What will the Fed do? When will inflation turn? Financial industry needs a 'paradigm' shift
Advisors are asking two key questions regarding the bond market as they decide what to do with their clients’ portfolios in the face of today’s challenges, but they still need to wait for the answers because not all the data is in yet, says one bond expert.
“The first question is what the Fed is going to do because, given everything that’s happening, inflation is going to turn at some point in time. The question then is: is it the change on the margin that triggers them to slow down in their policy? Or do they want to see a set number, or amount, of inflation before they change their tune?” asked Phil Mesman, portfolio manager, partner, and head of fixed income at Picton Mahoney Asset Management in Toronto.
He said the financial industry, which is used to low rates, needs a “paradigm” shift to the new regime since the Fed wants to adjust its rate policy and balance sheet reduction to a neutral rate as it balance inflation and unemployment.
“If the neutral rate is 2 to 2.5%, great, then that’s in line with current expectations,” said Mesman. “But, if it goes to 3% or higher, then we’re going to have a lot more pain in government bonds.
“We have insufficient information to make a conclusion with respect to whether now is the time to buy duration or not. Therefore, I’d recommend advisors wait for additional data before making their asset allocation moves,” he added. That means waiting for the employment and CPI numbers, and then seeing how the market reacts and the Fed then reacts to that since it will be providing its growth forecasts for the rest of 2022 after its key meeting in mid-June.
“So, if I was in an advisor’s shoes, I would continue to hold the line on buying duration now and wait for additional clarity. I would consider cash or money market alternatives.
“Obviously, I see a strong business case for hedged or long short strategies, because we have the tools and can take advantage of the opportunities that are happening.”
Mesman said the other big question that he’s hearing from advisors right now is whether now is the time to get back into core bonds and buy government bonds again.
“Every advisor in the country just got their clients’ statements for the end of April and they’re down 10% to 15%,” he said. “Now their clients want action, and they have to do something. So, what the heck do they do? The idea of rotating into duration doesn’t make sense yet. We don’t have the information to make an intelligent decision on that shift.
“So, I really like the idea of alternative income at this particular juncture because we can take advantage of the increase in yields that we see while continuing to hedge the risk. And then I like cash or money market or short-term GICs as the alternative for now.”
Mesman is recommending a three-step call-to-action for advisors: debrief on what happened in the portfolio, rebalance, and reallocate investors with resilient strategies and styles to navigate this market.
Mesman noted the questions and concerns that are arising are triggered by the two economic indicators that the Fed is watching - inflation and employment – and concerns about what they’ll do about it.
“There are more supply-driven inflation challenges and supply disruptions everywhere, whether it’s the Ukraine, Russia, China, getting products, or the Avian flu in the U.S. It’s the worst Asian flu situation in history,” he said. “I do agree that, at some point, inflation is going to turn. But, the question is what happens between here and there?
“Employment is so full that they can’t get enough people in jobs, and that’s going to be a really, really tough nut to crack. So, the Fed has a big challenge with slowing the market down.”
While there has been some confusion about whether the Fed Chair, Jay Powell, was being dovish or hawkish after the early May meeting, Mesman noted that the Fed has indicated that it will remain “data-dependent” and react accordingly to the new information that’s released regarding inflation and growth. But, he, like many advisors, will be watching the next Fed announcement in mid-June.