After a bad year for bonds in 2022, the outlook is brighter. Good that Sara Devereux, global head of fixed income group at Vanguard, started sporting a button around the desk stating “Bonds are back.”
“I haven’t seen this kind of opportunity in a long time, after a decade of returns at the lower end of zero,” says Devereux, whose unit has more than $2 trillion in assets under management.
Vanguard is the second largest asset manager in the world, with $7.7 trillion in assets under management. In bonds, he is best known for index funds. But it’s also one of the largest providers of US active bond funds, with $890 million in assets, and Devereux helps lead the charge in active management.
Devereux joined Vanguard in 2019 from Goldman Sachs, where she spent more than two decades specializing in mortgage-backed securities and structured products. This year, she was awarded Barrons for the second time among the 100 most influential women in American finance.
Devereux spoke with Barrons May 24 on the outlook for the US economy and inflation and where she sees opportunities now. An edited version of the conversation follows.
Barrons: Where is the US economy headed?
Sarah Devereux: We believe we are going to have a shallow recession later this year. That was our view at the start of the year, and it remains our view. We are not calling for a hard landing.
Inflation has fallen from its peak, but is still too high to be comfortable. Where to go from here?
The war on inflation is not over. We are up about 9% to 5% in the consumer price index. Our perspective is that basic PCE [the core personal-consumption expenditures price index] will end this year at 3.3% and by the end of next year will be in the bottom two.
Most of the progress has been on the supply side: the disinflation of goods as supply chain disruptions have been resolved. That’s great, but we need to see demand cool down, especially wages and the labor market. This has a big impact on prices for more rigid services. That’s what the Fed is focusing on, and that shoe has yet to drop.
The labor market has cooled, but remains tight. Earlier this year, there were two jobs available for every unemployed person who wanted a job. This ratio has gone down but is still at 1.8 and needs to get closer to 1:1. That’s the core of what the Fed needs to do: Calm the labor market so those excess job openings close, but try not to outrun layoffs and a deep recession. It is a difficult needle to thread.
The labor market is a lagging indicator, and when it cracks, it tends to move sharply. This dynamic is central to our outlook for a shallow recession. Historically, when unemployment spikes during a recession, half is due to layoffs or fewer job openings, and the other half to people entering or re-entering the workforce and not finding jobs. right away. This time it’s different in that we don’t expect labor force participation to increase as it has in the past. This is due to demographics and several other things. But this effectively puts a brake on the rise in unemployment beyond 5%.
To bring inflation down, the Federal Reserve will have to continue its fight and get us through a shallow recession.
Should the Fed raise interest rates again in June or take a break?
We believe the Fed will take a break in June to assess the impact of tight policy on inflation and the labor market, but monetary policy has long and variable lags, and plenty of tightening has taken place in the market in a short time. It is very difficult to predict when these stricter financial conditions will be felt.
Our base case is that the Fed will keep rates in tight territory for the remainder of the year as we believe this is necessary to slow the economy and cool the labor market in particular. This will cool inflation. We don’t think the Fed will cut rates later this year, like the market is doing.
Vanguard calls periods of economic uncertainty and market volatility Vanguard Weather. What do the forecasts look like?
As someone who has been in the fixed income space for 25 years, I see a ton of opportunity if you work with the right manager. An environment like this plays to our strengths and bodes well for assets [management]. Volatility leads to dispersion in valuations, and more dispersion means more opportunities to monetize that relative value. When everything is trading at the same level and there is no volatility, there is no opportunity to capture value outside of the index.
Volatility can also lead to periods of dislocation where valuations rise above. The Silicon Valley Bank crisis earlier this year is an example. A good active manager will have dry powder to deploy. We are heading into a recession and credit risk is increasing. This is where our best credit teams can differentiate themselves by choosing the right names. There are plenty of returns to be had in areas such as business credit.
Where are the other opportunities?
