Replay: The Deafening Silence of the Fed

Benoit Anne:

Hello, everyone, and welcome to our US Fixed Income in Focus webcast. I'm Benoit Anne, the Head of Market Insights at MFS, and I'm joined by Alex Mackey, co-CIO of Fixed Income. Alex, thanks so much for being here. So this being our US Fixed Income webcast, it's hard to avoid the topic of the Fed. The first question that I have for you then would be how has the new Fed chair and the new Fed approach, in fact, impacted US fixed income in your view?

Alex Mackey:

Well, it's having impact across multiple dimensions within fixed income. The initial messages that we received from Chairman Warsh as he was introducing himself to the marketplace in his chairmanship role focused on a couple of things which represented potential large change factors, the biggest of which was intentionally guiding to less communication out of the Fed. So that in and of itself almost definitionally means that the Fed track record is going to have to prove itself over time, right? If we're going to get less clarity around what the Fed is planning and the communication style of that, then it's going to be the actions that we observe over time, which will be the proof statement for what the goals of the Fed are and how they continue to follow through with them.

What we've seen over the course of the last number of months is many questions and high degrees of uncertainty about the chairman's intentions when he first stepped into his role. And then just recently with the Jackson Hole speech, there were some pretty important points of clarity. One was the focus on employment and inflation as the dual mandate, that that continues to be the case, and that the employment market is in a good spot, persistent inflation is challenging. The idea that there's work to do, that was the phrase, right? There's work to do if inflation doesn't actually come down to a more stable level. That's going to be where the proof statement and the track record are going to be borne out over the course of subsequent meetings, which we will see the results of in the not-too-distant future, and then the path for the policy rate.

The other point that was really important with that speech is the clarity around the policy tool, the primary policy tool, being short-term interest rate. That the Fed funds rate remains the primary policy tool. So that's all consistent with past practice, but we'll see what the actions are going to be.

Benoit Anne:

Yeah. So we've talked about the Fed and rates, but let's switch to credit. What's your view on the outlook for US credit, especially when we look at fundamentals and valuation?

Alex Mackey:

Right. Well, fundamentals have been really strong. Corporate earnings and the corporate market dominates the US credit and marketplace. Corporate earnings have been extremely strong this year, so strong that you haven't seen the type of growth year-on-year outside of a post-recessionary bounce-back environment.

Our research team in underwriting credit, in covering companies on a day-to-day basis, looking at it from an integrated equity and credit point of view and perspective, continues to feel quite good about the prospects for corporate earnings growth. And corporate earnings growth is going to be a powerful factor in sustaining the ability for the spread to be realized. Consistency of cash flows, the market's confidence in credit not having a credit cycle. So the outlook for earnings remaining relatively healthy is going to be an important factor in what the experience for credit investors is going to be over the course of the coming quarters and the following year.

On the technical side, or excuse me, on the valuation side, we remain pretty frustrated. Spreads are tight, risk premia is low, but that's not unique to credit markets. That's not unique to the US credit market. Spreads are tight globally, and risk premia is low globally. That in a lot of ways reflects all the things I was just talking about.

So while valuation is relatively compressed, and the upside opportunity for continued compression and excess return generation above and beyond earning your carry or earning your coupon, those are relatively modest, the strong fundamental underpinnings give us reasonably high conviction in having a view toward sponsorship of carry, of building portfolios and maintaining a degree of carry in those portfolios with the idea that you're going to earn that.

Benoit Anne:

Let's address the elephant in the room: AI. How do you think about AI and its impact on US fixed income, maybe from the angles of risk and opportunities? And you alluded to that already, but I would like to hear your framework.

Alex Mackey:

Right. So AI infrastructure, capital requirements for funding that, and evolution of financing structures, those are all kind of in motion right now. So the idea that there is much more in the way of capital need than there is available cash to support it means that the debt capital markets have become increasingly important for how this infrastructure build-out is realized. And that's so much more true now than it was a year ago. The clarity around the hyperscalers, enormously cash generative businesses not having the ability to pay for these projects on their own, that is a bit of a game changer. So we've seen a huge acceleration in debt issuance out of hyperscalers. We've seen a diversification of structured financings, both for datacenters, and we have seen a few examples of chip financings into the US public capital markets. Those trends are likely to continue.

