“In the midst of chaos, there is also opportunity.” ~ Sun Tzu
Inflation, Volatility and the Current Investment Landscape
We are living in unprecedented times. Core inflation is running at 7% YoY, a level not seen since the early 1980s. The Federal Reserve has now dropped its previous call that inflation would be “transitory” and is subsequently ending its asset purchases early. The Fed also appears set to hike rates as soon as March of this year. In fact, in a span of just a few months, the market has gone from expecting zero rate hikes to now anticipating five—with some even calling for eight this year alone! All the while, we are still battling Covid and its many variants. With elevated pricing pressures and uncertainty surrounding the virus and central bank policy, where can investors go to earn a return on capital without assuming unnecessary risk? Is it possible for the corporate bond market to provide good risk-adjusted returns against a backdrop of hot inflation?
It has been a very long time since investors have had to grapple with truly elevated inflation, and the reality is that most of us were not involved in the financial markets back then (including me!). Before we dive into the specifics of what’s at hand and what it all means, let’s first set the table with the current macro backdrop. Western Asset’s view on inflation, which we’ve maintained for a while now, is that the strong inflationary impulses of the last 18 months should prove to be more cyclical rather than structural. We believe that the larger secular forces of aging demographics, the global debt burden and incredible advances on the technological front (all three of which are strong deflationary forces) will ultimately temper inflation. Our expectation is that inflationary pressures will cool significantly over the course of 2022, which would create a favorable environment for spread product.
However, as our CIO Ken Leech is quick to ask, what if we are wrong? As investors, we have our base case view and even our strongest convictions, but in a time like this we must also acknowledge that there is a wide range of outcomes, and we must prepare our portfolios accordingly. Within the investment-grade (IG) corporate bond market, we continue to believe that fundamentals remain very solid. In fact, most IG sectors are currently experiencing consistent top-line growth while also expanding their profit margins. However, 2022 may present a test that we have not seen in quite some time, as pricing pressures threaten margins and, in turn, could negatively impact free cash flow (FCF) and leverage.
Investing in corporate credit has always been about FCF. Companies that have consistently positive FCF are better able to service their debt, thus appealing to a broader audience of investors, and subsequently having a larger pool of capital from which to borrow. This ultimately enables companies to borrow at a lower interest rate. When approaching the question of investing in corporate bonds in the current environment, one must start and end with a company’s ability to generate predictably positive FCF. This is derived from two main factors: (1) can the company successfully manage its input costs? And (2) is the company able to retain pricing power?
These are the two main levers that need to be examined. Many industrial companies enjoyed increasing margins in 2021 because they were able to hedge their input costs at much lower prices than in 2020, but those hedges have largely rolled off, which leaves them exposed. Some of these same sectors also struggle with the ability to pass through these higher costs, leaving them pinched on both sides. We continue to avoid these companies in our credit portfolios and would caution investors to do the same.
So where do we find value? Our long standing overweights to the banking and energy sectors should continue to perform well in this environment. Labor is one of their larger input costs and we believe both sectors will be able to effectively pass through increases in the cost of labor and thereby help preserve their margins. We would also point to the telecom and cable sectors, where they are doing an excellent job of managing input costs; we argue that no sector is better able to retain pricing power than communications. After all, who among us would blink at small increases in our wireless or broadband internet bill? These are staples to most everyone today, and if you asked my kids they would probably pass on eating breakfast if it meant keeping their iPhone connected (a sad blog post for another day).
2022 is likely to see a good bit of disparity in returns based on which sectors you are invested in. While we acknowledge that volatility will be elevated, we do not think that equates to avoiding the IG credit asset class entirely. We think this will be an excellent environment for active managers to prove their grit, but could be equally as painful for those who do not properly guard against the possible threats of inflation.