Third Quarter 2022

Tradeoffs underlie almost every decision we make in life.  Some are, quite frankly, not that consequential. Others have broader, lasting implications and the Fed’s drive towards restrictive financial conditions is having dramatic repercussions in the U.S. economy and financial markets.  The Fed faces one of the most complex set of decisions it has had to consider for some time.  Rapidly tightening policy is expected to stabilize inflation with the tradeoffs including less demand for goods, services, workers, and lower liquidity.  The Fed understands the potential implications and its decision to persist reflects a desire to prevent a worse outcome, based on what they know now.  Other central banks grapple with similar challenges.  There are no simple, painless approaches.

As markets digest the expected path of monetary tightening, a greater chance of a “hard landing” in the U.S. is beginning to be priced in across securities.  Uncertainty remains elevated and volatility in rates markets reflect this by persistently trading at elevated levels.  A new risk of financial instability has been introduced into the monetary policy equation with England providing insights into how the risks of rapidly rising rates can translate to problems, for leveraged entities and those with significant debt outstanding.

At Pugh Capital we are closely monitoring the markets, valuations, and fundamentals as conditions are evolving rapidly.  We are refining our strategy and framework to prepare for opportunities that are being created as both rates and fixed income sectors reprice to much more attractive levels.  The volatility has ramped up heading into the fourth quarter.  When valuations become extremely cheap, they don’t tend to linger in the market for an extended period.  For a sense of the opportunity set at the broadest level, consider that the current yield for the Bloomberg Aggregate Index is the highest it has been since the Great Financial Crisis.

When we look across sectors, investment grade corporate spreads have widened out and consistent with our outlook, we expect that trend to continue.  We are monitoring corporate valuations for an entry point to increase our allocation.  With a higher expectation for recession and some disorder given recent events, while yields are attractive, we will be exercising patience and vigilance to initiate our next allocation.  We favor higher quality for now but as a downturn becomes priced in more, we would expect to broaden our scope.

Mortgage returns have suffered from extreme rate volatility and an overhang from the potential effect of mortgage sales from the Fed’s balance sheet.  These risks provide an offset to the attractive convexity profile of the Mortgage Index and nominal spreads.  We have moved our mortgage position to neutral and would consider moving to an overweight as some of the clouds start to clear for the sector or if there is a further widening in spreads.

Interest rates have moved up to levels that we view as attractive.  However, with inflation at challenging levels and the Fed looking for proof that it is tamed, we expect high volatility over the near term.  Short rates are likely to remain under pressure and some additional curve inversion is likely.  We are targeting a relatively neutral duration position.


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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 September 30, 2022.