highs. And margins looked great. And think about it. We come into 2022 and revenues in the S&P 500 have grown single digit. I keep things real simple, and if you've ever worked for a company like hey selling more top line selling more so-called lemonade you know is a real hard thing to do. And if you look at the S&P 500, sales are up single digits. Earnings are up over tough comps last year. The last one, one of the graphs in our presentations we talked to our clients about are margins. And I say that, you know, it's something that I really got wrong during the pandemic. And I say, if I told you we're going to have a global pandemic and we're going to shut down businesses and we're gonna shut down restaurants and we're going to stay at home and the kids are not going to go to school, what happens to corporate margins? And if you look over the last three years, large companies have done a really good job of maintaining margins and passing through a lot of the bad stuff that's happened here.

Ryan Brist: [00:21:35] And so my first point is starting point. I think we're that that going into this slowdown or this so-called economic pain that we hear about, I think IG companies are in a real good place. And if we're going to have that harder landing, if we're wrong and we're going to have that really harder landing, I think you're going to want to protect. Bond people are always thinking about downside scenarios. We have a really negatively convex asset class like in the best case, we get our money back at par and in the worst case we can lose a lot of principal. And so cut that bottom tail off. And so we're advising our clients to go a little bit up in the capital structure and be more in an asset class like IG that can withstand a lot of the thunder and lightning and the rainstorm if that scenario happens. And so I would say starting point great IG as an asset class has a really low long-term default rate. And so that's another way just to think about bigger picture like how you want to allocate your portfolios that that IG has a pretty good track record from a default perspective and you could visit lower prices, but in the end you're going to get your par. And so I think from a fundamental perspective, companies look pretty darn good going into this this sort of difficult period we could be entering here.

Michael Buchanan: [00:23:00] Thanks, Ryan. John, I'll pivot back to you now on recession. And I, I know we keep bringing that up, but obviously it's absolutely critical for the market. Are we in a recession now? Are we going into recession? Are we going to be able to to somehow avoid a recession altogether? I guess my question is, if, in fact, we are going into a recession or it comes to fruition, what do you think that recession would look like? I recognize not all recessions look identical and they all have their nuances. What would you anticipate for a recession if in fact, we are going that direction?

John Bellows: [00:23:45] Let me pick up on something Ryan said. In terms of corporate kind of fundamental strength. And Mike, that's obviously a theme that you touched on at the beginning, too. I think that's a really important kind of observation to think about the recession question. And I would say it like this, I would say that right now there is one problem with the economy, which is inflation is too high. Now, if you take that problem or if you manage to address that problem, it's not obvious that there are other imbalances in the economy that need to be addressed. To the contrary, kind of the rest of the economy looks like it's in very good shape. We don't have overleveraged consumers. We don't have overleveraged corporates. We don't have resource misallocation in certain sectors. And in that sense, we're in a much better place than we have been at kind of the start of other recessions. So you think back to the 2008 recession. There are a lot of problems. You had kind of a lot of resource misallocation into the housing sector. So you had kind of people who had been building houses needed to find new work, you know, building cars or whatever the whatever the resource reallocation process was. You had overleveraged consumers. You had overleveraged financial systems. All of that needed to be worked out over a multi year period. You had a lot of underlying problems in the economy. It took a long time to sort out. None of those are there today. We do have a problem with inflation. You know, let's be clear about that. Inflation is too high. It needs to come down. But once that's addressed, I think it's entirely possible the economy can continue to expand. You can continue to have kind of supply-side increases to meet the elevated demand that would then support a lot of these ongoing revenue or profit considerations for corporations. And you don't need to see a lot of financial pain to go along with Jerome Powell's kind of economic pain. So I think our view relatively constructive on this question. To be clear, inflation's too high and it needs to come down. But I think once you address that problem, there are not any other imbalances in the economy that are overly concerning. I think to the contrary, everything else in the economy looks like it's in fairly good condition, and that would be the foundation of an ongoing expansion. If it weren't for the inflation problem.

