Debt limit: Investment opportunities as markets await deal

Morgan Stanley Investment Management Fixed Income Portfolio Manager Jim Caron joins Yahoo Finance Live to examine the state of the debt limit negotiations, its impact on markets, and how investors can prepare their portfolios for more interest rate hikes by the Fed.

Video Transcript

SEANA SMITH: --would hear President Biden returning from the G7 summit and is expected to meet with House Speaker Kevin McCarthy later this evening. For more on the latest with the debt ceiling dilemma, we want to bring in Jim Caron, Morgan Stanley Investment Management fixed income portfolio manager. Jim, it's great to see you here. So when it comes to the debt ceiling, markets still shrugging off the risk as we get closer and closer, like Akiko said, 10 days until that X-date. Why do you think that is and how do you see that, I guess, factoring into some of these talks?

JIM CARON: Well, first of all, I think it's very hard to predict anything that's actually taking place in Washington DC behind closed doors. And I think for many of us, we're all really just trying to make our best guess at this. So the way that we see this, our base case is that there is going to be a deal that gets done because the alternative would just be so much worse.

But ultimately, what I also think that the market has to focus on is what happens after the deal gets done. And people are going to start then talking about fiscal tightening, which isn't necessarily a good thing because it's going to come alongside of monetary policy tightening. So in the near term, I'd say that some of the health in the market is a case of buy the rumor. And I'm wondering if it turns into a sell the news once, as I said in our base case that we get through a debt ceiling agreement, that that becomes the fallout later on.

AKIKO FUJITA: You know, Jim, and sorry to feel like a broken record here where we keep saying, yet the US isn't going to default on its debt, but the risk of that alone is certainly significant. Now, you're a fixed income guy. When you think about what this means for the Treasury market, I mean what kind of disruption are you bracing for?

JIM CARON: Well, look, I mean, if it were to happen, clearly, we saw this back in 2011. This is going to have a very, very big impact on collateral and repo markets. It's going to have a very big impact on T-bill markets.

Some bills that are due to mature may not get paid out. That's a risk, right? You know, that's something that we have to worry about.

And what we also have to recognize is that the basic cost of capital starts with the short-term interest rate and these short-term interest rate instruments. So what this ends up doing is it creates a cascading effect of increasing risk premia across all of the broader asset class sectors, whether that's credit or whether that's equity, or high yield, or anything else. So it's really hard to prepare and brace for this because there's no real specific instrument that you can really hedge in a meaningful way to hedge your entire portfolio. So we're really vulnerable to what gets decided in Washington, I'm sad to say.

AKIKO FUJITA: And to that point that you just made in your first answer here, let's say there is a resolution, you say then we brace for fiscal tightening. What does that mean from your perspective?

JIM CARON: So that's where I think things get really interesting. First of all, the economy is slowing down, that we know. We know it's not slowing as much as people thought. And remember, even though the markets are doing well, the markets are not the economy.

So there is an economic slowdown that's taking place and I'm wondering if the blame game then starts to get played in Washington as it so often does. That if we start to get some declining economic data, that gets tied in together with some of the fiscal tightening. That creates a narrative that gains momentum, that creates some negative sentiment in the marketplace just broadly speaking. So that's something that I think we need to worry about.

Now, having said all that, a lot of the fiscal spending that was being done, this goes back to the American Rescue Plan, the infrastructure plan, and all the things that are being debated in the debt ceiling debate today, much of that by most measures, by most economists measures didn't create a lot of stimulus in the first place. So this could just all be a war of narratives between both political parties. But I think the sentiment in the market really takes a toll on this and there, again, it could increase the risk premia.

It just makes the markets a little bit more treacherous to navigate once we get through the debt ceiling. Now, clearly, we have to get through the debt ceiling. But once that happens, I think that we still are going to be debating a lot of different things.

SEANA SMITH: And Jim, one of the things that is being debated, has been debated on the street for quite some time, is Fed policy and what needs to happen next. We heard from St. Louis Fed President here Bullard earlier today advocating for the fact that we still need higher rates. He thinks that two more hikes may be necessary this year. Is that going too far?

JIM CARON: So I mean, my personal view is that it is. But now, look, this is a clear debate between those who believe that 500 basis points of rate hikes, that there's going to be lagged effects of those 500 basis points of rate hikes that's yet to hit the economy versus those thinking that even those lagged effects won't be enough to cure inflation. Now, I get the argument that if we end up having a resurgence of inflation, that if inflation becomes unanchored later on and the Fed doesn't do enough today to prevent inflation becoming unanchored, that could be much, much worse. And I think that's where Bullard and Kashkari are coming down.