Now, what's important from an underwriting perspective, and this is where we rely on our research team so heavily, is the nature of the structured financings that are being put into the marketplace require pretty deep research. Their interesting lease terms, their guarantees, the transparency of these is in some cases better than others, but that's going to create opportunities and risks, we believe.

The other piece of it is the technical, the trade-offs between the amount of debt that's coming into the market and the sponsorship for all of it, it has created some dispersion. And dispersion is in one sense a risk, you have relative underperformance, but it should ultimately create opportunity, and the ability to navigate and identify the relative winners and losers of the pacing of this spend, the debt needs of the spend, and then ultimately the balance sheet recovery profiles for the companies that are really leading this effort, that's where we think the selection process, the deep research work, is going to create some differentiation from a performance perspective for fixed income investors with a tilt toward credit.

Benoit Anne:

So you mentioned one of the magic words, technicals. Does that mean you are nervous now about technicals, or are you still relatively optimistic about that backdrop with the understanding of course that as part of your investment process, you're always going to look at fundamentals, valuations of course, but technicals are, it looks like, playing an important part of the equation.

Alex Mackey:

Yeah, yeah. So when you look at the index levels for US credit markets, so the investment-grade market and the high-yield market, spreads have basically been flat all year. It's gone nowhere. But when you lift up the hood and you look underneath, there has been dispersion, which I was sort of alluding to before. You look at the technology sector and you look at the communication sector, and those two groups for differing reasons have experienced relative underperformance. And that is, in our view, the beginnings of the realization of this risks and opportunities potential that the spend related to AI is going to create.

So the technicals within technology have become more challenged. I think the way to describe it is, over the course of 2026, the technicals, fixed income technicals, have been relatively soft. We would suspect that that continues because the companies need to spend, they need to continue to borrow to sponsor that spend rate, and the ability to tolerate a relatively marginal amount of incremental interest in order to provide that capital spend commitment, we think there's a very elastic function attached to that.

So we suspect that the amount of debt coming into the markets related to the AI infrastructure build will continue to run at a very high level, and you've seen it ramp so that these constituents are now becoming increasingly larger shares of the indices. The investment marketplace is going to have to ask the question of “how much exposure am I willing to take on a benchmark relative or on an absolute basis?” before you need to pump the brakes a little bit. Those conversations are already taking place, and if you have this future funnel of debt that's yet to come, we think that that is going to continue to put pressure on segments of the fixed income credit market, specifically.

Benoit Anne:

Okay. Yeah, very good. When you look at the broad spectrum of US fixed income, where do you see the most compelling opportunities right now?

Alex Mackey:

Yeah. Well, we've had, and this is true for most of this year, we've had an increased degree of conviction around building carry in portfolios, maintaining carry in portfolios, not bringing risk down in the face of risk premia compressing or spreads continuing to move somewhat lower, as you've seen small bouts of volatility at a couple of moments in time over the course of the year. And we like the idea of just earning your spread and doing that in an environment where you're not getting highly compensated for taking moderate and elevated risks leads to having a preference for investment-grade corporates, having a preference for higher-quality high yield. And then somewhat separately from the corporate environment, we still really like securitized credit.

Securitized credit gives you structural features that we think, as long as you can do the underwriting, are quite attractive, and the ability to capture spread in a structured product that is at least comparable to what you're earning in the corporate market. We still like securitized credit quite a bit.

Benoit Anne:

Very good. Well, that concludes the main part of the webcast, but we've had many questions from our clients, so thank you. Thank you for that. I'm going to throw a few questions to you here. We're going to go back to the Fed. One of the questions was, what's your outlook for Fed policy this year and next?

Alex Mackey:

It's really evolved. It's really evolved since the end of last year to where we see it today. And the persistence of inflation, the pressure, you've got three factors driving the inflationary pressure. One is clearly the energy markets and the echo effect of what's taking place with the conflict in the Middle East. The second is fiscal, and global fiscal deficits rising, spending, debt issuance associated with that. And then the third is the AI spend rate that's required.

So there are so many features that are applying degrees of inflationary pressure that our view is the Fed has to push back against this. And so as a result, the primary policy tool of Fed funds rate being the one that can be used towards that purpose, our view is that rates should be moved higher. The magnitude and the speed with which that happens is always the debate, but we think that moving moderately and moving moderately sooner makes more sense.

