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 June 30, 2022. Source: Pugh Capital, Bloomberg, and Bloomberg 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.

DISCLOSURE

Past performance is not a guarantee or a reliable indicator of future results. Investing involves risk; principal loss is possible. Investors should carefully consider risk when investing in bonds, which include, but are not limited to, default, credit rating, interest rate, duration, prepayment, liquidity, and structural risks. There is no guarantee that investment strategies presented will work under all market conditions. Risk management processes cannot eliminate the risk of losses. Diversification does not assure a profit nor protect against loss in a declining market. Each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Refer to the Legal & Disclosures section for additional disclaimers and disclosures regarding performance, risk, and investment process.

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. Investors should evaluate their own risk tolerance and ability to invest for the long-term, especially during periods of downturn in the market. 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.

This report is intended for U.S. institutional investors only. No part of this material may be modified, distributed or duplicated without the explicit permission of Pugh Capital Management.

Source: Pugh Capital, Bloomberg, and Bloomberg Indices.

As of .