The Insight: Conversations – Cutting Through the Economic Noise with Wayne Dahl

0:08Welcome to The Insight by Oaktree Capital. I'm Anna Shemansky, Oak Tree's senior financial writer, and I'm thrilled to be joined today by Wayne Dahl, Oak Tree's investment risk officer and the assistant portfolio manager of the Global Credit Strategy. Wayne, thanks so much for joining me. Thank you, Anna. it.

0:34Today, we're going to discuss a few economic trends that have been covered in Oak Tree's performing credit quarterlies, as well as the implications for credit markets. As we often say at Oak Tree, we may not know where things are going in the economy, but we certainly should know where we are. To begin, in order to talk about what's happening now, I actually wanted to look back a bit. About a year ago, Oaktree published a piece called The T-Word, and that was referring to the transition in the economy that we thought was going to be occurring as some of the trends that had supported economic activity in 2021 were starting to reverse.

1:15So I was hoping that you could discuss some of the arguments in that article and also how they relate to what we're seeing in the economy today. Yeah, and the main argument in that piece was we were definitely going to see changes in the future. There were going to be changes both on the fiscal side and on the monetary side, and those changes would ultimately feed into consumer behavior, perceptions of inflation, where spending is happening, and we've largely seen that take place over the last 18 months. I think one of the most significant things that we've seen, and not surprising to many, is a shift from spending on services versus spending on goods.

2:00When everyone was at home, trapped in their houses, they just continually ordered goods from Amazon, installed a new kitchen, put new patio furniture at their house, and that was kind of the dominant. We've seen a real change in that over the last 18 months, where spending on services has grown by about 13 % over that period versus goods at a little over 1%. So a real transition, and that has had broader implications in terms of inflation, where we've now seen inflation on durables with just under 3 % annualized over that same period, where the inflation on services is almost 7 % over that same period.

2:43So I think that's where we've seen some of the biggest impact. Again, services is a much bigger part of the overall economy and spending. It's about twice the size of the spending on goods. We've also seen a transition as some parts of the credit markets have seen spreads go wider. During COVID, money was readily available for everyone. Banks were flush with capital in the form of reserves, and that led them to a lot of activity, which compressed spreads for things like securitized credit, AAA spreads were very, very low. Those have now gone wider as banks have had to rebalance their activity.

3:23The Fed's balance sheet's declining. That has also contributed to that transition in banking activity. The other transition is really in the form of incomes and related to the savings buildup that consumers had during COVID. We've seen that come down. It's still relatively high to what it was pre-COVID, but this has all been a change to shift us towards what should be a more, quote-unquote, normal economy. We've also obviously seen some abnormal things in recent months. So obviously, in March, we saw the turmoil related to SVB, and then that's continued somewhat. So I was hoping that you could speak a little bit about that shift and maybe also in terms of what we should be looking at now.

4:09Which economic indicators do you think we should be focused on during this period where there's so much uncertainty? I think you definitely raise a good point about the increase in uncertainty. If you read a lot of commentary around these economic releases that have come out over the last few months, and I'll say largely in 2023, but it's almost like there's been a little bit of something for everyone. The bulls have dug in deeper because they've found enough little points to point to, and the bears have also found enough to continue their theme of imminent recession. I think one way you can see this point really in almost a graphical form is there are indices that are created called economic surprise indices.

4:54These really form the difference between what market expectations are versus what the real numbers are. If market expectations are low, then you get a surprise to the upside. If they're high, a surprise to the downside. If you look at two of the probably bigger surprise indices out there in the market, one from Bloomberg, one from Citi, since March, they've actually moved in opposite directions. So again, highlighting this notion that it's very difficult to really understand what is the right signal. And also, how do you think they should balance the information being sent by leading versus lagging indicators?

5:32I think this is something that's also been almost confusing in the market over the last several months. Two of the most important indicators to the market that they look for at every release, because they're followed closely by the Fed, are the cost of labor and the level of services inflation. What's interesting about those two points is both of those make up the conference board's list of lagging indicators. So are we looking too closely at indicators that'll really tell us too late whether we're in a recession or heading towards a recession versus some of the leading indicators such as new orders, building permits, hours worked in manufacturing, capacity utilization?

