Xavier Goss is a fixed income portfolio manager at Capital Group. Among his areas of focus are structured products, which are fixed income bonds created by pooling together a large number of consumer, commercial and corporate loans. We talked to him about the outlook for the economy and the bond market, as well as the state of the commercial real estate industry.
I’m not as negative as some in the market, who are bracing for a big recession or default wave. At the end of the day, the consumer is still strong. Obviously, there are pockets of consumers who are struggling, but today doesn’t feel like 2008 and its mortgage crisis and contagion risks. Wage growth is solid, and unemployment is near an all-time low. Consumer spending makes up a large percentage of the economy — if you assume that the economy is going into a recession, it’s hard for me to say that it’s going to be a deep recession considering that the consumer is in a much stronger financial position as compared to prior economic downturns.
Some of the biggest risks for bonds were taken out of the market or, at least, reduced materially. The debt ceiling agreement removed the near-term risk of a U.S. default, and the Federal Reserve appears ready to pause interest rate increases after the banking crisis in March. In addition, we are seeing steady declines in various inflation measures, albeit at a slow pace. Banks have also done things to shore up their businesses, most notably diversifying their deposit bases and raising rates. That’s a negative for the banks themselves, but it’s a good thing for the overall system. In addition, The Fed has assisted the banking community by creating liquidity facilities.
Before the collapse of Silicon Valley Bank, so many people were shouting “inflation, inflation, inflation.” The market wanted the Fed to do more. But we saw what happens when the Fed gets too aggressive too quickly. So, I think we’re in this weird but interesting environment where the Fed is on pause, and markets can do well in the short-term despite a slowing economy. In my mind, we got through one of the biggest potential headwinds, a banking crisis, and emerged relatively unscathed.
That doesn’t mean we’re free and clear. There probably will be other hiccups, and I think there are still a lot of headwinds. Financial conditions have tightened a lot, and quickly. But in terms of systemic risk, we got through the debt ceiling and a banking crisis. I think the things that will come down the road will likely be more company and sector specific. That being said, this is a great environment for security selection and generating excess returns relative to a benchmark, or “alpha,” when taking a long-term view.
One of the big areas right now is structured products, broadly. There was a big selloff of structured products this year, but many Capital Group portfolios had deemphasized those securities before that occurred.
When these kinds of market repricings occur, one of the ways to benefit is to purchase promising securities that we believe are underpriced. One of the key features of structured products is the diversification benefit potential compared to other risk markets. Coupling the diversification benefit with cheaper valuations relative to corporate credit helps drive my thesis of selectively adding structured products in the near-term.
Obviously, everyone’s talking about commercial real estate. It’s another area where I don’t want to be quite as negative. To be clear, this environment is not good for commercial real estate — period, full stop. Banks are large participants, and they’re tightening their underwriting criteria for new loans given the banking issues in March. You have the Fed appearing to signal that higher rates will be around for longer as it combats inflation, which is generally bad for real estate–related sectors. Office occupancy is about 50%, and I think that’s just a fundamental change in the market. I think things will recover, but likely won’t get back to pre-pandemic levels anytime soon, or even at all.
Commercial real estate fundamentals will likely worsen in the future. You’re seeing folks turn in the keys and walk away from properties — even some of the big sponsors and participants in the market. But this process isn’t going to happen overnight; it’s going to be a multiyear process. These loans are big, and the fundamentals of each property will vary significantly based on idiosyncratic factors. Commercial real estate securities differ a bit from other types of structured credit sectors that typically bundle thousands of loans — they tend to be less diversified and require a bit more granular loan-level and property-specific analysis.
My current thesis is that fundamentals in commercial real estate will continue to deteriorate but valuations have repriced materially in recent months, providing an opportunity to generate alpha through security selection for long-term investors. There will likely be properties and bonds that underperform, but chances are that a significant portion of the market is going to be fine. The better you are at picking securities, the more you can generate long-term alpha for clients. I think that’s why Capital Group is set up better than a lot of other folks. Our analysts are very good at security selection and identifying individual security risk.
I don’t feel this is the environment where you want to take an outsized macro view in either direction. I think the big theme right now is that there are a lot of great opportunities in the market. Duress brings volatility, and that can scare people. But for me, as a deep credit investor, times of elevated volatility are when I get the most excited.