Third Quarter Total Return Outlook

By: Eddy Vataru, John Sheehan, and Daniel Oh

The economy has held up remarkably well despite the Fed’s tightening program, but with two more hikes likely in 2023, the risk of a slowdown remains elevated.

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After a strong first quarter, the investment grade bond market treaded water in the second quarter. Treasury yields rose as there was some contagion following the bank failures in the first quarter as well as weakness in commercial real estate. This could become a problem for smaller regional banks, who also suffered most in the first quarter, as they tend to have relatively large exposures to commercial real estate. As they say, more news at 11.

The Federal Reserve continues down its path of steadying the ship in a sea of volatility that it largely created for itself. So far, so good – in recent weeks risk appetite has improved (outside of commercial real estate), lending to a narrative that any slowdown the economy may face will be relatively mild – if it happens at all. Corporate spreads ended June near their tightest levels of the year, with enviable equity performance to match. Mortgage-backed securities (MBS) have also improved as volatility has declined, though they remain vulnerable to a rise in rates as evidenced in May, when nominal spreads reached their widest levels in over a decade.

Against this backdrop, the Fed says it expects to raise rates at each of its next two meetings (for a total of 50 basis points). Recent -data substantiate the resilience of the economy against the 500-basis-point increase in rates over the past 18 months. For every weak manufacturing survey that is published, we find evidence of a relatively robust job market, remarkable strength in the housing market (despite lack of affordability), and diminishing inflation expectations that are contributing to a rise in consumer confidence.

On the topic of inflation, headline inflation is falling – but not fast enough for the Fed’s liking. Our favored inflation measure, the Underlying Inflation Gauge, continues to decline precipitously toward 3%, and it appears on pace to reach 2% by the fall. The real question, at this point, is whether the explosive growth in M2 money supply during the pandemic (the “printing money days”) contributes to a higher forward inflation path that will be more difficult for the Fed to combat. Time will tell.

Looking forward, we remain relatively constructive on duration as yield levels remain compelling for a longer-term investment. We continue to favor MBS over investment grade corporates at the former’s relatively wide spread levels. While the economy feels strong here and now, it has not proven to be able to withstand this level of the fed funds target rate in this century.

We appreciate your continued confidence in our management and will continue to focus on the areas of the market that we believe can deliver attractive risk-adjusted returns over time.

Originally Posted July 14, 2023 – Third Quarter Total Return Outlook

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