6:18I think we need to find a better balance to maybe zero in on some of those numbers rather than some of these lagging indicators that really should be the ultimate determination of how quickly we're heading into the recession rather than telling us that we're already there. And I think it's such an important point when you're referring to the Fed, because obviously what the Fed is trying to do is to reduce inflation without there being a recession. But if it's constantly looking at those lagging indicators, then that could potentially make that more challenging. and I think you see that in some of the response of the market you certainly saw it at the beginning of the year and we noted this in a past performing credit quarterly where we talked about the market expecting something that the Fed is telling them not to expect which is lower interest rates in the future now the market's doing this because they think we're heading towards a recession and they're going to start pricing it and honestly they anticipate that the Fed will respond on a lag so you're always going to get that difference it's probably just more magnified right now because of perhaps us getting closer to that moment.

7:20As you mentioned, there are these discrepancies between economic data points and what they're pointing towards. One of the areas where I think we continue to see strength is obviously in the labor market. But I know one thing that you've often noted, and I think we've noted in the performing credit quarter lease, is that maybe there has been some weakness below those headline numbers. So I wanted you to speak about that. I think the labor market releases are certainly something, as I mentioned before, where there's always just enough to satisfy the bulls and always just enough to satisfy the bears.

7:51But I do think you're right. Underneath the surface, there probably is maybe a few more questions that should be asked. A couple of things that do jump out right away are the difference between what is the establishment number, which is the headline number that they read on the first Friday of every month, versus what is the household survey. Now, it's important to note the differences between these two because the establishment survey is simply just establishing how many jobs are out there, whereas the household survey is actually telling us whether or not people have a job. So the first thing that can happen is if somebody has two jobs, they will be counted twice in the establishment survey and once in the household survey.

8:36So this can lead to maybe too much excitement around job growth when it's not really new people getting new jobs themselves. Over the last 12 months, ending in April, the difference between those two surveys is about a million jobs. So we are seeing a pretty significant divergence. The other thing that's worth mentioning is that in the establishment survey, there is also something called the birth-death model. Now, this has nothing to do with individuals dying or being born. This is as it relates to companies being created or companies going out of business. And the Bureau of Labor Statistics puts this in to try and smooth the numbers that they might not get on an immediate recording in the survey.

9:25But it's worth noting that if you look over the last 12 months, the contribution of that birth-death model is about 40 % of the jobs in the establishment survey. So again, not saying that they should fear the labor market and we're misreading it, but just be aware that those differences exist and can and should we get super excited about one data release that is higher or lower. This is one thing we always say at Oak Tree in terms of not making large bets based on macro forecasts. And I think also being aware, as you say, about not putting too much stock into one data point and also understanding the complications in economic data.

10:07Anna, let me add one more point when it comes to the labor market that I think is somewhat overlooked in the reporting on these numbers. And that is the average weekly hours worked. The reason why this is important is because this is actually a number that has been steadily falling over the last year. And I think what people don't realize is that when this number falls as much as 0.1 hours in a week with a labor force of 160 million people, that is the equivalent of 400 ,000 full-time jobs. So if you think about the headline number, let's say the headline number is 400 ,000 one month, but the average hours worked has fallen by 0.1.

10:51The total aggregate amount of earnings in the labor market actually hasn't changed at all. So did we really create 400 ,000 jobs? not really in terms of money coming into households, etc. So I think, again, another example of a little nuance that's probably worth paying attention to despite not grabbing the headline. And I think another data set that can be really challenging to interpret is consumer sentiment. What are some of the complications here? Sentiment indicators have been a challenge to interpret over the last year. And I think part of the reason is that they have somewhat disagreed with the hard data that comes in.

