MARKET OUTLOOK / STRATEGY
Third Quarter 2021
Every cycle is different and as investors, part of our job is to identify what makes each cycle unique. Our goal is to position client portfolios to take advantage of our insights and to lean into opportunities when we feel there is reasonable compensation for the risks that we undertake. This cycle has been distinctive in several ways including the catastrophic health issues of the Pandemic, the massive government stimulation that uplifted the economy and markets, the supply chain bottlenecks, and the compressed nature of the cycle relative to historical norms.
We are on the verge of transitioning from the extraordinary support of monetary and fiscal policy into a new, less accommodative regime for this cycle. The Fed’s increased comfort with the substantial progress in achieving their dual mandates has pulled forward the timing of Fed liftoff. Chairman Powell has indicated that tapering plans will be communicated at the November meeting. Market expectations are that tapering will be completed by mid-2022, with gradual rate hikes following. This shift to less accommodative monetary policy will be combined with a significant decrease in fiscal spending as well.
Supply chain disruptions have pushed inflation higher and have gained momentum and breadth. The shortage of semiconductors is impacting several industries’ ability to manufacture their products. While there are a lot of employers looking to hire, the Pandemic has created return-to-work concerns around health, safety, and family contributing to labor shortages. Energy supply and demand imbalances are occurring during a period of elevated environmental concerns. We expect that these bottlenecks will resolve themselves, but the unique health concerns of this cycle, create challenges that permeate and linger throughout the economy. The transitory inflation view may take longer to play out, creating market angst.
The key challenge across fixed income sectors are rich valuations. We expect greater volatility as we move forward with a less accommodative Fed. In general, tight spreads don’t provide much protection for a normalization of trading levels. We maintain a modest overweight to Credit as a strategy to capture carry and income. Our overweight is tilted towards BBB-rated securities that we believe have less balance sheet leveraging event risk. On the plus side, attractive yields for foreign investors and cash on the sidelines provide positive technical support for risk assets. Supply bottlenecks may hit earnings for some industries, while possibly providing margin support for others, so security selection remains important in this environment of tight spreads.
We maintain an underweight to MBS reflecting an expectation of modest spread widening into the taper, but we have become less negative on the sector. Differentials between model and actual prepayments have narrowed, reducing a major risk for investors. We are overweight non-Agency CMBS where we currently find attractive relative value versus other sectors.
We expect the 10-year Treasury to trade in a range of 1.20% to 1.75% for the fourth quarter. Surprises from economic or inflation data can act as a catalyst for breaking out of the trading range, but we expect the cross currents to persist and to keep rates within this range. Our strategy is to manage duration with a bias toward being neutral and to trade the range.
Disclosure – As of December 31, 2021. 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.