Second Quarter 2019

The economic recovery just celebrated its 10th birthday, making it the longest economic expansion on record. As tempting as it may be to bring out the party balloons and cake, there is cause to worry. We are seeing a shift away from globalization. Geopolitical risks are elevated and concerns about policy missteps are also rising. Meanwhile, incoming data points to a growth slowdown, both domestically and abroad. As we move deeper into the later stages of the expansion, idiosyncratic risks increase and “risk assets” will become more susceptible to shocks generated from the markets themselves or from policy mistakes.

GDP growth estimates are being revised lower. Forecasts for the last three quarters of 2019 are around 2%, consistent with potential GDP. We would expect GDP to surprise to the downside as the year unfolds and anticipate a slow migration to weaker forecasts. Given slowing growth, inflation missing the Fed’s mandate, rising geopolitical risks, and signaling from inverted yield curves, the market has shifted to pricing in cuts in the Federal Funds Rate starting in July. Additional cuts are expected at subsequent meetings.

There is significant divergence between the messaging of risk assets and the U.S. Treasury market. The 10-year U.S. Treasury rate has declined by about 70 bps since December, while credit spreads have tightened and the stock market is near record highs. This divergence can be validated if the Fed orchestrates a soft landing, thus supporting the economy and thereby risk assets. But it also illustrates that neither tail risks nor a recession are priced into credit assets, even while late-cycle signals abound and geopolitical risks are elevated.

Given that the election cycle is gearing up, there is tremendous pressure from the White House on the Fed to lower rates. Navigating monetary policy with a measured approach is an important responsibility and the Fed will need to use all available tools to achieve their dual mandates. This should be supportive for risk assets.

We have shifted to a tactically neutral position for the Corporate sector. We remain concerned about tail risks and continue to maintain a defensive underlying tilt to credit. Our expectation is that the current environment will present plenty of risks as well as opportunities for active managers. Longer term, we do anticipate that a recessionary scenario is on the horizon. Bottom-up security selection will continue to help differentiate performance in this late cycle environment.

Agency MBS spreads have widened sharply in the face of higher volatility and lower rates. As a result MBS option-adjusted spreads are near their five-year wides, and represent an opportune time to scale into a modest overweight to mortgages. CMBS and ABS spreads are relatively tight, but we believe these sectors will outperform Treasuries. As a result, we remain overweight in those sectors as well. Our projected trading range for the 10-year U.S. Treasury is 1.70% to 2.30% for the balance of 2019. The portfolio is presently positioned with a modestly longer duration than the Index. We also foresee modest curve steepening with short rates outperforming on a yield basis.

Disclosure – As of June 30, 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.