11:36So if we look at the Michigan consumer sentiment, for example, the headline readings last year were below any reading from the 2008 period. I don't know if anyone would truly think our economic backdrop is worse than it was in 2008. So that's a surprise. When you overlay that with something like consumer spending, you're seeing consumers still out there spending and consumer spending was growing. So again, hard to interpret that. But as we've mentioned before, if you dig a little bit deeper into some of these numbers, you see some really interesting trends. the michigan survey is an interesting one because that survey actually reports numbers based on political party and if you look at that today with a democrat in the white house you've seen democrats by and large be relatively positive on the economy whereas if you look at the numbers from the republicans that identify in that survey you'd think we were back in the great depression Now, I don't think Republicans have also stopped spending.

12:41They're spending equally fast. So it's interesting that we've had this more difficult time separating out our beliefs maybe about where things are going due to the political backdrop from what we're actually doing as individuals, which is continuing to spend and live and move and purchase things. And so that's, again, in one of these instances where we want to read maximum information into a data point, it becomes a little more challenging. Definitely. And I think in terms of the usefulness of that data, because often when people are interpreting data, obviously it's looking at what happened in the past and when data was near this low in the past, what did that imply?

13:20But obviously in the past you didn't have this political skew. Yeah, look, I think there are elements of the sentiment that are worthwhile. Meanwhile, people's expectations for inflation, again, nobody knows exactly where inflation's going. No model can really tell you. But I think there is something to learn if you see how ingrained the idea of inflation is becoming in people's mindsets. In addition, they report on sentiment for the likelihood of buying a home or buying a durable good or buying an automobile. And those things have declined. And I think that does speak to some of the nervousness that consumers do have.

13:59Again, we'll see if that behavior does play out. But that is somewhat of a leading indicator to tell you what consumers are expecting to do. So there are things to learn from there. But again, as you pointed out, Anna, we just have to be careful with how much we embed that into, in our case, our decisions for where we invest. I think what I'm really hearing here is that when interpreting economic data, it's really important to look in aggregate at many data points and to also really dive into them. And then even then, take everything a little bit with a grain of salt. Yeah, I think that's fair.

14:39And I think that would align with what our chairman, Howard Marks, has said many times in the difficulty of forecasting any one data point. Just look at the volatility we've seen in inflation expectations over the last year, anywhere from expecting 6 % inflation over the next year down to 2%, back to 3%, down to 2%. Nobody really knows. And we have to be really careful that we're not, as you said, zeroing in too much on this idea that we know exactly where these different macro variables are going. I know one of the things that Howard has also often talked about is it's not even just a matter of trying to figure out people's expectations for where things are going, but also how much of that is actually priced in.

15:26People often say if this recession occurs in the near term, it will be one of the most anticipated in history. And having said that, how much of the recession risk do you think is being priced in? Or are there any areas where do you think it's not being priced in? Yeah, I think that is the million dollar question, as people would say, as they look at this market and they look at their investments and how they'll move ahead. There are definitely signs of a slowdown. We mentioned looking at leading versus lagging indicators. A number of those leading indicators are showing that we are getting near to a slowdown and a recession could be coming.

16:02The interest rate market, I think, is one place where you have to be careful with how you interpret maybe the futures curve, which we've referenced multiple times in our performing credit quarterlies. But they would certainly indicate today that there is a growing expectation for a slowdown. And we saw a significant shift after the Silicon Valley Bank problems earlier in March, where we again saw those expectations shift. Now, they are exactly that. Expectations. The market does not have to realize those, but we can see it, as we mentioned before, as you look in aggregate and try and understand what people's behaviors will do.

16:41That's where I think we can get signs of how to maybe interpret the likelihood or expectation for a recession, which I think today right now has probably grown over the last couple of months. One of the things that Oaktree has noted a few times is that the rates market appears to be pricing in a Fed pivot, showing that they think interest rates are going to be cut later in the year. However, if you look at where credit spreads are, if you look at where equity prices are, if you look at a number of other things, it doesn't necessarily seem like their market is pricing in the type of significant recession that might cause that pivot.

