Jessica Schmitt (0:05)
Hello, everyone! I'm your host, Jessica Schmitt, Director of Investment Communications here at Diamond Hill, and welcome to another exciting episode of Understanding Edge. Today, we're once again joined by Douglas Gimple, senior portfolio specialist for our fixed income team here at Diamond Hill.
Today's episode takes a deeper look at what drove the November rally, latest comments from the Federal Reserve, and where opportunities await investors as we get ready to embark on a new year.
Whether you're a regular listener or tuning in for the first time, this episode promises to provide you with valuable insights and actionable advice.
So, sit back, grab a cup of coffee, and let's dive right in. Thank you for tuning in, and we hope you enjoy this engaging conversation with Douglas Gimple.
Jessica Schmitt (0:53)
Hey Doug, great to have you back on the podcast.
Doug Gimple (0:56)
Thanks Jess. As always, it is a pleasure to be here.
Jessica Schmitt (1:00)
Well, great having you. Let's kick it off as we typically do, Doug, with an update on the latest from the Fed. They had their meetings the last couple of days, today's December 14th, so hoping you can summarize the key takeaways and what fixed income investors need to keep in mind as we wrap up 2023 and head into 2024.
Doug Gimple (1:21)
Sure, as expected, there were really no shocks. The Fed held rates steady, for now the third consecutive meeting. The last time they raised rates was in July and that was by 25 basis points. And ongoing stabilization in both economic activity and inflation has kept the Fed off to the sideline, and expectations have shifted over the past several weeks from rate hikes to rate cuts next year.
The biggest takeaway from this meeting, it was the shift in the Fed's outlook for 2024 based on the dot plot, which basically outlines each Fed member's expectations for the future path of interest rates, looking at how many rate hikes or cuts will occur in 2024 in 2025, 2026 and now I think it's just longer term, beyond 2026.
The report is released on a quarterly basis from the Fed, and it follows their schedule meeting of that quarter. So, we had the September meeting where the Fed estimate was for two 25 basis point cuts by the end of 2024 and despite the market continually pushing fed fund futures to reflect five 25 basis point cuts in 2024, the Fed’s held the line, whether it's in speeches or it's on talk shows, they've continued to hold that line until this most recent meeting.
So now the Fed, based on the dot plot, is reflecting three 25 basis point cuts in 2024 and an additional 100 basis point cuts in 2025 indicating that they believe that they're at the end of this rate hiking cycle. But this meeting shift was really a close call. Jess, when you dig into it, there are 19 participants that make up the dot plot and they each provide their expectation for future rate movements. It was basically two dots. Expectations were the difference between an estimate of 75 basis points of cuts versus 50 basis points of cuts in 2024. So it was kind of right on the line there.
The Fed's economic projections were slightly lower or unchanged with 2024 GDP lowered from 1.5% to 1.4%, not a huge deal, and year-end unemployment unchanged at 4.1%. The big question now is rooted in how those three rate cuts map out in 2024. Is it March, June and September and then you have the option for December, if needed?
Optionality is the key for the Fed, and they've got the flexibility to adjust their plans as economic data comes to light. But it's important to note that the Fed remains hesitant to declare mission accomplished on controlling inflation, and they made sure that they did not rule out higher rates in their policy statement — the verbiage of which was really little changed. The Fed continues to hold the line on not committing to any type of finality regarding this tightening cycle despite what the market continues to price in and I think the Fed is taking the right approach. Now they're obviously not going to ask me because they don't care, but I do think they're taking the right approach.
Inflation, as we've talked about in other podcasts, Jess, it doesn't move in a straight line and there are going to be peaks and valleys as we move through 2024 and the Fed wants to maintain that data dependency approach that has dictated their policy the last call it 6 to 12 months. So, it's clear the Fed has shifted their stance on inflation. They noted that inflation “has eased” over the past year though it remains above their targeted rates. So, there's still this disconnect between what the Fed is saying and what the market is pricing. Even in his comments, Powell said, we still may raise rates even though the dot plot doesn't reflect that.
So, we're at an interesting time where the market feels like they're done but they're kind of not wanting to give that final commitment of, yes, we're done; the next move is lower. And I think it makes sense given uncertainty heading into 2024, whether it's the economy, whether it's elections or whatever else is out there.
