October 2022 Credit Market Update:
Will the 60/40 Work Again? Recession and Volatilty May Have Something to Say About That
CPI Moved in the Right Direction. Why Doesn’t the Fed Seem Happy?
The surprise CPI number of a 7.7% increase over the last twelve months beat expectations. This would seem to be completely in line with Chairman Powell’s remarks at the early November FOMC meeting that indicated the size of future rate increases would take into account “the lags with which monetary policy affects economic activity and inflation.” In other words, rate increases are likely to be lower than the 75 basis point hikes we’ve seen repeatedly this year, to give the economy time to catch up.
The problem is that Powell also indicated that overall rates would likely be higher than previously announced. In recent weeks, various Fed officials have reiterated the message. This means the emphasis has shifted from how high, to how many.
What’s behind this new messaging? With GDP growth turning positive, labor markets still demonstrating strength, and robust consumer spending, the goal is to get inflation under control, and to telegraph that very clearly to keep markets from expecting a pivot.
- The October non-farm payroll number was 261,000. The report from the Department of Labor marked the slowest increase since December of 2020. This was a slight decrease from the September number, released in early October, of 263,300.
- The unemployment rate increased to 3.7%. The unemployment figure that includes discouraged workers and those holding part-time jobs increased to 6.8%.
- Third quarter GDP came in at 2.6%. The positive number is a bounce back from the negative first and second quarter numbers.
- U.S. retail sales rose 1.3% in October. This is the biggest monthly gain since February. The Census Bureau report showed sales up 8.3% over the twelve-month period.
The question around a recession in 2023 has also shifted, from whether we will have one to the likely length and duration.
To get from 7.7% to an average of 2% CPI means the economy may have to slow substantially, and unemployment will increase. However, that doesn’t necessarily translate into a long or deep recession.
There are several factors that could indicate a recession may be shallow and short.
Since the run-up to the Global Financial Crisis, the Federal Reserve has seen intervention as a key part of its role. Powell is continuing to communicate that while the economy will need to cool off to get inflation under control, getting rates back down is also a priority, just not as quickly as markets may prefer.
The ability to throw off a recession also depends on the overall health of the economy and the markets. Systemic risk is not a factor the way it was during the GFC. Banks are healthy, and the extended period of low rates and liquidity throughout the pandemic allowed many companies to refinance at a very low cost of capital.
A Closer Look: A Traditional Credit Cycle, But With Extra Volatility, May Not Serve the Traditional Portfolio 60/40 Allocation
So where does that leave credit markets? We’re entering a more traditional credit cycle as interest rates increase and the Fed continues to reduce its massive balance sheet. In case anyone’s forgotten what that looks like (it’s been a minute), consumer spending tends to shift to credit cards, which is already underway. High prices and high interest rates eventually create a slowdown in consumer spending, which impacts corporate profits. Added to that is ongoing geopolitical risk.
Volatility will likely remain elevated over the next six-to-twelve months, with even the Treasury market seeing higher volatility. These factors create much greater dispersion in the performance of industry sectors and individual companies. Credit evaluation and selection are key to avoiding issues as defaults return to normal levels.
The shift to private assets that can find opportunity in volatility, and are not correlated to public markets, will most likely continue as demand for assets that can smooth help volatility remains high. Private debt has proven resilient through market downturns, and middle market, privately held companies have held up during past recessions. The National Center for the Middle Market reports that, during the GFC, large businesses shed 3.7 million jobs, while the middle market added over 2 million new positions.
Chart Spotlight: Default Rates Remain Below Historical Averages
Current low default rates are projected to increase to more normal levels over the next few years.
Source: Credit Suisse, as of September 30, 2022. Loans represented by the Credit Suisse Leveraged Loan Index. High Yield represented by the Credit Suisse High Yield Index. Distressed exchanges included in default rate calculation. Visuals: CION.
Performance Among Credit Indices
Source: Bloomberg as of 11/1/2022
Credit Asset Classes – Data as of October 31, 2022
Other Related Asset Classes – Data as of October 31, 2022
