Fourth Quarter 2019

As we enter a new decade, the economy is late cycle and there are many challenges that bias growth toward a continued slowdown as the primary trend. The current recovery has troubling developments that have been building over many decades. They include demographic trends and growing economic disparity. The U.S. is experiencing an increasing aging population combined with declining birth rates. Meanwhile, our knowledge-based economy and equity-based compensation have intensified rising inequality. These trends reduce the effectiveness of monetary policy and shift the risks toward slower growth. Potential GDP estimates are 1.6-2.0%.

Monetary and fiscal policies enacted in response to the Great Financial Crisis have provided significant stimulus to spur growth. Even with all of this support, core PCE inflation has remained below the Fed target of 2.0% and GDP has averaged just 1.8% over the past decade. The Fed shifted to a more neutral stance, after 3 cuts in 2019. The trend of the economy is slower, but the Fed and fiscal leaders will continue to lean in to offset weakness. Supportive monetary policy is an important technical for spread sectors and interest rates. However, it also is creating a misallocation of resources.

There are a number of idiosyncratic events which are on the horizon that increase the likelihood of volatility for rates and corporate securities. These include the U.S. elections and a multitude of geopolitical risks. Credit spreads and the stock market appear to discount these risks as having a low likelihood of occurring. It is possible that the economy proceeds at a measured, albeit slow pace and that the uncertainties that plague the economy remain just beyond the horizon. Our base case for 2020 is that growth stabilizes below 2%.

Our strategy is to be neutral Credit in recognition of the cross currents of attractive technicals, mixed fundamentals, and rich valuations. Credit spreads are tight, but are supported by U.S. yields being attractive relative to global counterparts, and an expectation of less supply. However, the modest yield advantage versus Treasuries provides limited protection against spread widening. In our view, market volatility is too low for the current late cycle credit environment.

We will look to use curve positioning, security selection, and industry weights to manage risks and provide yield. Security selection will play a key role as late-cycle conditions cause greater issuer performance dispersion. We remain concerned about tail risks and uphold a defensive bias to Credit. As issuance is expected to be a technical positive this year while market liquidity remains challenged, the primary market may provide opportunities to tactically add bonds of issuers that exhibit a stable to improving profile. Also, the risk/reward profile is becoming more attractive for some BBB-rated bonds as these issuers have become focused on improving their balance sheet profile and investment grade ratings. Lastly, we continue to view Financials positively as event risk in this sector is low.

The battle between a slow growing economy faced with a myriad of challenges and high idiosyncratic risks, offset by easy monetary policy will cause interest rate volatility in 2020. We expect these differences to translate to a 10-year U.S. Treasury trading range of 1.25-2.25% in 2020. Our longer-term bias for rates is lower, but the path will not be one directional and may take a while to play out. Please give us a call if you would like to discuss.

Disclosure – As of December 31, 2020. Source: Pugh Capital, Bloomberg, and Bloomberg Barclays 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.