Jessica Schmitt (5:32)
So more interesting times to come I feel is ahead of us, Doug. But let's turn now to the month of November, which was the main topic of your most recent market update, which is available on our website for our listeners. The month of November was quite a month for markets across the board — equity and fixed income. After spending most of the year worrying about rising inflation, interest rates, possible recession (hard or soft), markets rallied pretty strong in November. I saw in one Wall Street Journal article it was dubbed as the “everything rally.” Can you share some performance highlights from the bond market and what drove that rally across some of the different segments of fixed income?
Doug Gimple (6:16)
Definitely, I'll talk about the bond market because you don't want me to talk about the equity markets, but we'll dig into it. And normally coming up with the topic for monthly commentary, it takes a bit of time — trying to find aspects of the market that I believe investors and our readers will find interesting. There was no such problem this month. It was the dazzling performance in the fixed income markets in November was story enough, especially coming on the heels of a challenging 2022, which we've discussed and what can only be described as kind of an up and down 2023.
Consider this: From the beginning of 2022 through October 2023, the Bloomberg US Aggregate Bond Index lost 15.42% on a cumulative basis, which is about, it's down 8.73% on an annualized basis, so losing money in 16 of 22 months. But November 2023 delivered the best month for the Aggregate Index since May 1985 by returning 5.23% and it would've been even better had the index not lost 46 basis points on that final day of the month of November.
There were only five negative performance days in the month, which is roughly 23% of the business days compared to the preceding 10-month average of 52.8% of the business days experiencing a loss during the month. But it's the degree of losses on those negative days in November that really indicate the volatility during the month as those days had the highest daily average of loss since the beginning of the year. So, -0.53% on the days that there were losses, that's the average loss on those days. The preceding 10-month average daily loss was -0.37%. So significant down days, if you will, but not as many if that makes sense.
So why such strong performance? It's a combination of solid economic data including an increase in the Q3 GDP number reported earlier from 4.9% to 5.2%, but as well as continued cooling of PCE and core PCE inflation enforce the notion of a potential soft landing. So, one of the things that you had addressed in your question. As I mentioned in our discussion about the Fed earlier, they're reserving the right for one more hike, but no one seems to believe it'll happen except maybe the Fed, and the market's pivoting towards the idea that the next step is a rate cut — timing to be determined.
Here's some data, just historic comparisons on how strong the performance in November was. The Bloomberg US Treasury Index delivered its best monthly return since November 2008. The Bloomberg US Corporate Index had its best monthly return since December 2008 and the Bloomberg US Securitized Index, which includes residential mortgages, commercial mortgages and asset-backed securities had its best monthly performance since its inception in 1997.
So, as you deemed it, or as I guess the Wall Street Journal deemed it, the everything rally pushed spreads in the corporate sector to their lowest levels since the early days of 2022 and residential mortgage spreads even tighter. So yes, everything rallied, it was good news really for everyone because it's this feeling of maybe we are going to get that soft landing and now maybe we're going to have a more accommodating Fed and we're going to see rate cuts. Just no one understands what that timing's going to look like. So, it's just that general feeling of optimism, I think, just not knowing when anything's going to happen really.
Jessica Schmitt (10:04)
And Doug, with all the talk about the dot plot and some of the market expectations versus the Fed, I know throughout probably the first half of 2023, you and I talked about that a lot, how the market had views of where the Fed was going to go diverged greatly from what the Fed had actually told us they were going to do. And now sitting here today, we are pausing again as you said with three potential cuts in 2024 as estimated by the dot plot. We know that changes pretty rapidly, so do you think we're going to continue to see a big divergence in market expectations versus what the Fed has planned going into 2024 and what should we expect?
Doug Gimple (10:52)
At times I feel like I'm just banging the same drum over and over that the Fed says this and the market says this and never the twain shall meet. And that's part of just the market dynamic, but I'm not even going to try and predict what rates are going to do next year, and I've quoted our portfolio manager Mark Jackson many times and I'm going to do it again, “Many things can happen and one of them will.” It just reinforces the notion that we don't know what the future will bring, but we do know that the Fed is currently thinking about rate cuts in the future thanks to that, the aforementioned dot plot, but that report’s out of date within a couple of minutes of it being released as subsequent economic data is going to change how the Fed is thinking about the markets.
