"To know ahead of time what you're looking for means you're then only photographing your own preconceptions, which is very limiting, and often false."
Dorothea Lange
As we enter a profoundly uncertain investing environment, we find this quote from one of the most influential photographers of the 20th century to be incredibly apt in describing the opportunities in markets today. We see numerous uncertainties blurring the forward picture, with few analogies from history to wipe down the lens. As such, we find it most constructive to focus on the knowns in the equation and take advantage of the convexity of opportunities around the unknowns.
The most glaring uncertainties today, which contributed to early August seeing some of the largest market moves in the last several years, are the risks associated with the Federal Reserve’s dual mandate. Specifically, despite the inflation side of the mandate dominating the attention of policy makers for the last three years, there has recently been an increase in the perceived risk of a labor market deterioration. Fortunately, we believe this comes at a time that inflation, including the sticky services and shelter components, has moderated to a very healthy run-rate. Most measures are back around their average run rates of the five years prior to the pandemic; hence, we believe the Fed can draw confidence on this front.
However, the other side of the dual mandate is now demanding more attention. In fact, the July jobs report saw the largest downside surprise in monthly payrolls added in over two years, a jump in the unemployment rate (officially reaching a 0.5% increase since the trough), and more negative revisions to previous payrolls. Incredibly, 778,000 jobs have been ‘revised away’ since February 2022! The labor market showed unambiguous signs of slowing in July’s data; the good news here is that while, yes, unemployment is up half a percentage point from the lows, a large portion of this increase can be explained by new entrants coming into the labor force, rather than a pernicious increase in job losses. It’s also important to remember that the cycle low in the unemployment rate was the lowest it had been in more than five decades. Though we have breached the Sahm rule threshold, Claudia Sahm herself has pointed out that the idiosyncrasies around this cycle are creating larger swings in the unemployment rate than usual.
So, while the recent jobs data was weak, we maintain that the labor market remains in a state of moderation – not panic – and the economy in aggregate remains healthy. We do believe that a Fed Funds rate of 5-3/8 % is too high for the current environment, so we expect the Fed will start to moderate the policy rate lower in recognition of inflation data that is very healthy and a labor market that is balanced with some risks to the downside (especially at such an excessively tight policy rate).
Another large source of uncertainty is the U.S. election and its implications for the fiscal spending, regulation and geopolitical situations. Further, if and how tariffs will be implemented, the future tax regime, and trade policy with both allies and adversaries will remain largely unknown for the rest of the year. In more ways than one, the path for the deficit is akin to short-sightedness. What’s clear to see is that regardless of who holds office in January, neither party has any intention to address the ballooning deficit. In fact, the last two administrations were the first in history to engage in pro-cyclical fiscal policy. Government spending will continue to be a ballast for growth for the foreseeable future.
Though, similar to short-sightedness, the longer-term picture for the Treasury curve is still blurry. The Fed owns nearly a third of all Treasury issuance 10 years and longer, which combined with a strong proclivity for shorter dated Treasury funding, means that back-end yields have stayed contained despite this higher spending. While this may continue for the foreseeable future, increasing supply associated with higher government spending will continue to be a risk for the back-end – especially from these levels. This myopia, coupled with stubbornly positive correlations between stocks and bonds, means we maintain our preference for holding duration in the front-to-belly of the curve.
While we lack specifics around fiscal spending, what we do know is that the economy today continues to make progress in its post-pandemic normalization in a very healthy way. Consumption and investment continue to be healthily buoyed by two drivers we’ve talked about at length in previous months, the high-income cohorts and the artificial intelligence (AI) theme. The older and wealthier cohorts have little, if any, floating rate debt. They’ve also benefitted from an explosion in the value of their liquid assets and the rates earned on their cash. This culminates in a dynamic where the wealthier cohorts, who drive consumption, are benefitting while the less wealthy feel the textbook restrictive aspects of higher rates. This unorthodox feature of the modern U.S. economy means the Fed needs to give greater consideration to where the burden of rates is felt, even if the aggregate numbers show unrelenting growth. We believe it is time to bring the “too restrictive on some” rates down.
Likewise, investment hasn’t experienced the slowdown predicted by traditional economic thought. This is almost entirely because of the opportunity and urgency around artificial intelligence. In the last 30 years, every time small caps (as a proxy for the broader economy) were down, the Fed was easing policy - until 2023, when the AI theme overpowered all other considerations. We would go as far as to say that the exuberance around AI that we witnessed through July delayed the Fed from cutting rates earlier. Few people in 2022 could have predicted the equity market performance and headline growth figures we’ve gotten in this hiking cycle, and the boom in AI is almost exclusively why. For the last two years, holding a handful of tech stocks and cash has been a blockbuster trade. Now, with a pivoting Fed and the era of rapid price rises likely behind us in AI, this may need to evolve.
