Braking (and Not Breaking) the Economy

Matt Freund, CFA, Christian Brobst, and Chuck Carmody, CFA

We believe:

• There is a high level of uncertainty around economic outcomes.
• The growing possibility of future Fed cuts supports the case for increasing portfolio durations across the Calamos fixed-income funds.
• Credit spreads reflect an overly sanguine outlook and we are reducing exposure to credits vulnerable to a cyclical downturn.

Progress on inflation and surprisingly resilient economic growth allowed the Federal Reserve to pause its rate hiking campaign at its September 20 meeting. This pause affords the committee another six weeks to evaluate incoming data. It’s clear the Fed is looking for continued improvement in PCE Core Services (ex-housing). The message stayed the same and was two-fold. First, the Fed is confident a restrictive policy stance has been reached. Second, the central bank stands ready to do more if necessary. Despite this strong reassurance, long-maturity interest rates moved to a 15-year high.

We agree that monetary policy is restrictive at current levels, as evidenced by trailing 12-month inflation (core PCE) below the Fed funds effective rate and real yields on Treasury Inflation-Protected Securities well above 2% across the maturity spectrum. We expect future months and quarters to display some deterrence to consumer and business investment as a reduction in disposable income through higher borrowing costs roll into more areas of economic activity. We are squarely in the “impatiently waiting” phase, looking to ascertain how much economic momentum will be lost from past policy changes. We believe there is still a high level of uncertainty around potential economic outcomes and a recession cannot be dismissed.

We’ve seen fundamentals weaken modestly in levered credit. The traditional high yield market experienced year-over-year declines in both revenue and EBITDA through the end of the second quarter for the first time since 2020. Recall that prior quarter results looked healthier with 7.5% year-over-year growth in EBITDA, but the aggregate results relied heavily on significant strength within the leisure, energy and transportation industries. Although the direction of progress may have changed, aggregate levels of leverage and interest coverage continue to look healthy in our evaluation. We are monitoring the situation closely to determine whether a new trend towards weakness is emerging or whether results are simply becoming more volatile as the instability in input prices, labor costs, and consumer behavior show up in erratic results. Credit spreads in both the investment grade and high yield markets have widened slightly as strong balance sheets and technicals have offset the growing suspicion that results in coming quarters will be weaker.

On the topic of capital access, we believe developing private credit markets have ample capital available to fill the liquidity gap that occurs when banks and other traditional capital sources pull back. These new capital sources, along with low-cost, fixed-rate Covid-era debt, are likely to extend the transmission lag with which the Fed’s monetary policy affects economic activity. Nevertheless, a recession is still a possibility as liquidity conditions continue receding.

Positioning Implications

Recent increases in Treasury yields moved the market into closer harmony with the Fed’s own expectations for its forward rate path. Futures markets now indicate that at least two rate cuts will occur in 2024, down from the five cuts the market had priced in last quarter. Although this feels more measured, we believe rates could eventually reflect a scenario where no rate cuts are priced in for the next calendar year. We have been gradually increasing portfolio durations across strategies in expectation of peak-Fed policy rates and a greater likelihood that the next rate move is a cut. This leaves us with a modestly long benchmark duration in both Calamos Total Return Bond Fund and Calamos Short-Term Bond Fund. The duration of the Calamos High Income Opportunities Fund remains below its benchmark duration, but interest rate sensitivity in the high yield market is a smaller driver of risk and return. This has also led to selective reductions of our leveraged loan positions, although we maintain a significant loan allocation across mandates based on relative value and seniority considerations.

In our estimation, credit spreads reflect an outlook that is too sanguine. We are beginning to see a deterioration in fundamentals within the leveraged finance space. Although it is too early to determine whether this is a wobble or a new trend forming, we are actively reducing exposure to credits we evaluate to be more exposed to a downturn in cyclical activity, credits with weak contingent liquidity or credits with exposure to rapid deterioration of asset value. Based on our fundamentally driven investment philosophy, we believe there are select high yield issuers where investors are being well compensated for associated risks, and we are maintaining allocations in those areas. We are also increasing allocations to securitized structures that offer relative value in comparison to investment grade corporate debt.