So even if we agree on next year's Fed outlook of three 25 basis point cuts, we have no idea what that timing looks like. Is it spaced out? Is it backend loaded, front end loaded? Who knows? Prior to the meeting, and this gets to your question about the difference between the Fed and the markets — prior to your meeting or prior to the meeting, sorry. The market was pricing in, let's call it roughly 114 basis points in cuts in 2024. Again, Fed is saying 75. Before the meeting, market was saying 114 basis points in cuts. After the meeting, the Fed again indicated that they were going to add another cut. Essentially going from 50 to 75. Fed futures adjusted to reflect about 138 basis points in cuts in 2024. The market's essentially adding another 25 basis point cut to their prior, I believe overly optimistic, expectations. So we don't know what the economic data is going to be in the new year and we certainly have no idea how the geopolitical environment will develop and what risks are lurking out there.
It's always the risk you don't even consider that rears its ugly head. But don't forget, we've got a presidential election next year and all signs point to it being even more contentious than what we saw in 2020. Maybe we just look at 2024 as the end of the tightening cycle, whatever day that will be, whatever meeting they finally come out and say, “Hey, we're done.” And it's a potential beginning of an easing cycle with the caveat that — as I used quite a few times — anything can happen. Yesterday, so December 13th, the day of the meeting, we saw a huge rally in the Treasury market and it's evidence of kind of that disconnect between the Fed and the markets. The 10-year rallied more than 18 basis points and flirted with the three handle and actually today on the 14th it pushed below 4% and it is trading with the three handle right now. I think it was before I jumped on here, I think it was 3.92% or something.
The 2- year rallied more than 30 basis points, so 0.30%, even though the Fed was clear that they may not be done with rate hikes. So, there's this big disparity between what is being said and what is being interpreted by the market.
So it's very, very hard to try and predict and you've got on all the financial news networks, you've got various PMs coming out and saying, well, I think it's going to be this and I think it's going to be this and that's great. They have an opinion; they're going to stick to it. Are they managing money that way and is anybody checking up with them six months from now to say, “Hey, you said this was going to happen and you were wrong.” It's always whoever's right is the one they find to bring back. So, that just gets to my entire point of the market doesn't really know, everybody's going to have an opinion, but the Fed, they're the ones behind the wheel and they're the ones that are controlling everything.
Jessica Schmitt (14:35)
Well, let's shift now to some different segments of the fixed income market, Doug. We often touch on the various areas of those markets on our podcast and last time we touched on the consumer. This month I thought before we close out the new year, I just wanted to circle back to commercial mortgage market, which we all know has been in the news and the headlines for much of the year. That market has been knocked down across the board and maybe that's created some opportunities, but certainly maybe some risks still remain. What areas of the CMBS market are showing some potential long-term value and which ones do you think are showing some cracks or heightened risks?
Doug Gimple (15:16)
Yeah, I don't think it's news to anyone that the office market would be showing some cracks. It's been hit incredibly hard since Covid and it's still struggling. Though it does feel like things have kind of steadied heading into the end of the year. That could be a factor of just the market tends to quiet down and calm down in the final month of the year.
There are definitely areas of concern. When you look at major metropolitan areas that have seen an exodus of residents due to the flexibility offered by remote work, rising crime rates or soaring housing costs, but there's still pockets of opportunity even within office. Class A properties that are operating at anywhere from 90% to 95% occupancy, for example, are pretty attractive because these deals have been impacted by the overall damage done to the commercial real estate market. And so, they've felt it from a pricing standpoint despite steady performance, strong technical structure.
Hotels are definitely bouncing back. Personally, thankfully I only drove over Thanksgiving holiday and it was a very quick drive, so I was able to kind of sit back and look at the news reports illustrating the pure agony of flying during Thanksgiving, and I went out TSA.gov to look at some of the numbers and passenger volume through TSA peaked at 2.9 million per day or in one day, which is ahead of the prior record day that was set in November 2019. The average for the week of Thanksgiving this year was 2.4 million people per day passing through the TSA, which is a 9% increase from last year and a 1% increase from the pre pandemic time of 2019.
What does this mean? Why am I mentioning all this? Well, that means that people are out on the road, they're out traveling and where do they stay? They're staying in hotels, they're staying in VRBO, they're out spending their money. Hotel occupancy is nearing 54%, which is kind of in line with what we saw in 2019 before the pandemic and revenue per available room is continuing to show growth and strength.
So, we're starting to see areas that were a concern are doing better and the only crack again is I would say maybe in office, but there's still opportunities there. When we look at this market, the spread levels or what you're earning over comparable duration treasuries, so basically what you're getting paid for risk, those continue on the CMBS side. They continue to exceed levels seen in both investment grade and high-yield corporate debt. There's some bifurcation within credit quality. So, if you look at BBB-CMBS and single-A CMBS spreads, those exceed both high yield and investment grade corporate debt and all credit levels of CMBS from a spread standpoint are exceeding investment grade corporate debt.
