First Quarter 2022

With the outbreak of war in Ukraine, the need to mind the tails has become front and center.  Financial markets have digested the primary shocks that have given way to a broad set of secondary considerations that are not as inconceivable as they seemed prior to the invasion.

Responses to these implications will not be solved in the near term, rather they will absorb the attention of decision makers across entities as they reshape strategic plans to reflect heightened geopolitical risks.  This is on top of ongoing planning around inflation spikes and tighter financial conditions as the Federal Reserve takes strong actions to re-establish price stability.  And while improved, the pandemic is not over, which continues to cause periodic disruptions across communities creating multiple pain points.

The U.S. economy remains strong with some cautionary signs appearing around the forward look.  The resilience of the U.S. consumer is possibly waning as sentiment falls.  Tight labor markets have boosted wages, but pressures exist from price spikes across a range of necessities.  Personal savings built up over the past two years are back to pre-pandemic levels suggesting less insulation for spending from any future shocks, including higher interest rates.  The shape of the yield curve reflects some of this concern with the spread between 10-year and 2-year U.S. Treasury yields approaching zero.

Implied volatility for interest rates has touched the highest levels experienced during this expansion.  We expect volatility across markets to remain high as participants discount uncertainty, high inflation, and the implications for slowing growth.  The Fed reaction function has become more data dependent, and this increases uncertainty.  Market liquidity is also likely to decline as the Fed reduces its balance sheet.  While these conditions are challenging, they do create opportunities for active managers to add alpha through both sector allocation and security selection.

Businesses are entering this phase of the cycle with strong fundamentals.  With recent spread widening, we have started to see more opportunities appear in credit.  We expect the next couple of quarters to exhibit continued volatility, with a bias toward wider levels.  We will use market technicals such as new issue concessions to add bonds.  As valuations cheapen, we will lean into credit at more attractive levels.  Nimbleness, discipline, and strategy are key to effectively manage risk and opportunity in the face of the many challenges that need to be navigated.

We have maintained an underweight to Mortgages in anticipation of fading Fed demand.  Increased rate volatility also has negative implications for MBS spreads.  While spreads have cheapened, we expected some further widening.  As concerns are reflected in market pricing, we will look for windows to reduce the underweight, but we are at early stages.

The Fed’s resolve to tighten policy above their long-term Fed Funds target has repriced market rates higher.  As a result, we have updated our trading range for the 10-year U.S. Treasury yield to 1.25% – 2.75%.


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Information presented is for informational purposes only. It is not intended as investment advice nor an opinion or a recommendation as to the appropriateness of investing in any particular security, asset class, strategy, or product. Nothing in this publication is intended to be relied upon as a forecast or research; legal, tax, securities, or investment advice. Nothing in this publication is a solicitation of any type.

This commentary contains Pugh Capital’s opinions based on the information available at the time of the analysis. Opinions, outlook, and strategies are subject to change without notice. Statements concerning financial market trends are based on information available and current market conditions which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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Source: Pugh Capital, Bloomberg, and Bloomberg Indices.

As of March 31, 2022.