Given our economic forecast, we favor a high quality tilt. It’s treasury bills, municipal bonds and investment grade bonds [securities]. But there is also an opportunity in the riskiest segments of the market – high yield and emerging markets – where we are going to be selective.
We find that investors are focusing on four areas, from lowest to highest risk profile. First of all, we recorded strong inflows into our money market funds. This is not surprising, as yields are attractive and there have been outflows from bank deposits where yields are lower. Yields are higher because the yield curve is inverted and it is interesting to invest your money in a monetary fund if you have a short investment horizon. This is a great place for cash for three to six months.
If you have a longer time horizon, you might be better off going higher on the yield curve. That way you can get a yield, but also a duration that could recover, especially if we have a recession.
What is the second area that attracts investors?
The second area where we see a lot of flow is in our treasury funds and our exchange-traded funds. Again, the returns are attractive. At the same time last year, to get 4%, you had to turn to high yield or private credit. Now you can get 4% in US Treasuries, which are backed by the “full faith and credit” of the federal government and are very liquid.
Another reason people love Treasuries, and why we love them, is that they’re the purest diversification game if you have a stock-heavy portfolio. If we are heading into a recession, these bonds will generally recover, but that also means credit risk is rising, which means corporate bonds may lag treasuries in a recovery. . Corporate bonds will be more correlated to the equity market.
The sweet spot is the middle part of the Treasury curve, say five years, but it depends on your time horizon. Regardless of your investment horizon, your bond fund should have a shorter horizon. An example is the
Vanguard Medium Term Cash
ETFs [VGIT].
The third area where we see good flows is in municipal bonds. Last year, the muni market saw record outflows because investors had the unique opportunity to reap tax losses [sell losing stock positions to offset taxable gains]. This sell-off caused valuations to overshoot on the cheap side. And that contrasts sharply with the fundamental value, which is strong: more than 70% of municipal debt is rated AA or better.
In March, we launched the
Vanguard Short Term Tax Free Bond
[VTES]a municipal bond index ETF for investors with a short time horizon and low tolerance for interest rate risk.
And the fourth?
There is a lot of yield to be had in corporate credit, with 5.5% to 6% in investment grade and 8% to 9% in high yield. We strongly recommend that you use an asset manager. The waters are going to be choppy ahead of a recession. Not all boats will rise with the tide, and choosing the right companies to invest in will be key, as avoiding losers can be just as important as picking winners.
Within corporate credit, we favor quality. In investment grade, we favor superior quality, which we define as earnings stability. We are in sectors such as pharmaceuticals, healthcare, utilities, large cap banks, non-cyclical rather than cyclical.
THE
Vanguard Base Link
funds [VCOBX] And
Vanguard Core-Plus Bond
funds [VCPAX] offer investors an easy way to gain diversified exposure to high quality bonds. These are mainly investment grade bonds with some high yield and emerging markets. In the Core-Plus fund, managers have a bit more flexibility to add risk when market conditions are favourable.
Earlier this year, we launched the
Vanguard Multi-Sector Income Bond
funds [VMSIX] which has exposure to investment grade securities, high yield corporate securities and emerging market debt.
How should investors think about high yield and emerging markets?
You should consider funding both from the equity portion of your portfolio, as they have a higher correlation to stocks. These are going to be attractive relative to equities, with yields of 8% to 9% currently. But you have to be selective.
In high yield, we are cautious based on current spread valuations. However, the overall returns are attractive, so it is important to be selective. We favor premium segments, particularly dual B and B grades. Sector-wise, we see opportunities in food and beverage, paper and packaging, healthcare and other non- cyclical. We see a lot of opportunities in stock picking. Our teams use a quality improvement bias and focus on bottom-up stock picking.
Also within high yield, we prefer bonds to loans, especially bank loans from loan-only issuers, which are lower credit quality issuers. The variable rate nature of this debt increases their financing costs, which could cause some stress. You need to go company by company and look for strong balance sheets and cash flow.
Thank you Sara.
Write to Lauren Foster at lauren.foster@barrons.com