So, there is opportunity out there on that relative value basis where credit spreads, as in corporate spreads, are incredibly tight and you're still getting paid quite a bit to take on this CMBS risk and you have the ability to really drill down and understand what you're buying so you can hopefully avoid some of these areas that are feeling a little bit more stress than others.
Jessica Schmitt (18:39)
That seems to be really key. Doug, you stressed that last time we chatted, which is knowing what you're buying and getting down to that security level, especially as you said, nobody knows what the Fed’s going to do. We're not going to make bets on where interest rates are going to go because we don't really know. And so, it's really important to focus on those underlying securities and the fundamentals of each of those.
Doug Gimple (19:02)
Yeah, that's exactly right. That's where you can really differentiate as an investor is not just blindly buying, call it CMBS, call it agency mortgages. It's finding the value for the risk that you're taking.
Jessica Schmitt (19:18)
We've seen some significant interest in core fixed income much more recently than we've seen in the past years. Of course, there are lots of articles out there about the 60/40 portfolio. Is it dead? Is it alive? And as rates have reset from historic lows to their current levels, that interest we've seen in core fixed income has gone up. Any thoughts on the benefits of owning core fixed income and the opportunities that can be found in the current environment?
Doug Gimple (19:48)
Jess, we joined Diamond Hill in mid-2016 and subsequently launched both our short duration and our core bond strategies. And for the first five years or so, the majority of conversations were around short duration as no one really wanted to talk about core fixed income that came with we'll call it roughly five and a half to six years of duration or that sensitivity to interest rate movements, yielding 1.5% when the most logical path for rates long-term was much higher. A lot of things have happened in that timeframe, but you fast forward past the carnage of 2022 and core fixed income is definitely back, and it's helped by that reset in rates and an attractive yield.
Anecdotally, I attended an institutional conference recently and it was quite the shift from what we've been seeing in previous years. Prior to this conference and the conferences over the last several years, fixed income where I was speaking was usually slotted after lunch or the last spot of the day when everybody was headed out to the airport or first thing in the morning when no one's awake. Everything else was private equity, private debt, hedge funds, sexier asset classes.
At this most recent conference, five of the first six topics were fixed income with a few focused solely on core fixed income. So, you mentioned the 60/40 portfolio, maybe it's not as dead as everyone originally thought. If we look at the Bloomberg US Aggregate Bond Index, one can achieve a yield just shy of 5%, which is well ahead of inflation. A well-diversified portfolio that allocates within and outside index-eligible securities can deliver a yield north of 6%, and that's all investment grade.
If you're allocating to core fixed income right now, you've got the benefit of yield levels not seen in many years as well as the potential for principal return if the Fed does move forward with rate cuts in 2024 and beyond. We see just in these, call it a month and a half, November and middle of December, we've seen the turnaround in fixed income returns.
The Agg, I think is somewhere north of 5% on a year-to-date basis. That's all coming off the last call it six weeks. So there's a lot of opportunity there, and even if rates hold steady from here, we may see some day-to-day fluctuations. Investors can enjoy a solid level of real return. But if the economy slows down or there's geopolitical angst in the coming months and the Fed cuts or rates rally on their own, not only are you getting the income, there's a significant amount of upside from principal appreciation as prices rally hard if there's this flight to quality or just rates are coming down.
The key takeaway is that core fixed income can once again serve as the ballast in an asset allocation, can help to mitigate some of the volatility in equities. Although with the equity run we've seen this year, you maybe don't need it. But it's able to deliver attractive income while limiting some of the volatility through a broadly diversified portfolio.
So, definitely think that core fixed income is back in vogue. I'm not saying it's taking over the world and that core plus is going away or private debt is going away, but I do think investors are going to be looking at core once again as kind of that stabilizer in their asset allocation, which it's been forever. I mean, that's always been the whole point of it. The last several years, maybe not the case because yields were so low, but with what we went through in 2022, it definitely feels like core is finding a home again.
Jessica Schmitt (23:40)
All right, well hope for more good things to come in 2024, Doug. Thank you again for joining us today. Always a pleasure to have you on and we look forward to catching up with you in the new year, and I just want to wish everyone listening a wonderful holiday season and a prosperous new year. So, thanks again, Doug.
Doug Gimple (24:01)
Thanks Jess, and thank you to the listeners, clients, investors and everyone else out there that helps us do what we do.