Portfolio Manager Q&A - Bill Ford

As expected, the Fed held rates steady at its last meeting, but it did offer guidance on its expectations for future rate cuts. What should investors take away from the Fed’s inflation fight and market expectations?

Markets were focused on the Summary of Economic Projections (SEP), also known as the dot plot, which showed some subtle changes. The median numbers didn't change significantly, especially in terms of rate projections for 2024 or even for 2025 and 2026. However, within those dots, we saw some more dovish outliers (expecting more aggressive rate cuts and lower terminal rates) move up closer to the median. This indicates a Fed whose expectations for rates are shifting towards a “higher for longer” scenario.

Markets had been pricing in more interest rate cuts than the Fed telegraphed following the data in November and December of 2023. The inflation, consumer, and growth data that has come in so far in 2024 has really pushed back on that narrative, and the market has since moved back toward where the Fed said they were all along.

While the Fed thinks inflation is trending in the right direction, and it looks like there hasn't been too much collateral economic damage, they are not quite ready to cut. Without an exogenous event or shock that would cause a big economic slowdown or concern within the financial system, we think aggressive rate cuts are unlikely.

With corporate spreads at historically tight levels, are investors being adequately compensated for taking on risk in the corporate bond market right now?

We believe this is a time for more discipline rather than opportunity-seeking in the bond market. Throughout most credit cycles, we tend to see that spreads grind tighter and tighter when things are good, and people feel better about taking more risk and chasing yield. Then, there tends to be a sudden gap wider when something happens that causes investors to reassess risk levels and pull back from taking more credit risk. Over the past 15-20 years, this happened in the global financial crisis, the European debt crisis, the Fed being perceived as having overtightened at the end of 2018, COVID, and in 2022.

In each of those cases, we went from a point where spreads had been wider to a point where they got tighter and tighter, which was good if you were exposed to credit risk in those scenarios. But then you reach a point where you’re not being compensated for taking credit risk. It feels terrible at the time because you think you’re giving up yield, but it is important to be disciplined in those times.

When risk reprices and spreads move wider, they tend to move very quickly, usually due to something that nobody saw coming. At Reinhart, we tend to be fairly conservative on credit risk; we believe now is a better time to be more defensive. We will certainly take it on, but we want to be careful about how and when we do.

With rate cuts widely expected to come later this year, how is the portfolio positioned? Where are you finding opportunities to add value?

From a rates perspective, the market is finally in alignment with the Fed. The shorter end of the yield curve will depend more on monetary policy and the timing and pace of cuts, while the longer end will be more defined by where the terminal rate ultimately lands. As much as one can have an opinion on where rates will move, we think both long and short rates are moving toward fair value. Short-term rates may be more likely to move down than up, but we don’t have a strong conviction on this. Without a strong conviction on rates, we’re staying much more neutral to our benchmarks.

When it comes to credit, I would come back to the idea of discipline. We add value by maintaining our flexibility, pulling back on credit exposure, staying higher quality, and waiting for whatever shakes loose to make credit spreads widen.

One area where we are still seeing spreads at attractive levels is within the US regional bank sector, particularly with the Super Regionals (the larger regional banks). We have to be selective here, but we are maintaining an overweight to the sector. It has been a year since Silicon Valley Bank and First Republic sparked fears within the banking sector, and wider spreads in the sector can still be attributed to this. Regional banks tend to have a little more exposure to commercial real estate and offices, which is becoming a greater area of concern. But as we look at the regional banks we have exposure to, we feel very confident that these types of risks are well contained. We will shy away from the banks that are more exposed to higher stress or troubled areas.

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