Let’s Get Real
In fixed income, the current level of real yields in the front-to-belly, while somewhat diminished in recent days, continues to be attractive. Rates in this part of the curve lagged inflation for most of the past 15 years, today it’s possible to get a higher real yield in the front of the curve than the long bond averaged in the last decade, with significantly less price volatility. On the eve of a cutting cycle, the opportunity to lock in these yields continues to be compelling. The picture in Investment Grade credit is similar. Fundamentals are very healthy; the top 100 U.S. issuers have both meaningfully higher cash flows and 0.5-1.0x lower leverage than in 2010. Though yields are certainly attractive, valuations look somewhat rich in the U.S., with material risk of widening when the Fed begins moving. We prefer to lend in Europe, where the FX-hedged yield of investment grade bonds rivals that of High Yield in the 2010s. Having navigated through the bulk of the fog around their elections, volatility across European assets has dropped commensurately. And still elevated spreads of European credit relative to the U.S. make us more comfortable with valuations here.
In High Yield (HY), fundamentals have also improved, but with a great deal of dispersion under the surface, selectivity in this market is key. There are also durable technical tailwinds. The amount of HY debt outstanding compared to M2 money supply has been shrinking for the past decade, and demand for yield is robust. We’ve seen defaults trending higher, but still below long-term averages, meaning being selective here is more important now than ever. Companies will have to balance a Fed that is easing (but to a level that is just “less restrictive”) with potentially slowing growth. We should see rising defaults, particularly in the very low-quality space, and higher financing costs. The index trading at a 300 basis points (bps) spread conceals the fact that the majority of the underlying bonds trade tighter than 200 bps! Just owning the index means underwriting the long tail of constituents trading wider than 500 bps. Targeting where we get HY exposure matters a lot these days.
There are similar amounts of dispersion across emerging markets (EM) macro regimes currently. Real rates are very high in some quality issuers here, but the blurriness on U.S. foreign policy and trade is amplified when it comes to how it will affect emerging markets. It still makes sense to have selective exposure, but mostly in conservative sizes until we have more clarity.
Forwards are pricing in a significant cutting cycle through the end of next year, and credit spreads, despite coming off a bit, are still relatively tight; yet, implied rate volatility remains very high (and even higher as of late!). We like selling rate vol and the setup in mortgages as convex opportunities around this dynamic. With abating balance sheet run-off, very little prepayment or refinancing incentive, and elevated implied vol, the picture in mortgage-backed securities (MBS) is the clearest it’s been in a long time. We believe there is no rush to take positions that are very large here, until the buyer base broadens, and like tactically adding on widening.
Finally, the price action of late has laid bare the blurriness of the short-term picture for equities. While more portfolio balance makes some sense, we do not think this theme should be overdone. It’s worth noting that 41% of Russell 2000 companies reported negative earnings in the trailing 12 months. Investors have been trained to jump from A-to-C (cutting cycle = buy small caps), but this neglects that the Fed will only be moving to a “less-restrictive” stance. The constraints on margins and moats will continue to be a challenge for small caps versus large caps. We don’t see a case for a durable small cap rotation, other than some technical crowding unwind, which could take time. That said, we do like pockets of opportunity in small caps where cash flow generation is well-supported.
Meanwhile, the blowoff in tech has captured significant attention. With the return-on-equity (ROE) of the S&P 500 near 30-year highs, and research and development (R&D) continuing to drive margin expansion, the fundamental picture for large caps is still very sound. However, crowding has caused a whiplash reversal recently. This has presented some renewed opportunity but, given the uncertainties abound, we are also reminded that, in a slowing growth environment and during seasonally challenged periods, it can make sense to keep a lower risk profile.
So, while several risks are blurring our lens, a good clean and the right parts can build an efficient and convex portfolio that takes advantage of a still-attractive global opportunity set. Many of the themes we’ve been espousing have been working, and we see little need to adjust them. Yet, it’s worth having a bit more equity portfolio diversity from here in sectors with decent profitability. With efficient portfolio balance alongside equities, there is still a golden opportunity to build a diversified and dynamic fixed income portfolio and tactically managed duration.
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