First Quarter 2021

When you are learning to ski you may sail smoothly to the end of the first run safely.  Or the run may cause inner terror if you accelerate past your ability to manage the speed and you fall.  The U.S. is in unchartered territory with record fiscal and monetary stimulus fueling positive momentum across markets and the economy.  It is possible that growth booms while inflation remains in check giving the Fed room to gradually pare accommodation.  But there is increasing angst around policy makers losing control and the ability to offset any excesses that build.  The Fed’s inflation averaging approach and their strong stance on low rates will be increasingly at odds with robust growth expectations.  We expect heightened uncertainty.

Some of the unknowns continue to be tied to the path of the vaccine-driven reopening of the economy.  As COVID-related risks abate, we acknowledge that they are not yet insignificant.  The time required to recapture the jobs lost and return to full employment supports our expectation that the Fed will maintain accommodation through 2021.  When the Fed does tighten, their balance sheet policy will be an early area of adjustment.  We anticipate markets will continue to debate the need for tighter policy sooner, pushing rate volatility higher.

The passage of the $1.9 trillion American Rescue Plan and possible additional stimulus creates apprehension about the consequences.  We expect to see Treasury yields continue to rise over the near term as investors factor in elevated uncertainty and supply pressure.  With the Fed on hold, the yield curve should be anchored for shorter maturities, while longer rates are likely to move higher.  With building inflation expectations and elevated Treasury issuance, we have shifted our 10-year U.S. Treasury trading range higher to 1.15% – 2.15%.

The backdrop of strong economic growth, improving business fundamentals and natural deleveraging with increasing cash flow, should be supportive for the corporate sector.  Higher yields will begin to entice some investors off the sidelines and corporate supply will be down from prior year levels.  Some offset could come from the retail sector as the first quarter’s negative total returns may trigger selling pressure and a desire to reduce fixed income exposure.  On balance, we expect technicals to be a modestly positive influence.

Corporate spreads are trading at historically rich levels, which provide little room to absorb negative shocks.  This dynamic creates uncertainty around the most optimal asset allocation positioning.  We are embracing bottom-up opportunities to incrementally add carry.  We believe that defensive security selection remains the best orientation at these valuations with an emphasis on stable to improving high quality credit.  Our risk management at the sector level will rely on our ability to be nimble if concerns continue to rise.

Other sectors are also trading at tight spreads and security selection remains a key driver of returns.  MBS are beginning to offer select opportunities with higher rates and an expectation of slowing prepayments.  We are modestly reducing our underweight to the sector.  Non-agency CMBS offer relatively attractive risk-adjusted returns.  Agency CMBS and ABS continue to have sound fundamentals, but valuations are rich.  These sectors will be used for funding sources for other ideas.

Disclosure – As of December 31, 2021. Source: Pugh Capital, Bloomberg, and Bloomberg Indices. This market outlook and succeeding pages contains Pugh Capital’s opinions based on the information available at the time of the analysis. Opinions are subject to change without notice. Investors should evaluate their own risk tolerance, time horizon and other restrictions for their investment decisions. Statements concerning financial market trends are based on information available and current market conditions which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and investors should evaluate their ability to invest for the long-term, especially during periods of volatility in the market. Please do not redistribute. Refer to the Legal & Disclosures section for additional disclaimers, disclosures, forecast, outlook and other information.