The opposite, if the Fed continues to be passively sitting on the sidelines, I think the market's going to apply a lot of pressure on the Fed and test its resolve by pushing yields even higher from here. So the track record needs to be built by Chairman Warsh, and we may have the beginnings of that come to fruition here in the very, very near term.

Benoit Anne:

I'm going to stick with the Fed. Very topical these days. Do you think that the issue of Fed independence has disappeared with the appointment of the new Fed chair?

Alex Mackey:

My view is no. There are plenty of reasons to think that the independence is fighting frictions in a way that's quite different than maybe prior chairmanship experiences have been realized. Chairman Warsh has made it clear, and again, goes back to the track record. We'll see how it gets built out over the next quarter and couple of years. The commitment to focus on the dual mandate, the focus to remain reliant on a primary policy tool, and the goals are very much the same as they have been in the past.

All the media, all the messaging that gets pushed around the Washington, DC marketplace, those are frictions, but thus far there haven't been actions inconsistent with that, at least out of the Federal Reserve. So the independence continues to remain, in our view, in place, and we'd like it to stay that way.

Benoit Anne:

All right. That sounds reasonable. Let's change gear a little bit with another client question. How do you explain the perceived poor performance of fixed income over the past few years?

Alex Mackey:

Right, right. And I get asked this question all the time, "is fixed income going to still provide the experience that I have come to expect of it over the last century?"

And 2022 created a lot of scars. It was a risk-off period, and it was a rapid rise in yields, base rates, risk-free, creating negative returns from an asset class that historically had provided outperformance in periods of risk underperforming. What has happened, though, is you've had a reset in the rate market, right? That was what '22 and '23 positioned the fixed income marketplace for.

The perceived poor performance, and I like the way that it's phrased, “perceived poor performance” of fixed income in the recent past, I would challenge that notion, and I would challenge it because you've seen risk really perform. And so when risk is performing, what do you want your fixed income allocation to do? Our view is you want fixed income to deliver you most of the income that you expect to earn and then in periods of risk off, to deliver some form of protection, some ballast to counterweight the risk in your allocation decision.

So for the time being, we have inflation pressuring yields. We have growth around the world at a relatively healthy level. We have risk performing, and fixed income is not delivering significant positive returns. That seems like it's kind of a diversifier, and that diversification I think is what we would expect to come from fixed income in the future.

Benoit Anne:

Very good. Let's go back with the final question maybe onto the topic of credit fundamentals. You said they're very strong overall, but what would be the indicator or a set of indicators that would prompt you to change your mind? What is it that you're watching to see or identify a potential crack in there?

Alex Mackey:

Yes. I think it's twofold. The first, and this is going to be true in most cycles, is the consumer and the condition of the consumer's balance sheet. The consumer's balance sheet in the aggregate has been on an improving trend ever since the GFC. So if you look at the consumer in the aggregate balance sheet, debt burden, ability to cover debt costs continue to trend in the right direction. If we see a broadening out of consumer credit deterioration and we rely on our securitized credit team for giving us some transparency and look-through to that marketplace, together with our financials team as well, if we see some deterioration there, that could be the beginnings of some form of a credit cycle. So that would be a watch item, that would be a cause for concern.

The second piece would be as all the debt financing that we've seen related to the AI infrastructure build-out continues to progress, and we continue to have more structures and larger quantities of debt put into the marketplace, were there to be a meaningful breakdown, and the catalyst for what that breakdown might be, of individual projects and/or the scope of what the market is increasingly believing to be true related to the infrastructure development and success and conversion to cash flow, if you start to see defaults run through that channel, that could be the beginnings of a credit cycle which would be cause for concern.

We don't see any of that right now. And it may take some meaningful period of time for that to demonstrate that it's happening. But those two would be the ones that we think could be a catalyst for something that we haven't had in a long time, and that is a credit cycle.

Benoit Anne:

Excellent. Well, that concludes our webcast. Thank you so much for being here and sharing your insights. Thank you for everybody who tuned in as well. That's all we have for now, but we look forward to the next episode. Thank you, Alex.

Alex Mackey:

Thank you, Benoit.

Benoit Anne:

Have a great day.

 

 

 

The views expressed are those of the speaker and are subject to change at any time.  These views should not be relied upon as investment advice, securities recommendations, or as an indication of trading intent on behalf of any other MFS investment product.  No forecasts can be guaranteed.

 

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