What do you make of the market movement following the July FOMC meeting and the weaker-than-expected labor market report?
At his post-meeting press conference, Chair Powell reflected a broad but not unanimous consensus at the FOMC that while policy remains mildly restrictive, the economy is holding up well as inflation risks persist. The decision to hold rates steady was met with two dissents, which is unusual, but markets were largely expecting this outcome. There is a growing contingent for easing within the Fed, and their case was strengthened by the July jobs report, which indicated that hiring has stalled and that the past couple of months were not nearly as strong as initially reported. GDP reports also came out, indicating that the economy has slowed in the first half. The Fed no longer has the luxury to “wait and see”, and as a result, the yield curve shifted down, with the expectation of a cut, maybe even a 50 basis points catch-up cut, in September. With concerns that the economy may be weaker than previously thought, spreads widened out, and equities sold off as well.
Within the corporate bond market, how are CFOs navigating the macro uncertainty, and what does that mean for investors?
The impact of tariffs will be different based on the industry and company, but broadly speaking, corporations are waiting to see what will happen with final tariff rates and the impact on their businesses. For now, many companies have started to take the hit to profits in the short run, indicating that they will look to raise prices where they feel they have the pricing power to do so to offset rising input costs. Investors should be cognizant of these dynamics in the companies and industries that they invest in and look for firms that have discipline around pricing and profitability. Our focus is on higher-quality, strong moat firms that have the pricing power and discipline to raise prices and protect profitability, rather than chase volume and sales.
How are you thinking about credit risk right now?
By historical standards, credit spreads are at extremely tight levels. Not only that, but lower quality credit spreads are also historically tight, and investors are not being compensated nearly as much as they used to for taking the extra risk. So, in this low-reward, high-uncertainty environment, we want to be more defensive. We are skewing higher in quality than we typically do, looking for credits that have less cyclicality and less exposure to tariffs and trade policy. Then we’re looking for credits that we would call lower beta, which means that historically, when spreads widen out, they tend to widen out less than the market. We think this defensiveness and discipline will help to protect capital while giving us greater flexibility to take advantage of the opportunities as the market eventually adjusts.
Beyond credit risk, are there other risks that investors might be overlooking?
Beyond credit risk, one of the most underappreciated risks is the potential breakdown of the relationship between the different tenors on the yield curve. For decades, there’s been a fairly consistent pattern between the Fed Funds rate and yields across different maturities. Investors typically earn more yield as they take on longer duration, relative to the Fed Funds rate. Going forward, we may see that those term premia start to rise more than anything based on the fiscal trajectory of the U.S. Rising deficits and long-term entitlement obligations, combined with a lack of political will to address them, will have a much greater impact on the movement of longer rates than Fed policy.
This matters not just for fixed income investors, but all asset classes, because longer rates are generally more important to the real economy. They are what drive mortgage rates. They will impact equity price valuations. But specific to fixed income investors, relying on historical curve behavior to anticipate rate movements may no longer be as reliable in a world where fiscal concerns hold more weight.
Investors continue to sit on high levels of cash. Is there a case to be made to move into fixed income right now?
Cash yields right now are around 4.25% and the yields on high-quality intermediate fixed income are at or above that level. Why would you take extra risk to earn the same yield? Well, if you look at the past six months, rates did come down, and intermediate bonds saw price appreciation. It’s more and more likely that the Fed continues easing, so cash rates will be coming down, while you can lock in a similar or better rate further out the yield curve. If you try to wait until the cash yields come down, there’s a good chance that yields will have also come down on an intermediate portfolio, and you will have missed the opportunity for price performance. The only situation where you start to lose is that the yields on intermediate bonds go up significantly, which we view as a much lower probability scenario.