17:20So how do you think that investors are justifying this? I think part of it goes back to our discussion, which we've had, is on how does the Fed look at its policy? We mentioned two indicators that get a lot of press in unit labor costs and services inflation. Well, as we mentioned before, those are two lagging indicators. So the market is already basically saying, well, if the Fed is using its data dependency to look at lagging indicators, then they're going to actually miss the slowdown. If the slowdown is going to come, we need to start expecting it now. So maybe you could say the investors in the rate market are looking at leading indicators and they're getting ahead of the Fed who they anticipate is going to be slow.

18:08So some of those leading indicators, such as the S &P 500, which is one, maybe those investors await as long as possible before they pivot to what could be a change. But in a way, you could argue that some of those investors in something like the S &P 500 have also anticipated a recession. And you've seen a real narrowing in the breadth of what is contributing to the moves in the S &P 500. And we noted this recently. But really, if you look since the Silicon Valley bank challenges, about five stocks in the S &P 500 have really accounted for all of the moves. So maybe that is a flight to quality in a way where you're looking for those large cap, almost recession proof type companies, as opposed to some of the small caps where you've seen a complete reversal and quite a bit of negative performance over the last couple of months.

19:02So again, that goes into the idea of really diving into the data. You look at equity markets and you might say, oh, how does that match with what we're seeing in the rates market? But as you say, if everybody's piling into a few companies, then that perhaps does signal that people are getting a little bit more worried. Yeah, and I think one thing with the rates market that's worth noting is people really want to look at that expectation curve and say, oh, the market is expecting a 50 basis point cut in six months and a 100 basis point cut in 12 months or whatever. And that's really not what futures markets do.

19:36I think David Zervos from Jeffries was one of the first people I saw point this out, which is we treat these numbers in the rates market like we would take information from the options markets, which really give probabilities. So I think we have to be careful with trying to read too much into those curves. But again, as you said, it is a data point that certainly should be looked at and considered, especially in the context of how we're thinking broadly about investments and more importantly, what we're hearing and seeing from the individual companies that we're investing in. In terms of the rates, there's obviously been tremendous volatility in that market in the last year, but especially in recent months.

20:17Can you speak a little bit about that volatility and the impact that that has had on some credit asset classes? Yes, Anna. I think the volatility in interest rates has been partially a product of just interest rates being higher. When rates are 25 basis points, 50 basis points, 100 basis points, it's very, very unlikely that you will get moves of 20, 30, 40 basis points in days, weeks, or months. Whereas when interest rates grow to 3 and 4 and 5%, depending on where you are on the curve, there's just a lot more room for rates to have wider moves. We saw the reaction in rates after Silicon Valley Bank, where in some parts they moved over 100 basis points lower, like the two-year.

21:03We would have never seen the two-year move 100 basis points previously. It was less than 100 basis points in an absolute level. So when you think about fixed income investors, especially those investing in longer duration assets, that really can add some volatility that was largely missing. You really had to look at credit spreads and think, well, credit spreads will really tell me the story. Is credit going to get riskier or not? How will credit spreads move? That's going to move my fixed income asset. Whereas today with rates where they are, that is making a significant difference in how we think about fixed income investments, how we think about yields, and really the attractiveness of that market overall.

21:46Last year, obviously, in the credit markets, it was really a duration story because of how much rates did shift. Now, considering where we are in terms of where the Fed funds rate is and the signaling we're getting out of the Fed, what we're seeing in the economy, looking forward, how do you think about duration risk and how that relates to the relative value of fixed versus floating rate asset classes? That discussion has certainly evolved over the last few months, as you mentioned, just given some of the moves driven by duration in 2022. And again, this is where I think it's important to look at a lot of these factors when thinking about this.

22:26Where is the market expecting interest rates to go? How does that impact my floating rate securities, as you say? If the market were to realize expectations today, it would tell you that coupons on floating rate securities will come down and duration will become a benefit to your fixed rate assets. So I think you have to think a little bit more about how you want to balance that risk in the short run of certainly the market being wrong, but also having some exposure to that dynamic if the market is right and we do see a recession. So it has shifted a little bit from basically, if you think of 2022 is everything was all about how high will rates go, but I don't think anyone doubted that rates were going to go higher.

