MARKET OUTLOOK / STRATEGY
Second Quarter 2022
At a recent client conference, the theme was Driving Forward. This approach could also apply to the Fed’s quantitative tightening strategy as they have shifted into high gear to curtail elevated inflation, even while economic growth is slowing. The impact of supply chain disruptions from the pandemic and Russia’s invasion of Ukraine have translated to broader and prolonged price increases that created traction for a more sizeable hiking cycle.
The economy and markets are in a period of high uncertainty as the road ahead to combat elevated inflation is one that has not been traveled in many decades. The Fed’s focus has tilted towards its price stability mandate, necessitating a temporary overshadowing of its goal of full employment. While expectations for a recession to occur are gaining ground, a “soft landing” is still the scenario most likely being discounted. With the Fed’s intentions to tighten policy aggressively, Pugh Capital’s view is that the economy will more likely be driven to a “hard landing”.
The significant move higher in interest rates has repriced long Treasury rates to levels that we view as attractive. Both income and yield levels are at decade level highs and we consider them to be appealing based upon their absolute levels and better risk profiles. Given the prevalence of low coupon bonds that have been issued across all fixed income sectors, the existence of a meaningful percentage of securities trading at large price discounts is unique to this cycle. Their expected price profiles relative to future interest rate increases have improved. Nonetheless, rate volatility remains high and inflation will likely need to fade to bring stability to the rates market. We favor a neutral duration position.
The mortgage market has changed quite significantly over the past six months as mortgage rates have followed the upward march of other rates and currently sit above six percent. Refinancing has generally become uneconomical for most borrowers. Most MBS are also trading at a discount price with the Index convexity at a level never seen before. With the recalibration of rate risk and overall rate volatility, nominal MBS spreads have widened to attractive levels. As a result, we plan to increase our allocation to the mortgage sector and move toward neutral positioning. This would be a major shift from last year.
In the initial phase of Fed tightening, corporate credit repriced in an orderly fashion. In this next phase, there could be more differentiation as markets begin to assign a higher probability to the risk of slow growth. Our outlook leads us to expect more widening in Corporate spreads as we expect them to continue to reflect late cycle conditions. However, given the selloff in interest rates, Corporate bonds are also trading at significant discounts and absolute yields have reached levels that make the forward return profile attractive. We look to leg into a higher credit allocation in the coming period.
Our strategy given our outlook is to favor mid to high quality issuers that can withstand more stressful conditions. Security selection will be important as credit has entered the late cycle phase and liquidity is being withdrawn. We favor A to BBB+ issuers that are deleveraging and will look to take advantage of new issue concessions when available, as well as deep discount prices through secondary market purchases.
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 June 30, 2022.