Michael Buchanan: [00:26:08] So, John, just I'm going to put words in your mouth and tell me if I'm wrong or not on this. But the idea is, if we are going into a recession, there is a lot of evidence to suggest that it would be a mild recession. Is that fair to say?

John Bellows: [00:26:25] I think that's right. Yep. Thank you for making making it more succinct.

Michael Buchanan: [00:26:32] All right. Well, Ryan, one of the things I talked about in the beginning is that we would explore some areas of opportunity. Obviously, we spend a lot of time with our teams deconstructing every sector, every industry. But I know banks we've had generally a pretty bullish theme with respect to banks for quite some time. So I'm going to maybe ask you on that: what are our thoughts on if if we have a harder landing scenario? Can banks continue to hold up reasonably well and maybe talk about some other opportunities that you see in corporate credit and maybe even some weak spots, if you will?

Ryan Brist: [00:27:13] Yeah. It's funny, we've had kind of a long-term overweight to bank and finance in our portfolios at Western. And the textbook, the business book, the CFA textbook says, listen, you always learn if you're going into a recession or a slowdown, you know, the last sector you want to be in is bank and finance. And if you talk to our banking team, there are some things that are upside down on its head within the subsectors this time going in is kind of what I'm trying to say. And we're maintaining our bank overweight here. And, you know, I think a lot of people know the story, the secular kind of de-risking of the banking system. We've already had our great financial crisis. Our lead analyst here in the US always says more and better capital, this time a lot more thicker capital and a lot better type of loss-absorbing capital, and that's the basically the the secular component of it. You know, I think if you look at the cyclical side of it, though, you know, banks get into trouble kind of in three ways: excessive loan growth lending, reduced lending standards. And like you saw in '07, '08, massive M&A. And I don't really think you have any of those maybe maybe lending standards are leaking at the edges. But I talked about starting point earlier, just about the whole market. And I just say loan losses on real loan losses on bank large bank balance sheets, they're tiny. And so they're coming from a tiny place. So you might see a tick up. But from a cyclical perspective, I think loan growth and standards and there's been no M&A. And so and then if you marry, you know, we're a value shop. I mean, we look at price. If you you know, I said credit spreads are 45 wider this year. If you look at the on the run large down the middle of the fairway large bank, 10-year banks are easily 110 wider this year. And if you stack that on top of a three and one half percent 10-year, you get a pretty darn good yield versus a year ago. And so we've maintained we don't think banks are going to be the quote "problem" this go around and we've had to push back and near term. But banks have had marginal underperformance. But I think it's going to prove longer term to to still be OK; there's areas within bank and finance where we're avoiding there's there's a lot of cropping up in this go around if you will or this credit cycle things famous things like business development corporation, SPACs, all financial-related, low-end consumer exposure.A lot of the large bank and finance companies, you know, aren't funding subprime credit cards or subprime auto lending like we did in last time. So we're trying to avoid that stuff. REITs and commercial real estate we've avoided and we think regional banks are going to be brought up to the standard of the large banks. You're going to see borrowing there. So we've avoided some of those. We have no real exposure in emerging markets. And, you know, I always say these just these long-term things you learn in lending. Our analyst says about once a week on the desk, like in order to be a financial, you've got to be an investment-grade company and so on. On the below-investment-grade side in a high-yield we've avoided financial, so first off we maintain our bank and finance exposure there. I was going to mention, you know, like what do you buy in a recession? What do you sell in a recession? And the second or so I just said banks, you know, the textbook says don't buy. The second one is we continue to be long oil and energy related. And just think about where we've come. You know, 18 months ago, the front page of the newspaper said energy is an un-investable. We've had this onslaught of ESG and ESG-related-toward sector. We did an analysis. One of the things we're presenting to our clients is, is that if you look in the IG index, almost every ticker symbol in 2022 were net paydown of debt, gross paid out of debt within the energy sector. And those old adages is lend money to the guys that don't need it. And if the energy sector is, quote, paying down debt with oil at 80 or 90 or at 100, you know, you want to hold on to those bonds. And so I think it's still an okay place to say we're not making a call on $60 or $100 oil. We're just talking about that these companies, on two occasions in the last seven years, saw death and our acting management teams are acting very differently. So I'd say, hey, in a recession, you don't buy oil. So it's a little bit upside down on its head, again, I'd say, listen, we're holding on to our oil positions.

