Bridging Macro and Micro Perspectives

Rob Hall: Hello, and thanks for taking the time to watch this video. My name is Rob Hall and I'm an institutional portfolio manager on the MFS fixed income team. Today we'll be focusing on an important component of our risk budgeting process for portfolios across our suite of strategies managed against the Bloomberg US Aggregate Bond Index. The amount of risk we take in portfolios and where we allocate that risk is conditioned by three things. Number one, our assessment of the fundamentals. Number two, the technicals of bond market supply/demand. And number three, evaluation. We're going to focus in this video on the first part, the fundamentals. And here we're talking about the big picture, the drivers of growth and inflation, the policy responses to both, and all that forms the backdrop for the capital markets. Traditionally, fixed income portfolio managers have leaned pretty heavily into the macro data, reports like CPI or non-farm payrolls to gauge the health of the economy. The problem with that data is that it's mostly backward looking. It tells you what's behind you, but not necessarily what lies ahead. And as we know all too well, the past is not always prologue. So how do you bring a forward-looking element to bear as a compliment to the backward looking macro data? We've tried to solve for that by building a systematic, repeatable process for integrating the top-down data with bottom-up observations, which largely derive from the forward-looking messages our analysts are hearing from their interaction with corporate management teams. That integration takes place in the context of a quarterly Macro/Micro Forum. I'm here with my colleague, Josh Marston, who is the head of North American Multi-Sector Fixed Income Portfolio Management at MFS. Josh, could you talk about the thinking behind the forum? Who participates, how they participate and what we hope to get out of these interactions?

Josh Marston: Yeah, Rob, so the forum started about 10 years ago and the notion, the premise behind it was, and you pointed out in your introduction, there are blind spots in each the macro, the top-down, or the micro, the bottom-up perspective. And those blind spots or those points of failure tend to be at different points in time and in different ways. So the thought process with the Macro/Micro Forum is by putting the top-down and bottom-up perspectives together in parallel in a way that we can compare and debate. It really reveals those blind spots. When putting together, it allows us to build a more robust market thesis that ultimately drives risk budgeting, how much risk we take and where we take it. So how do we do it? The process is quarterly. So on a quarterly basis, we're asking our chief economist, our chief strategist, which represent the macro side, as well as our corporate analysts in North America, both high grade and high yield across all the sectors. They're asked to rate the economy in the case of the macro, the top-down voting, rate the economy across four dimensions. Those dimensions are across labor, across capital expenditures, top line revenue growth and profit margins. The ratings are one through three. A one is a positive impulse, something that's above trend, positive for growth. A two is neutral, and then a three is a negative impulse. It's taking away from growth. So in addition to chief economists and chief strategists doing that, the corporate analysts are doing it across credit quality and across their sectors, rating the ones, twos and threes. Ultimately on a weighted average basis, the sector weights in the corporate index weighted based on their contribution representation in the economy areput together. We end up with weighted averages across the four dimensions and we have a comparable framework that we're able to compare the top-down with the bottom-up. And frankly, it's an important discussion. When we have this discussion, it really starts with Erik Weisman, our chief economist leading us out, so to speak. He's spending about 15 to 20 minutes talking about his voting and why the more important part of the discussion, or I should say the larger part of the discussion, going around the room for each of the credit analysts, for each of them talking about their ratings, why they rated. And in essence, they're looking to either refute or support what was put forward from a macro perspective. As a portfolio manager, as someone that is in that meeting and running that meeting, it's really my role to pull on threads when we see dissonance, or difference between what we're hearing from the bottom-up, from the companies that we're investing in versus the top-down and really utilizing that to test different market thesis. Are there structural changes in the economy? Things that might lead a reaction function to changes in the economy that might be different than the past.

Rob Hall: Okay. So a follow-up question on everything that you said. As you think about all of the inputs that you're hearing in the context of this discussion, both the top-down and the bottom-up, certainly it gives you the sense of a far more nuanced and comprehensive view of the economy than you'd get otherwise. Have there been times when that dissonance that you referred to has actually made a difference in terms of making risk budgeting decisions that you might not have otherwise made if you hadn't seen that dissonance?

Josh Marston: Well, first I would say most times the view from the top and the view from the bottom actually agree with each other. And typically it's when there's more uncertainty in the marketplace. When there's more volatility in the marketplace, you're going to have that dissonance and that dissonance is really critical. That's when you have something to debate and something that we're really trying to flush out. So there have been times, I mean, the best example I can think of, the greatest disagreement more recently was in 2022 into 2023. At about that time, we had the Fed reacting to higher inflation prints. We saw the Fed respond with 11 consecutive rate hikes, 525 basis points of rate hikes. Historically that's an unprecedented amount and the speed oftentimes leading to recession. We had macroeconomic data that was weakening. And from a top-down perspective, based on history, based on an inverted yield curve, based on some slowing growth, there was near market consensus that we're going into recession.
As a differentiator though, as we were going through this macro/micro process and having this debate internally, we were getting different signals from the bottom-up that in fact, while we may have an economy that was slowing, it'd still be growing. It'd still be an environment that would be supportive of credit and supportive of investing in areas like corporate bonds, even emerging markets and mortgages and whatnot. So the takeaways that we're getting from our analysts covering sectors from consumer finance to home builders to others that A, we're really starting with the consumer that's in much, much better shape than we've ever seen before going into recession. And that's a consequence of 2022. Prior to that, all the COVID stimulus. So you had consumers that had paid their credit cards down, they were on time. In many cases, you had homeowners that were able to refinance their mortgage and put a mortgage in place of two and 3% for 30 years. I mean, truly the gift that just keeps on giving.

On the corporate side, you also had companies that were able to do the same thing. And what I mean by that is terming out their debt, taking advantage of the very, very low interest rates and financing that low rate environment going forward. We also were hearing from companies when we were polling them that their response to a slower economy would be different than it had been in the past, this concept of labor hoarding. Scars that kind of remained of trying to hire people after COVID still were evident. And the cost of doing that in the very short term was such that there was really reluctance to shed labor in the very short term. And most of the companies that we were talking to actually had very reasonable growth expectations going forward, really more of like a two or 3% type growth environment, which was at odds with recession.

So what we did in this case, we actually started stepping in and buying risk. Most of that was in the form of high grade corporates and high yield corporates. This was late 2022 into early 2023. Not only did we have the poor macroeconomic data, we also had a regional banking crisis at the same time. We had the Russia-Ukraine war that had also started in 2022. So there was a lot of market uncertainty and we saw credit spreads double. So well above the historic averages and again, reflective of a market that viewed recession coming. So our view from the top-down gave us the conviction at a point in time when the market had very low conviction to step in and add risk. We did that and by doing so we were able to add value for our clients. And what I say by that is we never got that recession. In fact, credit spreads which had doubled retreated and by the end of 2024 we were back to 25 year lows on credit spreads.

Rob Hall: Josh, thanks very much for that explanation of what we're doing in macro/micro. So the takeaway is that we've found that integrating top-down macro and bottom-up micro perspectives in a structured systematic way enhances the process of risk budgeting for fixed income portfolios. Not only does it help us formulate a more comprehensive and nuanced thesis on the fundamentals, but also at critical inflection points in the economy. When macro and micro stories diverge, it can prompt risk budgeting decisions designed to create alpha for our clients.

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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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