Market Insights

MARKET OUTLOOK / STRATEGY

Third Quarter 2024

As the seasons shift from Summer to Fall, we experience less daylight, the introduction of autumn colors and lower temperatures. Similarly, our outlook has evolved, and we expect a modest downshift to growth and a change of Fed regime as we turn our attention to upcoming elections. While the seasons are different, there is much to value in this soft-landing scenario.

We expect economic growth to moderate to its noninflationary trend projections of 1.5 – 2.0%. While this is a stepdown from faster paced growth, it represents a more sustainable level that is positive for risk assets. Even as risks to a recession have risen, we assign a low probability over the near term. Our growth scenario anchors on resilient consumption fueled by high levels of wealth and low debt burdens among upper-middle-income and wealthy households. Despite some softening, the labor market is expected to remain healthy. Furthermore, as market interest rates start to reflect the expected lowering of the Fed’s policy rate over the coming quarters, lower-income families, small and mid-sized businesses and those with weaker financial profiles should benefit from a reduction in borrowing costs.

The Fed and investors’ focus has shifted from worrying about high inflation to concern about a weakening labor market. Labor market dynamics are being driven by supply factors tied to high levels of immigration, and while the demand picture has softened it but remains constructive. Further expected monetary easing in the coming quarters should support economic growth.

Once the Fed embarks on a path of rate cuts, the yield curve typically shifts to a steepening path, driven by a decline in shorter maturities tied to the lower trajectory for the Fed’s policy rate. Longer tenor rates, however, face cross currents driven by uncertainties such as the outcome of U.S elections, fiscal spending policies, and the implications on the forward path of monetary policy. Our current 12-month trading range for the U.S. 10-year Treasury yield is 3.0% – 4.25%. We plan to maintain duration positioning generally in line with the Index but with a bias to curve steepening.

For investment grade issuers, corporate fundamentals are expected to remain constructive, and balance sheets are relatively healthy. With lower interest rates, we could see an uptick in issuance especially to fund further M&A activity and other shareholder friendly initiatives. We maintain a modest overweight to credit, favoring select BBB-rated companies with stable to improving profiles, acknowledging an increase in idiosyncratic risk. Corporate valuations are rich, therefore, carry and security selection are expected to be the main levers for generating alpha. We believe the current economic environment, along with a more accommodative Fed is supportive of credit. However, we are well positioned to add risk in the event of heightened volatility.

We have a modest overweight to the MBS sector as valuations are reasonable. Security selection can also be additive through analysis and investing in coupons that can perform well in our expected rate scenarios. A headwind for the MBS sector continues to soft demand from the banking sector and the Fed. ABS continues to be a sector we favor with a strong overweight. Along with the ability to add value through structure analysis and security selection, significant issuance allows us to source and build decent positions and is a low-risk way to add incremental alpha. Our approach to non-agency CMBS remains opportunistic and selective, as the office space adds headline and valuation risks.