Ryan Brist: [00:31:58] One other quickie, Mike, I want to go too long. But John mentioned, hey, we got an inflation problem in the United States and kind of, you know, on the credit side say, hey, we got an inflation problem, we also have a tech wreck going on in the marketplace. And, you know, there's big debate and and discussion in the marketplace about the 2000 time period. And, you know, one side says, hey, we have a tech wreck. And, you know, the Nasdaq went down 78% in 2000 over 20 months. And the positive side says, yeah, but all those companies now are a lot bigger and they pay down free cash flow and they generate free cash flow. It's an area we're avoiding in our portfolios. On those long term themes and credit, what you buy and sell in a recession. One of the things we learned you learn is, hey, you don't lend money to technology or technology companies. You deserve an equity-like return. It's funny, if you look at all the indices on the fixed-income and bond-related size, technology has grown to about 7% of the IG index. And, you know, I don't mind lending to some of these large tech companies for two years and three years. You can see the horizon; our analysts can see cash flows out that long. But if you look at the long credit index, technology has grown to about 10%. So people are really willing in the IG market to lend 30 years to technology. And I just say there's a lot of companies that weren't even alive five and 10 years ago, let alone 30 years ago. It's funny, one of the things that we've done analysis on at Western and said that if we look 15 years ago in the credit index, there were two triple B technology names in the index. And today there are 47 tech tickers that are mid or low triple B and kind of hang around on that area of the end of IG and so big hurts bond holders when debt has exploded you should be careful and we've seen it in IG, we've seen growth in high-yield and in the bank loan market. Technology is a big part of it. And we all know this. The famous FAANG stock trade five stocks represent 25% of the capitalization of the United States. And so throughout all the markets, technology has grown big. I'm not saying that the great big companies are going out of business. I'm just saying that they can go down a lot in price. So we've maintained an underweight; as a markets become really comfortable lending the technology, we've really tried to be careful and avoid that sector in our in our client portfolios.

Michael Buchanan: [00:34:37] This is a good takeaways, Ryan, and yeah, I think when we talk about technology, if you think about the foundation of our discipline and who we lend money to, it's always reliable, predictable, consistent cash flow streams. And no question, when you look at technology, those in many cases, not in all cases, those cash flow streams are less predictable. And I think you see that resonate throughout our portfolios. If we are investing in tech, it's going to be companies that are typically going to be more on the consistent cash flow generators, a little more predictable.

Michael Buchanan: [00:35:19] Hey, John, I'm going to be real quick one last question, because I do want to leave enough time for for Q&A. And I think we got to talk about this. Just the dollar, the US dollar, how it's appreciated this year and maybe are there any macro risks that you see associated with that? What are your thoughts there?