23:10Whereas now it's a little bit more of, are we at the peak? Could we go higher? Could we go lower if we went lower by how much? Again, these are questions that I think fixed income investors are facing now as they consider how to reposition their portfolios. And I would also say, considering the impact that those rate changes are having on credit quality in terms of borrowers' ability to deal with higher rates, especially obviously floating rate borrowers. I think the benefit of floating rate securities is almost a double-edged sword. As you mentioned, that was certainly a benefit in 2022. Floating rate securities, such as broadly syndicated loans, performed very well relative to high-yield bonds or investment-grade bonds, just given their low duration.

23:58But as you mentioned, the cost of that is a higher interest burden for those companies. So anyone who has excessive leverage, potentially in a market where their earnings are declining or declining faster than expected, you could see that cost of interest slowly deteriorating some of the earnings power of that company. And one metric that we look at is what's called the interest coverage ratio, which really looks at a company's earnings as a ratio of their interest cost. The high yield bond market today has record high interest coverage ratios. They did so much issuance in 2020 and 2021, their coupons went to all time lows on average.

24:42Whereas in the loan market, you've seen that interest coverage ratio decline a lot as that cost has continued to rise. And for many, they haven't fully appreciated a year's worth of this higher short-term rates that we saw really accelerate in the second half of 2022. So I think you do have to be a little bit more careful when it comes to analyzing these companies and making sure that you're doing that fundamental work so you're not getting trapped in what looks like, this could be my safety from rising interest rates, but you end up in a space or at a company or a part of the market that maybe sees rising defaults.

25:21And as Howard has said many times over the last year, the great thing about fixed income today, and he talked about this in his memo that he wrote in December called C-Change, is yields are much higher. You can actually earn a good return on fixed income investments, but that's conditional upon not giving that back to defaults. So you do have to be careful about where you pick your spots in that market today. I think in terms of that question of credit quality, I know one thing people will point to today in terms of the high yield bond market is where credit spreads are. And we'll say, well, historically, they still seem kind of narrow.

25:59But I think that there are obviously a lot of things that when people say that they aren't kind of taking into account about the high yield bond market today versus in the past. So I wanted you to speak about that. I think the high yield bond market has seen a lot of changes. And I think today we can look at the yield and say yields are 9%. That's pretty attractive. But as you mentioned, people are quick to point out that, yeah, but spread should be 800 basis points or 700 basis points, not 500 basis points. And I think it's worth maybe comparing to some historical points in time. One point that's, I think, relevant today for a couple of reasons is 2011.

26:39In 2011, the US was also going through the stress of a debt ceiling debate, which ultimately landed on a downgrade. But at that time, yields in high yield were around 9%, very similar to where they are today. The big difference is that five-year rates were 1.5%, and the average coupon at that time was over 8%. So naturally, credit spreads were near 800 basis points. Today, we have coupons below 6%. We have five-year rates that are closer to 3.5 % to get that same 9 % yield. So again, that's left credit spreads around 500 basis points. Now, I think another reason why we can also say that makes a little bit of sense is there's been a significant shift in quality since 2011 through 2023.

27:33That quality mix has consisted of a significant growth in BB-rated high-yield bonds, or the highest rating tier for non-investment grade credit. We saw a significant growth in this area following COVID, where a number of investment grade names that were BB-rated were downgraded to BB and therefore fell into the high-yield bond market. At the same time during COVID, we had a number of defaults in the riskiest or triple C rated high yield bonds. So we've seen a significant drop in triple C rated assets, and we've seen a move to record highs in double B rated assets. So the high yield market today is certainly not the same high yield market we saw in 2011 or in times past.

28:21And I think that is also impacting the market and why credit spreads haven't had the same move that we've seen in the past. And that question of quality that goes back to that relative value question between high yield bonds and loans, because obviously that quality is quite a different story in the loan market. The loan market has actually seen basically the exact opposite move that the high yield market has seen. Their double B exposure is between 30 and 40%. So opposite to that, a high yield where you've seen a largely growing single B, especially at the bottom of the single B rating and growing triple C.