'Markets were already in the process of repricing' before Omicron, portfolio manager says

Morgan Stanley Investment Management Fixed Income Portfolio Manager Jim Caron joins Yahoo Finance Live to discuss markets, the Fed, and what to expect in 2022.

Video Transcript

KARINA MITCHELL: We will stay on markets and bring in our guest, Jim Caron, Morgan Stanley Investment Management fixed income portfolio manager. Thank you so much for being with us today. Jim, just want to get your reaction to the price action that we're seeing. And then are you surprised at all by the level of volatility that we've seen, given that we really knew so much about this-- so little about this variant up until this point?

JIM CARON: Well, first, thank you for having me on your show. Look, I think the level of volatility is somewhat logical here, right? Because a lot of this started prior to the omicron variant really emerging. We knew that Powell was changing course in terms of his policy actions. He's speaking more hawkishly. Markets were already in the process of repricing a bit if I look at the credit spread markets prior to the omicron. I know after Thanksgiving, that all came out and that created a pretty big volatile event.

But I think the initial conditions where valuations were pretty full, we knew the Fed was starting to change course and starting to tighten financial conditions a bit. And that's going to mean that asset prices are going to have to reprice. Now clearly, you start to get somewhat of a perfect storm when you add a health risk-- health variant like the omicron variant comes in. And that adds just fuel to the volatility.

So I wouldn't say that it's surprising. I'd say what is surprising is really the level to which yields actually fell, how much exacerbated the flattening of the yield curve became, and how much lower long-term Treasury yields actually fell to. I'd say that was probably the one thing that was more surprising to the markets.

ALEXIS CHRISTOFOROUS: You know, Jim, it was just a couple of weeks ago that the stock market as a whole and small caps in particular were hitting record highs. Very different story now. And it seems as though investors are really dumping those small caps. I know the Russell 2000 fell into correction territory. Some are talking it may fall into bear territory. Talk to us a little bit about those small cap stocks. And where do we go from here?

JIM CARON: Sure, well, small caps are going to really have a lot to do in terms of their performance with the relative economy in terms of how people's mobility is, what people are doing. These are generally smaller businesses. So when you have, like, the omicron variant come out, what people start to price in is slower foot traffic and in companies that might not have, like, a large cap company might have a bigger storage or war chest of cash stored up.

Now, once you start to get into a situation where consumption might start to get impeded upon because of this travel, and, you know, foot traffic starts to get impeded, this is where small caps are really going to start to have a bigger price difference. We also have to recognize that they were doing very, very well. And, you know, my personal opinion is that they probably continue to do well as we get past this variant.

KARINA MITCHELL: Given last week's jobs numbers, Jim, there's been a lot of talk that the Fed, you know, accelerates the pace of tapering and then also considers hiking rates sooner. What is your opinion? Where do you stand on that? And does it create a taper tantrum?

JIM CARON: OK, so, first, I don't think it creates a taper tantrum. We've seen long-term yields come down. We've seen bond yields be relatively stable, even with the announcement. So I think the ship has sailed on a taper tantrum. The other is that the net issuance of treasuries is still very, very low. So there's a lot of demand for US treasuries. So I think, like I said, taper tantrum is off the table.

Now as far as going faster at a faster pace of tapering, Powell pretty much announced that that's what they're going to decide. And that's what they're really going to discuss at the December 15 FOMC meeting, so a week from this coming Wednesday. So I think we're all bracing for that. I don't think it has a material impact on the level of yields. I think the markets are already anticipating it. And like I said, we're seeing the exact opposite impact right now on yields. We're seeing yields go down, as opposed to higher.

But you bring up a very, very good point, which is that people think of this in terms of sequencing risk, meaning that once you're done tapering, you can start to hike interest rates. So the faster you're done tapering, the sooner you can start hiking interest rates. So that means that many forecasters have now started to bring forward their first rate hike from, say, the beginning of the third quarter to some time at the start of the second quarter. So bringing that forward by about three months, and many forecasters are even calling for three rate hikes. In fact, the markets are pricing two to three rate hikes next year.

So all of this is in the price. The question is, how far does the Fed actually go? And this is where the markets are in the exact opposite position. So while we're pricing in a faster pace of rate hikes by the Fed, we're also pricing in that they may not be able to go to as many rate hikes. So what the market is saying is that the Fed will be able to hike no more than 625 basis point rate hikes and that the terminal Fed funds rate where the Fed stops hiking is at 1 and 1/2% versus what the Fed is telling us, which is 2 and 1/2%. So this is where the big disconnect actually is. And it's one of the reasons why long-term yields are so low.

ALEXIS CHRISTOFOROUS: But let me ask this, Jim. Is that really going to have a material effect on higher prices? Because a lot of, you know, what's happening with inflation is being Fed by the supply chain issues. So does a series of rate hikes sort of contain that situation or not? Because doesn't the Fed, in essence, need to deal with the demand side of things? They need to bring demand down in order to come in line with these supply chain issues. And that would actually lower GDP.

JIM CARON: All right, listen, you're absolutely right. And this is a perfect line of questioning here for the Fed. What we're seeing is inflation because of a supply shock. Fed rate hikes do not address rate shocks. And the joke I like to tell is that if auto prices are higher because of semiconductors not coming from Taiwan, what does a Fed rate hike do to the supply of semiconductors? Nothing. So if it's a supply shock, Fed rate hikes don't do anything, but really address demand.

Now what the Fed does not want to do is absolutely kill demand and throw us into a slower growth environment. So they're trying to have a delicate balancing act with trying to address inflation risks by talking a little bit tougher on inflation and possibly rate hikes and tapering and things like that.

But they don't want to go so far as to slam the brakes on the economy and actually tighten financial conditions such that we start to see a-- or it starts to reflect a much more material slowdown in growth. Because if that happens, the unemployment rate is going to go higher, and a lot of the good work that's been done, you know, over the previous years in terms of getting, you know, people employed, all of that stuff is going to start to-- all of that stuff is going to start to go away. And that's the last thing the Fed wants.

KARINA MITCHELL: So then, really quickly-- not too much time left-- how do we position ourselves for this, then, going into the end of the year and beyond?

JIM CARON: The way we look at it is, what's the most dislocated? So there are a couple of things. We think the long-term long end of the yield curve is relatively dislocated. So we think yields are too low there, so we would be underweight duration at the very, very back end. The other is that when we look at spreads, particularly in the high yield sector, short duration high yield in particular, also looks pretty attractive. We still have a good growth environment. We think default risk is going to be low.

The last point I'll make is that the most dislocated market seems to me to be emerging markets, where many of these central banks have already been hiking interest rates, and yields are very high at the front ends of those markets. And that's where we see some of the great opportunities for 2022.

KARINA MITCHELL: All right, Jim Caron, Morgan Stanley Investment Management fixed income portfolio manager, thank you so much for your time there.

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