John Bellows: [00:35:37] Yeah. Just two observations on what's going on. The first is that a stronger dollar is kind of part and parcel with Fed tightening. That's part of their toolkit. That lowers prices of imports. That's kind of intentional. And so the fact that the real dollar trade-weighted is at the highest level in the last 30 years, I think tells you something about just how much tightening the Fed's done. So that's kind of that's kind of mechanical and by intent. The second thing about the strong dollar, though, I think you have to think a little bit harder about is I think it reflects a lot of the really real, very real risks around the world that demand, you know, China really remains under pressure in terms of their demand. Europe has a very challenging energy situation combined with tighter policy. Now, demand there is really quite under pressure. And so I think that's also putting upward pressure on the dollars that we have, kind of a global demand picture that's really quite challenged. I think those are the two things that are contributing to it. You know, in terms of risks, you know, the dollar is certainly something you watch in terms of the generally speaking, the world is short dollars. So when the dollar goes up, it can tend to expose some vulnerabilities. It's something we're paying a lot of attention to. I think the EM team in particular, I think kind of the starting point is perhaps a little bit better than we've had in previous cycles in terms of other emerging markets in particular, central banks have been a little bit more proactive in this cycle. Floating currencies is a big difference from fixed currencies in previous cycles. So I don't think we're yet at the point where the strong dollar is creating really acute problems around the world, but it's certainly something to watch. So again, I think the way we got here is this is type Fed policy. That's what type Fed policy looks like. That's by design. I think the demand picture around the world is really quite challenged and that's putting some upward pressure on the dollar. And I don't think we're at the point where it's kind of acute in terms of the risks, but it's certainly something to watch.

Michael Buchanan: [00:37:31] [00:37:31]Thank you. [00:37:31] Yeah, as promised, I did want to leave some time for four questions, so I'm going to open it up now for questions. We received a number of them and, you know, kind of sifting through just we're not going to be able to get to all of them, but, you know, maybe grab a handful of them here. And this first one I'm going to direct at you, I think it's a really good one here. The Fed's focus on high inflation is well understood, but what do you think their position is now regarding growth, especially as it has slowed to below trend?

John Bellows: [00:38:06] I think the Fed is focused on high inflation, bringing that down. I think there's a real question in terms of how much of a growth slowdown is required in order to bring down inflation and the special, particular uncertainties with regard to the labor market and we've been in this period that I mentioned earlier of zero GDP growth and we've hired 3 million workers during that period. That's unusual, to say the least, and it's also unlikely to continue. So I think the way I would think about this is slower growth will eventually very likely eventually lead to softening in the labor market, and that will be important for inflation. So it's not we want to see growth slow down because that's the objective. Instead, we're working towards lower inflation the way we get there, slower growth, slower in the labor market and slower inflation. The thing I would really highlight is the kind of relationship on each of those steps is highly uncertain. And so I would really be cautious about anybody who tells you with conviction that the unemployment rate needs to go up a point or two points or less than that in order to bring down inflation. The reality is that we've never been in a situation like this, and so we'll see on that. But I think that's the way I would think about the slower growth which we already have will eventually lead to slower job growth, which will contribute to low inflation. Again, I think we've done a lot of work on that already, but that's kind of the way I would think about that question.

Michael Buchanan: [00:39:32] Thank you. This next question If a formal recession hits, what are the default rates we're likely to see in the high-yield space? And do you think the current valuations and implied default rates today reflect that possibility?

Michael Buchanan: [00:39:48] Ryan I'm going to step in front of you on this one and intercept it just to have some views here that and I know you you gave some of that on this in your earlier comments, but.I think high-yield right now when you look at it, I mentioned this is in a uniquely strong--we're going into this if we are going into a recession with uniquely strong fundamentals, doesn't mean that those fundamentals won't fray and get worse in a recession. But we're going into it from a pretty good starting point here. So I think one thing that we would see is typically when you go through a recession, you see defaults, you go anywhere from, let's say, two-ish percent to two and a half, three percent, and they could get up to eight, nine, 10, even north of 10%. I think this would be very unique in a recession. You would see defaults go higher. Right now, let's say the run rate is about 2%. I think they do go higher, but I don't think you're going to see the types of defaults that we've witnessed historically. I think they're going to hold in reasonably well because balance sheet health is, like I said, uniquely strong. Now, in terms of current valuations, current valuations are suggesting a higher market implied default. We have a five-year market implied default model not to get into much to the weeds there, but current pricing is telling you that the market's pricing in a default scenario quite a bit higher than what certainly is the case now. And what we expect doesn't mean that spreads can't go wider. To Ryan's point earlier, I think when you talk about recession, typically spreads do go wider. So I do think, again, we're going into this or this this period of economic stress, if you will, or economic challenge in pretty good shape fundamentally. And I think the the the impairment backdrop, the default backdrop would hold up reasonably well and maybe surprise some investors. So, Ryan, I'm going to I'll give you this next question. And it's it's it's fairly targeted here. How would spread products in general react in the event of a recession? I think we know the big picture answer, but maybe give us some nuances beyond that.

