Transcript
The economy has been surprisingly strong over the last two years due to the savings that people built up during COVID and government transfer payments. This allowed people to continue spending despite increasing inflation. Additionally, many individuals have locked in low mortgage rates, which also enabled them to keep spending even as interest rates rose. From the perspective of the Federal Reserve, this means that they need to be cautious about cutting rates too early or too quickly in order to avoid reinflating certain parts of the economy.
The Fed's willingness to keep rates higher for longer has caused some concern in the bond market. It seems that every piece of news makes the bond market think that the Fed is going to start cutting rates, but the Fed has remained committed to keeping rates higher for longer due to concerns about inflation picking up again. As a result, the Fed has created opportunities for investors to finally lock in higher yields that they've been missing out on due to the zero interest rate policy of the past 10-12 years.
The Federal Reserve needs to see consistently positive data regarding inflation and labor markets in order to justify a rate cut. While there were some concerning economic indicators at the start of the year, recent inflation numbers have been more favorable and are approaching the Fed's target of 2% in the long term. Unless there are unexpected surprises in the upcoming data, the Fed is likely to proceed with one or possibly two rate cuts this year, depending on the trajectory of the data.
Many investors are currently attracted to overall yields, which are relatively high, ranking around the 65th to 70th percentile. However, spreads are narrow. From an investment standpoint, corporate spreads may not fully account for the potential of a significant economic downturn, even though such a scenario is not our base case. It's essential to be mindful of the risks involved and assess the compensation for taking on those risks. Despite the attractive yields, it's possible to achieve decent returns without significantly compromising quality in high-quality investments. This, in our view, should be the primary focus for investors, instead of solely pursuing the highest possible yield in the current market environment.
Given the economic outlook and current spread levels, we believe that financials remain appealing. While they are trading at slightly wider levels compared to some segments of the industrial market, we specifically favor bank bonds and the securitized space, including high-quality asset-backed securities at the front end of the curve, offering substantial income. Additionally, we find mortgages, especially higher coupon mortgages, appealing, as they could perform well if the yield curve steepens at the front end, with rates decreasing and potentially rising slightly at the back end. Even in the event of a recession and significant rate decreases, purchasing discounted bonds should still yield positive returns.
Looking ahead to the second half of the year, we anticipate at least one rate cut by the Fed, likely in the fourth quarter. A second rate cut may occur if the inflation data improves. Concurrently, we expect the yield curve to gradually steepen as these rate cuts materialize. However, if the labor market remains robust, we do not anticipate the Fed lowering rates to their long-term target of 2.5%; instead, we foresee the rates settling around 3.5% to 4%. Although a deterioration in the labor market could prompt the Fed to lower rates to 2.5%, given the current strength of the economy, we find it unlikely for the Fed to cut rates as aggressively as some predictions suggest in order to stimulate growth.
From a strategic perspective, investors should carefully consider all fixed income risks in the current environment. We recommend extending the duration of fixed income portfolios in response to the Fed's signal of rate cuts, thereby locking in yields and allowing flexibility to select the appropriate part of the curve to secure these yields. This strategic decision can enhance total returns and provide greater protection against other risks in the portfolio, such as equities or other segments of the private market. Concerning credit risks, lower-quality segments of the market have priced in the likelihood of a soft economic landing, which aligns with our expectations. However, these segments may not offer significant additional performance potential. While opting for higher-quality securities might involve sacrificing some yield, it could provide better protection and potentially improved performance in the event of a soft landing. On the other hand, sticking with lower-quality securities may add to the overall risks in the portfolio in case of a downturn. Ultimately, owning fixed income is about providing a hedge, and reaching for credit risk or other excessive risks without appropriate compensation may hinder diversification benefits.