MARKET OUTLOOK / STRATEGY
Second Quarter 2021
Investor lore says to be wary of the period between July 4th and Labor Day when volatility rises and liquidity declines as vacation plans are put into action. While the existence of the summer doldrums phenomenon is debatable, it is clear that competing market forces are heating up, along with temperatures. This summer could be anything but cool, calm, and collected.
The inflation and employment outlooks are front and center for the Fed as it contemplates the eventual tightening of policy. While there has been progress in their employment mandate, job demand remains challenged by safety concerns around COVID-19, childcare considerations, and attractive unemployment benefits which are set to expire in September. Recent price gains in shelter, commodities, and consumer goods have pushed inflation higher. Eventually, we expect that technology, innovation, and excess slack in the economy will keep inflation in check. Without the benefit of aggressive monetary policy, the U.S. economy would be challenged to maintain its momentum amidst high government deficits, relatively high debt leverage, labor imbalances, and other secular deflationary trends.
While the economic recovery is still mid-cycle, we wonder if risk assets have gotten too far ahead and are priced to late-cycle perfection. Second quarter GDP will likely represent the high point in growth, and it should moderate going forward absent the passage of additional meaningful fiscal stimulus. Although economic data points to continuing above trend growth and optimism remains high, risks are rising due to very elevated credit valuations and the possibility of a monetary policy misstep. This quarter all eyes will be on the Jackson Hole economic symposium, upcoming economic data, and comments from Fed officials to get a better sense for both tapering and the timing of the first rate hike. We expect inflation to peak this year as well and fall closer towards the Fed’s long run target as base effects wane, productivity increases, and shorter-term supply constraints are resolved.
We maintain our trading range outlook for the 10-year U.S. Treasury at 1.15% to 2.15%. Rates are currently in a much tighter range of 1.40% to 1.75%. Surprises from economic or inflation data will likely be a breakout catalyst. Persistent monetary accommodation and pension demand for yield supports the case for lower rates. Conversely, stronger global growth, optimism, and inflation concerns could move rates higher. From here, the “pain-trade” is for lower rates as short positioning in the market is still elevated. Our strategy is to manage duration with a bias toward being neutral and to trade the range.
We maintain a modest overweight to Credit as a strategy to capture carry and income. We expect greater volatility in the rest of the year from monetary policy uncertainty, shareholder-friendly initiatives, and higher projected corporate issuance. Tight valuations provide limited protection from spread widening, creating a difficult environment to navigate. On the plus side, improving corporate fundamentals should stay positive for risk assets. Additionally, we believe BBB-rated Corporates will outperform A and AA-rated alternatives as event risk should be lower as these companies focus on balance sheet repair. We remain underweight MBS given the sensitivity to rate volatility, rich valuations, and sustained prepayment risk. We maintain overweight allocations to ABS and Non-Agency CMBS as high-quality yield enhancement strategies supported by the reopening economy and an improving jobs market.
Disclosure – As of September 30, 2021. 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.