Ryan Brist: [00:42:18] Yeah. I feel like Mike, I think we kind of I feel like we kind of answered that when I listen down in the capital structure is going to get hurt relative to higher up. Nobody exactly knows; and I advise clients put some insurance on there and go up in the capital structure. I don't respect it enough. And just because I sit in front of the screen every day. But, you know, one of the areas that I think, one of the trades that I have really high conviction on is two-year, three-year, four-year IG credit. And the front end of the curve yields 4%. And you could buy single A three-year issuance in high-quality banks, industrials and pick 150. So four plus 150 to 200, get you to a five and one half to a six percent yield for IG risk. And so and I want to go back a tiny bit, you know, I said starting puts good Mike you said hey we're starting from a good I don't want to I don't want to sound naive on the phone like I liked your word fraying at the edges. You know, one of the things that we're noticing is that the absolute yield between single As and the highest quality of high-yield, double Bs, that absolute yield has steepened from the beginning of the year. And listen, a lot of times smart people think that, hey, that's a form of fraying at the edges. Absolute yields are coming in line. So so I don't want to deny that at the lower end of the spectrum, the lower end of credit, we aren't seeing some changes. We aren't seeing some bad actions at corporations. I say go up in capital. In the Western Asset Corporate Bond Fund, we're really trying to load that front end of the portfolio in that two-year, three-year, four-year part of the curve in our multi-asset class portfolios when Ken or John or the team on the other side of the desk want to buy IG, we're really trying to focus on that front end, you know, and if we do think about it, say we're wrong and we have a bad recession, you're buying a three-year IG corporate bond, you know, six to 12 months from now, you're two years away from maturity and you're still going to pull to par in a lot of those situations. And so when I talk about buying insurance and going up in quality, not only are you buying insurance, you're kind of covering for some real recessionary scenarios here. And you could be you might you might have you might get woken up once or twice during the night, but you're going to get your money back and you're going to get par. And I think so those are good kind of downside protection where you can earn pretty darn good yield. I mentioned I don't respect five percent. I was with an insurance client earlier in the week and he just said, hey, for the first time in our insurance portfolios, we're putting on five percent coupons and high quality. And you got it. When you're adding up the whole market and you're marrying things back to valuation, you can't disrespect that the Treasury component has done a great job and then you put a really nice credit spread on there and they're buyers that it opens their eyes for. So there's a technical backdrop when you go above that five percent yield. And so, I'm not trying to prop the thing that I focus on, Mike. I'm just trying to say that, hey, there could be bad scenarios. And I think if you go up in capital structure, if our base case happens, you're going to be pretty darn happy. And if a bad scenario happens, you're still going to be not 100% protected, but you're going to have some protection on in portfolios.

Michael Buchanan: [00:45:54] No, well said. This next question. I'm going to handle two more questions. John, this one's for you. And it's a good one. What does the Fed need to see to pivot from their current hawkish stance?

