The initial drag from higher rates was muted by the trillions of dollars that were poured into the economy through government stimulus and relief packages at the height of the COVID-19 pandemic in 2020. Today, while there is still a tremendous amount of residual stimulus money being spent in the economy, it has fallen dramatically from its peak levels, and will likely continue to do so moving forward. When it runs out, so will the spending sprees.
Higher interest rates are now starting to have a substantial negative impact across the economy. For the consumer, the rise in mortgage rates from a low of 2.8% in February of 2021 to just over 8% in October 2023, has caused a huge slowdown in housing activity, with sales of previously owned homes in the United States down 2% from August to September 2023. That's the lowest level since October 2010. While home prices have actually increased over that time period, this has largely been driven by the dearth of supply, as most homeowners are hesitant to list their homes if it means letting go of their existing low mortgage rates and buying a new property at today's rates. In my view, this dynamic is not sustainable in the long term in much the same way that Wile E. Coyote cannot continue to float after running off the cliff without eventually falling into the chasm below.
There has also been a notable increase in delinquency rates across consumer spending categories, such as credit cards and auto loans. The 60-day delinquency rate for subprime auto loans has increased from just under 3% in 2020 to over 6.1% in September 2023. This is in large part due to the surge in borrowing costs, with commercial bank auto loan rates increasing from 4.5% at the start of 2022 to over 8.0% in September 2023.
The labor market has also begun to weaken, which will likely erode the wage growth that has supported consumer spending over the past few years. Both the unemployment rate, at 3.9%, and the number of the unemployed, at 6.5 million, changed little in October. However, since their recent lows in April, these measures are up by 0.5% and 849,000, respectively. Another brewing problem for the consumer is the huge amount of student loans that still need to be repaid, some $1.77 trillion. The resumption of student loan payments that began in October takes money out of the consumer's pocket that likely would have gone back into the economy through spending.
The negative effect of current higher interest rates is reverberating across the entire economy, as governments and corporations are feeling the pinch on their balance sheets. In the bond market, high-yield default rates have also begun to rise, with J.P. Morgan estimating that default rates will reach 3% for 2023. While this is just below the long-term average of 3.2%, it represents a sharp increase from the 0.4% in 2021 and 1.6% in 2022. Additionally, the recovery rates so far have been significantly lower than recent history. High-yield bond recovery rates are just under 25%, vs. their long-term average of 40%. First-lien leveraged loan recovery rates are similarly depressed at 40% vs. a long-term average of 65%. The rise in defaults and severities could add additional pressure to the already high refinancing rates and could eventually slow the economy as companies fail and lay off employees.
Furthermore, bank lending activity remains very low, with balance sheets once again coming under attack, due to the ongoing deterioration of commercial real estate (particularly office) loans. Based on the most recent Senior Loan Officer Survey, banks willingness to lend to consumers has deteriorated from +20 (the net percentage of banks reporting a willingness to lend) at the beginning of 2022 to -20 today, a level that has always resulted in a recession over the past 50 years.
Then there is the new, unforeseen geopolitical conflict that has recently erupted between Israel and Hamas, highlighting the risk of a sudden interruption to global growth. Of course, regional conflict within the Middle East could cause a dramatic spike in oil prices, at a time when consumer pocketbooks are already stressed by rising indebtedness, let alone falling incomes from job losses.
Given all those factors, bond portfolio managers need to do some careful planning to protect their portfolios. To assist in this planning, it is helpful to use the thesis that something is always cheap. If risk assets are expensive, then safety is cheap. In this environment, traditionally safe assets such as Treasuries and agency mortgage-backed securities are generally cheap relative to equity multiples and corporate spreads, and therefore can offer an attractive way to better protect your portfolio in a future downturn.
Choosing an allocation amount for these assets can be difficult, as there are many benchmarks to measure exposure against, with the Bloomberg U.S. Aggregate Bond index being the most popular. While it can be hard to quantify a recommended amount to increase an allocation, directionally increasing a portfolio's allocation to mortgages, for example, or moving to an overweight allocation of about 5% vs. one's benchmark in mortgages, can be helpful.
For Treasuries, adding about 5% to whatever the portfolio's prior weight to Treasuries was in 2019 could be a good starting point. The reason being that the pandemic period skewed a lot of allocations, so potentially adding 5% sets up more of a normal state allocation vs. pre-pandemic levels makes the most sense.
Moving to an overweight duration position is also an option. As the economy enters into a recession, we typically see rates fall. That's what we saw over the last two months of 2023, as the market began to price in the increasing likelihood of a federal funds rate cut, as a way of supporting an economy that's faltering. Therefore, it's possible to position a portfolio to do well in a recession by increasing the duration of the portfolio by a quarter to a half a year, to benefit from the expectation that rates are going to fall.
As the economy enters a recession, we also typically see spreads widen, causing most spread sectors to have negative excess returns. Moving a portfolio up in quality and longer in duration can help protect against those negative excess returns by being less exposed to the risky spread sectors, and more exposed to the positive effects of lower rates on bond prices.
Peter Cramer is senior managing director and senior portfolio manager, insurance asset management, for SLC Management. He is based in Redmond, Wash. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.
