Welcome to Soundbites, weekly insights on market trends and investment strategies, brought to you by Investment Executive and powered by Canada Life. For today’s Soundbites, we’re talking about interest rates and Fed policy with Katie Klingensmith, senior vice president and investment specialist with Brandywine Global Investment Management. We talked about the current economic climate, bond yields. And we started by asking what explains the resilience of U.S. growth.

Katie Klingensmith (KK): The U.S. economy has been remarkably resilient. We really think about three factors. The first one was more the result of a natural disaster, with Covid, than a regular economic cycle. So, a lot of the dynamics that we would typically analyze have really different behaviours this time around. The second big factor is that households and corporations had access to a lot of very inexpensive financing back in the era of zero-interest-rate policy, and they took advantage. U.S. households generally have fixed-rate mortgages, and many companies of different qualities had access to long-term, very cheap financing. So, we’re still enjoying those very low rates. The third one is that the U.S. government provided a lot of fiscal stimulus. So, the past year has had this massive fiscal tailwind, even after the government distributed that money.

The Fed and data dependence

KK: The Fed is always data dependent. Like any central bank, it will have to respond to whatever the economy is actually doing. Right now, it’s particularly difficult because they know that there are big lags to many of the policies that they’ve implemented. They will have to be data dependent. The question is, can they have the patience to really see the full effects of the policy moves that they’ve already implemented. And our fear is that they will not be able to have that patience. And in the scenario that we’re most worried about, the Fed actually keeps rates too high for too long, because they will have not yet seen the relevant data that could show the real hurt or demand destruction that is caused by rates being so high. So, to us there’s a real risk that the Fed keeps rates too high too long, and in fact we do see inflation overshoot, and we could get into a period of disinflation or even temporary deflation going forward.

The possibility of recession

KK: So, we  have been in a rather cautious camp for a while about the fundamental outlook of U.S. economic growth. We don’t say that for sure there will be a recession, but we think the potential for a rather rough landing is still very real, and that we need to be prepared for it, especially in our fixed-income portfolios. We’re really thinking about the uncharted territory of a central bank exiting from quantitative easing, and what it means to have rates this high and reducing the balance sheet this quickly. We worry that we could see something break.

And finally, what’s the bottom line on Fed policy and bond yields?

KK: From our perspective, it’s actually a really interesting time to be buying bonds. We think that the real rates are extremely attractive, historically very high. If you follow our logic — that inflation is coming back down and unlikely to remain far from the Fed’s target long term, and that growth is unlikely to return to the same levels that we saw over the last couple of decades — we really see a lot of value in locking in some of that duration. We also like a lot of other opportunities in bonds right now. We really like the idea of having some duration especially, again, on the safe side, looking at high-quality government debt. At the same time, we think that there are very interesting opportunities across a number of different sectors. We want to be choosy, because we think that there are, again, macro risks. They’re quite idiosyncratic. So, it is a time to be really tactical around duration and around sectors. We like credit exposure. We don’t want to go too far down the credit quality stack because there could be macro headwinds that could cause real troubles. So, we like higher-quality credit, including in the high-yield space, but still on the higher-quality side of high yield. And we like to keep duration relatively short  in that credit exposure because we think that rates are more attractive, we’ll see a little bit less volatility, and we’re compensated for holding them for those short periods of time. There might be a lot of volatility given the quantity of uncertainties in the macro outlook, but there also are opportunities that have not existed in a generation or two in actually finding attractive total returns in the fixed-income market.

Well, those are today’s Soundbites, brought you by Investment Executive and powered by Canada Life. Our thanks again to Katie Klingensmith of Brandywine Global Investment Management. Visit us at investmentexecutive.com, where you can sign up for our a.m. newsletter and never miss another Soundbite. Thanks for listening.


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