Focus on Carry and Selection Opportunities

The U.S. economy continues to display remarkable resilience, emerging from the period of peak policy rates with strong growth momentum. We expect this trend to continue, as gradual monetary policy easing should leave financial conditions supportive of growth. In addition, with the labor market stabilizing, real wage growth should support robust household spending, especially given gains in overall household net worth. Importantly, recent revisions to national output and employment figures suggest that productivity growth has been stronger than previously thought. In this event, firms may have greater flexibility to manage higher labor costs while preserving margins.

The economy’s sustained momentum has recently brought about a shift in investor perceptions of the balance of risks to the outlook, with previous concerns over recession giving way to higher risks of reflation.  While we have been at odds with the market’s focus on recession risks, a sustained pickup in growth and inflation also strikes us as unlikely. Importantly, we attribute some of the strength in the economy to higher potential growth, given increases in labor supply as well as the aforementioned evidence of higher productivity growth. These developments have allowed for solid economic performance without renewed tightening in the labor market or a resumption of inflationary pressure.  In addition, the ratio of job vacancies to the unemployed is at a level that historically has been associated with low and stable inflation. Absent a renewed surge in job openings, the better balance evident in this and other labor market indicators suggests that inflation should continue to moderate.

Figure 1: Labor Market Balance and Cyclical Inflation

Source: Bureau of Labor Statistics, Federal Reserve Bank of San Francisco, MacKay Shields. Core cyclical inflation includes those core PCE categories that have historically responded to the level of slack in the economy.

As we analyze the current fixed income landscape, we anticipate that markets will remain sensitive to upside risks to the outlook and the Federal Reserve’s reaction function.  Therefore, several key themes emerge as we position portfolios into the fourth quarter:

Ride the Carry

The Federal Reserve's decision to lower interest rates signals a proactive approach to stimulate economic growth amid evolving economic conditions. Lower rates typically lead to reduced borrowing costs, encouraging consumer spending and investment. This environment can enhance demand for fixed income securities, particularly as investors seek to lock in yield.

Moderating Inflation Is a Boon to Fixed Income

With inflationary pressures easing, the fixed income market has seen a shift in investor sentiment with risk appetites reinvigorated by loosening monetary policy.  Investors may favor longer-duration bonds, anticipating that lower rates will persist, which could lead to price appreciation in those segments. However, it remains crucial to monitor inflation trends closely, as any resurgence could prompt the Fed to reconsider its stance.

A Healthy Labor Market Supports Credit Fundamentals

A robust labor market supports consumer confidence and spending, underpinning economic stability. This dynamic typically bodes well for fixed income securities, as steady employment can lead to improved credit conditions and lower default risks.  One caveat is that if wage growth accelerates significantly, it could reignite inflation concerns, impacting bond yields.

Figure 2: Investment Grade Fundamentals

Data as of June 30, 2024
Source: JP Morgan

Credit fundamentals should continue to provide solid support, resulting in range-bound credit spreads from current levels.  Leverage metrics remain contained, and while interest coverage has been declining for many issuers (due mainly to higher rates), the easing cycle should reverse this trend. Investors can still look to take advantage of attractive all-in yields.  However, an area of focus for us is the consumer cyclicals sector, particularly the auto industry, where slowing demand and weaker financial conditions among lower-income consumers have put pressure on the sector's performance. 

Figure 3: High Yield Fundamentals Remain Supportive

Data as of September 30, 2024
Source: BofA Securities.

Valuations Should Temper Generic Beta Trades, So Emphasize Selection

Despite the favorable macroeconomic backdrop, stretched valuations across many fixed income sectors warrant caution. Yields have compressed significantly, but many bonds are still trading at a discount.  Investors should be wary of potential risks in stretching for yield, so security selection and credit quality will be crucial in navigating this environment.  We also believe Treasuries are overbought so investors should be cautious about extending duration.  The yield curve is likely to continue to steepen with a 4% rate on the 10-year as the fulcrum point.

Conclusion

The fixed income outlook following the Fed rate cut presents a mixed picture.  While lower rates, moderating inflation, and a healthy labor market create a supportive backdrop for fixed income, current valuations require a selective approach.  In our view, investors should consider diversifying their portfolios, focusing on solid structures, higher quality, and durable cash flows.  Delve into niche sub-sectors to identify compelling income generation opportunities and total return potential.  At the same time, remain vigilant regarding macroeconomic indicators that could influence future rate decisions. Balancing the pursuit of yield with an awareness of valuation risks will be essential in navigating this evolving landscape.

Our multi-sector investment approach is predicated on four critical principles that we believe will serve investors well heading into the end of the year:

• Exploit the whole credit toolkit and avoid over-reliance on any one sector
• Focus on misunderstood and underappreciated sectors
• Take advantage of generalized sell-offs to identify strong names in weak sectors
• Recognize the value in complexity and lean into research as an edge