As Economic Growth Slows, U.S. Government Bonds May Provide Opportunities

 

 

 

The U.S. economy is growing at a slower pace, as rising rates and higher inflation take their toll. Anna Castro, Senior Portfolio Manager at TD Asset Management, explains why now may be the time to consider adding U.S. government debt to your portfolio.

Transcript

Greg Bonnell: Equity markets have been shaking off concerns about high interest rates and a potential recession. In fact, stocks continue to march higher this year. But my next guest says now may be a good time to take a closer look at fixed income, especially in the coming quarters. Anna Castro is senior portfolio manager at TD Asset Management. Anna, it's great to have you back on the show.

Anna Castro: Thank you, happy to be here.

Greg Bonnell: Let's talk about this then. Let's talk about the effect that higher rates are starting to have on the economy– we're seeing some of those effects– and what it could mean for the markets.

Anna Castro: So you're starting to see the economic growth momentum slow down. You're seeing consumer confidence slightly weaken, retail sales growth could be lower than they were before, as well as manufacture activity, mainly because it's now more expensive to borrow, and it's also harder to borrow.

Greg Bonnell: So this was the intention of the central banks, when they raised rates so aggressively, Anna, to try to cool the economy, bring inflation down. You have some charts that highlights what you're seeing out there from those efforts.

Anna Castro: Yes, good point, Greg. I do want to mention, when you said, we've been here for a year, technically, it's only been six months since the summer, wherein rates were higher than they were in the prior cycle. So it's taking time to flow through. The chart we have here is our spider web of various indicators. Obviously, a market bottom is not event that you can call, but a process.

And so I'll go through some of the metrics. The ones in yellow are, for example, inflation. It's lower than it was in the prior year. So we're seeing it move closer to 4%, but certainly below what the Fed is targeting, at 2%. And the other portion is valuation. We believe equity valuation is too high, especially relative to where fixed income yields are at. And then the third one is risk sentiment. We do think that the equity market specifically is quite positive or optimistic in terms of the outlook, especially if we think that this economic slowdown is only in the early innings. And we might see more of that manifest itself closer to the summer and towards the end of the year.

And the indicators here as well, you see the red circles. So we do see that earnings revisions are — have been guided down. So they're slowly being revised lower. So that's a good sign, more realistic expectations. But it's still a question of how deep this recession would be. The other component is growth.

We do see, as I mentioned, economic growth indicators weaken. And if we think that we're just still in the early innings, we expect that to further weaken in the coming quarters, as the lag effect of higher interest rate and tighter conditions show itself. And that's why we're concerned about what equity markets are pricing in versus fixed income.

Greg Bonnell: Okay, given that, then let's talk about fixed income. You say it is the time to take a look now, especially US government debt. Walk me through that.

Anna Castro: So long-term US government debt that's, like, 10-plus years, 10, 20, 30 years, are offering around 3% income yield, which we have not seen in the past 15 years. So that, by itself, is attractive. But more importantly, these long-dated US government bonds would benefit or appreciate in value during an economic slowdown.

So because when inflation expectations go down and economic growth expectations slow down with worries about recession and flight to quality, long-term government bond yields go down, that means government bond prices go up, and so they would appreciate in value. And in that setup, US long-term government bond in a risk-off setting can offer you double-digit type of returns in total returns, and highly liquid to help you adjust your portfolio if the market conditions change.

Greg Bonnell: Now, when someone hears US government bonds, they might think, if they're following politics, the US government wrangling about the debt ceiling. How concerned do we need to be about what's happening with the debt ceiling and where we might end up if we're investors?

Anna Castro: So overall, the US debt ceiling, this time around, is more concerning than it was in the past. Like, in 2011, you had a risk-off response in the market, and equity markets sold off. On a relative basis, US long-term government bonds would appreciate in value and benefit from this setup because there would be a flight to safety.

And again, if you have a prolonged polarization or debate on the US debt ceiling, the longer this is not resolved, the more volatile it is and the more negative it is in economic growth. And that would actually mean that lower economic growth expectation is positive for US government — long-term US government bond yields.

Greg Bonnell: All right, so that's the case for fixed income. But you're also, when you talk about portfolio management and allocation of funds, not saying no to equities. What does an investor need to be mindful, though, in times like these, if they're taking a look at the fresh equity positions?

Anna Castro: So it's all about focus on quality. So US government bonds provide quality sources of income and optionality. Equities and alternatives are not bad places to be, as long as you're focused on quality, resilient business models, quality assets, and again, quality sources of income that can handle different types of the economic cycle.

Greg Bonnell: Now, when we talked about the fact that, of course, we've been living with these aggressive interest rate hikes for a year now and we're seeing it starting to flow through the economy, we think about the labor market. We think about a lot of the things you talk about, consumer retail spending. We're seeing some stress, very specific to some US regional banks. That story hasn't gone away. The Fed did suggest that, that could do a bit of the work for them, in terms of tightening credit. How should we think about those events?

Anna Castro: That's a good point. Mainly because small and medium businesses rely a lot, in terms of their sources of credit, from regional banks. So there's challenges in the regional banks, while it's not a contagion, makes it very — not just only expensive for businesses to borrow, but harder for them to borrow. And that has implications on their capital spending as well as their ability to continue paying their workers or increasing their worker base. So there has downstream implications there.

Overall, difficulty in credit, more expensive credit is not good for the economy, longer term. But it takes time to play out. And that's why, going back to my point earlier, it'll be a couple of quarters for us to really see the impact on the broader economy.

Greg Bonnell: Before I let you go, I just want to ask you, what are the risks to the thesis about some value in bonds going forward, given everything that's happening, everything that may happen?

Anna Castro: So the main risk there is another inflation shock that throws off the current trajectory of the moderating pace of inflation.

 

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