Second Quarter 2023

Our last outlook discussed the scale and speed of policy decisions that led to rapid and sizeable market response.  Not all areas of economic activity reprice as quickly as capital markets do.  That creates friction as investors await confirmation from macro data of views which they have already expressed in portfolios.  But the reveal is slow.  And in that period, second guessing becomes rampant.  Currently that tension for us has been about an expected U.S. recession which, after re-examining inputs and assumptions, continues to be our base case.  If anything, the delay of the onset could make the downturn worse when it occurs.  What happens to a recession deferred?

The risk posed by the failure of a handful of banks faded during the quarter.  This has allowed the Fed to double down on hikes in its efforts to return inflation to a tolerable level.  The challenge from the Fed’s hawkish stance is the increased probability that policy causes additional cracks to appear and/or that higher for longer rates depress demand more severely than currently discounted.  While not our base case, we acknowledge this chance is greater.

Our thoughts on interest rates are grounded in a base case of inflation continuing to decelerate, the Fed is near the end of its tightening cycle, and that the U.S. economy moves into a mild recession.  In that scenario, we expect Treasury yields to move lower across the curve.  We would expect the curve to steepen if Fed cuts come back into play.  Conditions that would support steepening are more likely to be present in late 2023 or early 2024.  We expect 10-year Treasury yields to trade in a range of 3.00% – 4.00% over the next year.  At current rate levels, we view the income from fixed income investments as attractive.

Our expectations for performance of spread sectors remains favorable in the context of a severe downturn not occurring nor a credit event that triggers systemic risk such as the demise of Long Term Capital, Worldcom, or Lehman Brothers.  The long lead time to the slowdown has given business leaders better opportunities to get in front of margin compression by managing costs.  For investment grade borrowers who locked in long-term financing, there is the added cushion of being able to avoid refinancing into higher rates.  Corporate valuations are fair and likely rangebound, with the potential to reprice lower.

In the securitized space, we remain convicted that MBS offer a superior opportunity to deliver strong risk adjusted returns with the sector trading at attractive valuations.  Rate volatility remains elevated yet is trending down which we believe will turn from being a headwind for the sector to a meaningful tailwind.  Non-Agency CMBS are even more attractively valued but they have a challenging fundamental profile requiring a rigorous examination of underlying collateral.  We are selectively adding back exposure to non-Agency CMBS through new issues when spreads offer what we believe to be solid compensation for those risks.


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 or other securities, which include, but are not limited to, default, credit rating, interest rate, duration, prepayment, liquidity, and structural risks. Securities are also subject to general market risks due to factors that affect the overall market, which may include, but are not limited to, government actions, investor behavior, and economic conditions. Economic conditions may be influenced by liquidity risk, geopolitical risks, monetary and fiscal policy, interest rate risk, and inflation, among others. There is no guarantee that investment strategies presented will work under all market conditions. Risk management processes including diversification cannot eliminate the risk of losses nor assure the likelihood of a gain. Each investor should evaluate their ability to invest for the long-term, especially during periods of downturn or volatility 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. 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.

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Source: Pugh Capital, Bloomberg, and Bloomberg Indices.

As of June 30, 2023.