But then you've got Mary Daly, you've got Bostic on the other side of this essentially saying that, look, I think that at this point, we have to wait and see. We've done 500 basis points. We've had some turmoil in the banking sector.

Does more rate hikes-- does that actually solve the problem or is it really just a question of time? Do we just need to be a little bit more patient? And I come down on the Mary Daly-Bostic side of the argument and a little bit less on the Kashkari side and the Bullard side, which seems to be much more immediately hawkish.

AKIKO FUJITA: So what does that mean from an investment standpoint?

JIM CARON: So the way that I see it is that, from a default risk perspective, I would argue that credit spreads actually look reasonably attractive. So my base case is that we do not see a hard landing. If that's the case, then high yield looks reasonably attractive. US housing-related securities, non-agency mortgages look reasonably attractive at this point.

If we don't have a hard landing, I think that the credit risk default premia doesn't necessarily get realized and essentially it's good for an investor to capture that. So it's not that spreads are particularly wide, but I think that the all-in yield for bond investors today looking at high yield or even investment grade is actually reasonably attractive. The only time it's not attractive is if we end up going into a hard landing and have a deep recession and have default risks spike.

So if the Fed is on hold, and this is what my view is that they're going to be-- that there's going to be a big pause, this is going to be reasonably friendly for the credit markets. This is going to be good for fixed-income markets. And essentially, I think it can create a good investment opportunity to look at some of these high-yield yields that are yielding somewhere around 7 and 1/2% or 8% or some investment-grade yields that are yielding somewhere around 5.25%. These are reasonable yields and potential returns that one could get by the end of the year. And I think this is looking pretty interesting right now.

SEANA SMITH: So Jim, investors, as you say, it's critical here to make sure that your portfolio is balanced rather than just defensive. Why do you think a time like this, it's so important to do just that? And as investors are trying to evaluate some opportunities outside what you were just talking about with high yield, where do you see that?

JIM CARON: , Yeah so I'm glad you asked that question. Because, look I mean, one of the things I think the market's missed this entire year is that the risks in the market are more balanced than what the consensus negative narrative would have us believe. So many people, forecasters in the market are quite negative and they're quite pessimistic at the moment.

And my personal view is that the risks are a whole lot more balanced, meaning that if risk on is a risk just like any other risk, it needs to be hedged. So let's not try to convince somebody to be bullish in these markets, but let's at least convince people to understand that there is potential and possible upside. And I think that's been true all year.

So if you select a defensive style in your portfolio, you are basically forecasting an economic outcome, which is a negative outcome and you're trying to position for that outcome. Rather than position for one specific outcome, why not position for either outcome and just have a diversified portfolio? And say, look, if good things happen, this part of my portfolio does well. And if not so good things happen, then this part of my portfolio should make up for the shortcomings. And that's the way that we've been thinking about it in our global balanced funds and strategies is that we've really been thinking about this as more of a balanced risk market as opposed to just grabbing on to the bearish consensus narrative and trying to position for that.

AKIKO FUJITA: The balanced risk outside of the US, you see any other opportunities?

JIM CARON: Look, Europe. I mean Europe's been doing really well. European equity markets are up between 12% and 15%. Much of the European equity market is really a value story. So the value markets within the European side still look reasonably attractive and they've had a pretty good run.

There's been some great opportunities within Greece. You know, Greece recently had elections and it seems to have more of an investment-friendly result. And they might go from a high yield or subinvestment grade entity to investment grade. So there could be some-- I think there's a lot of positive momentum that's still within the eurozone.

It doesn't mean that economic conditions aren't going to slow. I mean the central banks there are hiking. It's just that I think that the sentiment indicators right now has kept people and money on the sidelines such that they're missing a lot of the rally that's in the marketplace and they may be forced in as conditions don't deteriorate as much as they thought that they might.

So I think that's the other timeline that we have to worry about is a lot of the negative sentiment is starting to run out of time. It was supposed to happen already. We were already supposed to have a bad first half of the year. That hasn't materialized.

So therefore, how much more time do we need to give it? Now I'm hearing that the recession might be in 2024 not in 2023. Well, what do you tell investors who were expecting some performance in 2023? Oh, sorry, let's wait and let's do it again.

[LAUGH]

So this is what we have to really be worried about. That's why we like a balanced strategy.

AKIKO FUJITA: Yeah, certainly a tough market to navigate. Thankfully, we've got some takeaways from you there. Jim Caron, Morgan Stanley Investment Management fixed income portfolio manager, appreciate your time today.