Time, we believe, is on our side
Defensive positioning didn’t hurt the first half. In the second half, it may help.
Given their high quality—the average credit rating is AA—and elevated yields relative to the last 10 years, municipal bonds continue attract investors in a challenging environment. While the strength of economy surprised in the first half, it nonetheless is exhibiting signs of deterioration. While an eventual recession remains our base case, abetted by a Fed that appears committed to higher for longer, it would occur at time of strong credit conditions for most state and local governments. Many state and local entities are cash rich because of large federal Covid-relief transfers and strong tax revenues during the economic expansion. To be sure, some states are starting to see sequential declines in income tax revenues, while bank stress and declining office real estate values represent additional headwinds. These risks to date remain manageable, while low new issuance and solid demand has supported favorable, modestly positive municipal bond returns through the first half of 2023. — R.J. Gallo
From a big picture perspective, 2023’s first six months played out largely as we previewed at the start of the year. The thinking then was that even though the Fed should remain in play throughout this year, the bulk of market effects from one of the most dramatic tightening cycles in history already had been experienced. This led us to begin the year with a more constructive view on fixed income after being defensive throughout 2022’s historic bear market with its double-digit negative total returns. At the headline level, that call has been roughly on target, with the Bloomberg, S&P and other U.S. aggregate returns in the 2-2.50% range in the first half, when the 10-year Treasury yield slipped just 4 basis points to 3.84%. Nothing dramatic, and nothing like 2022, when the 10-year more than doubled, soaring 237 basis points to close at 3.88%.
Underneath the hood, however, it’s been a different story. Far from beginning to normalize as the end of the Fed’s tightening cycle grew closer, a yield curve that started the year inverted, inverted even further. In the credit space, where our sector committee was underweight investment-grade (IG) and high-yield (HY) corporate bonds on expectations of a slowing economy, spreads (the yield gap relative to comparable maturity Treasuries) narrowed, returning slightly more than 3% and 5%, respectively. The good news is both our rate and credit bets were relatively small. So, combined with solid performances in EM and mortgages—two sectors where we had above-benchmark exposure—along with strong security selection within IG and HY, our strategists “kept us in the game,’’ if you will, allowing the majority of our strategies to be competitive with their benchmarks through June.
Sticking with our bets on rates …
Where do we go from here? We’re sticking with our broader bets. On rates, with markets priced for continued labor market strength, sticky inflation and some additional Fed hikes, the larger risk to us is a potential asymmetrical move down on any material softening in the labor market or inflation data. History tells us when such moves come, they tend to come quick and violently. This view has us entering the second half modestly long duration (105% of neutral) in our models, with a small steepener in the 2-year/10-year and 5-year/30-year sections of the Treasury yield curve. The latter reflects the severe cheapening in 2-year and 5-year Treasury yields, which ended June at 4.90% and 4.15%, respectively, just off March’s cycle highs and in line with pre-global financial crisis levels. Hard to see either cheapening much further from current levels.
… and credit
The string of upside surprises in the economy made for what Federated Hermes Senior Portfolio Manager John Sidawi called a “consensus killer’’ first half. We aren’t expecting a repeat. The economic headwinds are growing and many. Higher costs of capital due to aggressive Fed tightening. Muted bank lending activity. Weakening commercial real estate markets. Fiscal spending restraints. Fading corporate profit growth. A consumer facing dwindling excess savings and the resumption of required federal student loan payments averaging nearly $400 a month. Recent ISM and PMI data suggest manufacturing is contracting, Conference Board leading indicators have been negative 14 straight months and June’s nonfarm payroll gains were the smallest since December 2020’s decline. With the economy and credit conditions likely to deteriorate, it’s hard to be constructive on IG and HY. We think EM will offer more opportunities before year-end, but took profits in late June, shifting from overweight to neutral. Wide spreads, low prepayment risks, attractive yields and rising flows are keeping agency MBS our biggest overweight.