John Bellows: [00:46:10] You know, I think it's just an observation. You know, I think that they were pretty close a few weeks ago. I think that, you know, the all the changes that have happened through June have mostly gone in the right direction. So the lower inflation expectations, lower commodity prices, big turn in the housing market, waning of supply shocks. You know, all of those are kind of necessary pieces in order to get to a lower inflation environment in the future and those of all kind of progressed, more or less as expected. So what didn't happen? Why haven't they pivoted? Well. Pretty straightforward is the CPI print last week was higher than expected, and given their rhetoric, they kind of responded to higher than expected CPI with a with another another unusually large rate hike. So I think when you pull back and think about everything in the context, a lot of things have moved in the right direction, CPI didn't. So how do we think about this going forward, clearly if CPI were to move lower, that would do it, there's one possibility. I think another possibility that the Fed, and Jerome Powell was on this is that we see some change in the housing market or sorry, in the labor market dynamic. You know, labor market has been strong. But again, the labor market's been strong in an environment of zero GDP growth, and that's unlikely to continue. So at some point the labor market will soften. And when that happens, that'll be important for the Fed. And then the third possibility is the Fed gets to the point where they think rates are restrictive. You know, I think we're already there by the Fed's own measure of two year, two year real yields are positive. There's just look at Tip's yields. They are positive. But I think we're getting close. So so there's three kind of possibilities that could get us there. A change in CPI, a change in the labor market, you know, softening from the kind of strength we've seen or getting to a level where real rates are significant, substantially positive. And again, the reason that that that any one of those three could get us there is because so much has changed in the rest of the landscape. If that were the case, if it weren't the case that all those other things had changed, then it would look like the Fed pivot's a long ways off. But again, the world has progressed since where we were over the summer and mostly progressed in the right direction. We do need a final piece to fall into place lower inflation, softening the labor market or more substantially positive real rate. But I think any one of those three things could do it.

Michael Buchanan: [00:48:33] Okay. Thanks. And then the last question. Correlations are all positive in 2022. What do we need to see for correlations to return to historic norms and any idea of a time frame? I think I'll tackle this one.

Michael Buchanan: [00:48:53] Correlations, if you recall that very first slide we talked about or we showed that the total return for every year since 1977 for the for the aggregate index and fixed-income reason why 2022 stands out as such a drawdown relative to all those other years is because we had exactly what's mentioned in this question that positive correlations where rates were higher spreads wider. Typically if you think about rates, you think about government securities, they are negatively correlated to risk assets. So you had that positive correlation, which really translated into deep drawdown as we're all witnessing in 2022. So what do we need for that to change? First of all, I think it's likely to change. The answer really would be normality, because if you look back almost every cycle, it's a fairly reliable inverse correlation. Treasuries tend to do well in rally when risk is is under pressure. So I do think that that it's unlikely we see both treasury and Treasuries and risk continuing to trade off. So so that's one takeaway that I have from that. I think in terms of the metric we'd have to follow, it really would be inflation. Inflation, as we all know. John talked a lot about it. It's front and center with the Fed right now. So to the extent that that that the market starts to become more convinced that inflation is heading in the right direction, I think you'll start to see that normal inverse correlation begin to take hold somewhat.

Michael Buchanan: [00:50:44] The other thing I would add, and again, this is not really to the question, but going back to that, that very first, I call it the spaghetti slide that we had that showed the total return for every year. It's interesting, and I'm not predicting anything but the worst year prior to 2022, 1994. And then if you look, what is the best year, 1995? So that's kind of interesting. You know, it's a little bit of mean reversion. But I also think, you know, the one thing about fixed-income, Ryan brought this up earlier. You know, best you could hope for is you're getting your coupons, you get back par, but there is some of that that pull to par. And just think about that relationship know big nasty ugly year in 2022. You know be tough to see a year similar to 2022 and 2023. So I'll leave you with that. And again, I apologize. I know we went a little over our allotted time, but I want to thank everyone for participating today. All the questions and thank our panelists, John and Ryan, for your for your insights.

Michael Buchanan: [00:51:56] And as we close out our discussion, I just want to note that we're going to be directing you to the Firm's quarterly key convictions piece, which aggregates our current overall views in an added glance dashboard. And additionally, it provides a snapshot of some of the current market opportunities in a sector focused spotlight and others other insights as well. So finally, we really do value your feedback, so we'd really appreciate it if you could take the time to fill out a very brief survey at the end of this webcast. Thank you and take care. Appreciate you listening today.