Weekly Investment Commentary: Where to allocate as the Fed hesitates
Bottom line up top:
- Cause for pause: Economy grows, inflation slows. Equity and fixed income markets rallied in the wake of last week’s U.S. Federal Reserve decision to keep its benchmark fed funds rate unchanged for the second meeting in a row. The S&P 500 Index gained nearly 3% on Wednesday and Thursday combined, while U.S. Treasury yields declined by an average of 12 basis points (bps) across all maturities. After months of hoping the Fed would fast forward to rate cuts, investors now seem content as the central bank keeps its finger on the pause button.
That said, the Fed left the door open to another possible rate hike before year-end — a stance consistent with its progressively upgraded characterization of U.S. economic growth, from “moderate” to “solid” to “strong” in its past three policy statements. Third quarter GDP growth of nearly 5%, more than double the second quarter’s 2.1% pace, undoubtedly informed the Fed’s data-driven perspective. Meanwhile, inflation has slowed markedly from its 2022 peaks. But at 3.7%, the Core PCE Price Index is still too far above the Fed’s 2% goal to rekindle hopes of an imminent pivot to rate cuts. Inflation remains squarely in the Fed’s crosshairs, even as markets expect the inflation rate to fall to about 2.4% over the long term (Figure 1).
- Dealing with the labor market wildcard. The U.S. monthly employment report is arguably the most closely watched of all economic data releases. It encompasses several key metrics on the health of the labor market, which in turn may signal trends in the broader economy and influence Fed policymaking. Among these metrics, job creation —measured by net new nonfarm payrolls added — has been difficult to forecast in recent months. It has either lagged or exceeded economists’ projections by sizable margins and is often significantly revised after the fact. Unpredictable job numbers and other labor market indicators, especially wage growth and the labor force participation rate, can further complicate attempts to position portfolios in a Fed-driven environment. October’s payrolls, released last Friday, fit this uncertain mold by surprising to the downside. In our view, this latest snapshot of the labor market is unlikely to change the Fed’s approach.
“In our view, this latest snapshot of the labor market is unlikely to change the Fed’s approach.”
To add, or not to add — that is the question. Topping the list of investor FAQs in today’s environment are two related topics: “Where do you see rates going in the near-to-medium term?” and “What’s an appropriate level of duration for my portfolio?” It’s an apt pairing of queries, as fixed-rate fixed income assets experience capital appreciation when yields fall, and capital depreciation when yields rise. Because yields have risen sharply over the past few quarters, bond math now favors adding duration to both taxable and tax-exempt fixed income allocations. Figure 2 illustrates this concept, showing the expected total return of various Treasury maturities over the next year under three scenarios: yields stay the same, rise by 100 bps or decline by 100 bps.
For example, the 10-year Treasury would return +4.6% over the next year if its yield remained the same. If the 10-year yield were to rise by 100 bps (as it essentially has done year-to-date), the return would be -2.5%. And if the yield were to drop by 100 bps, the return would be +12.3%. We think today’s elevated yields could decline over the next year, which would result in healthy capital appreciation.
Up in quality, up in duration. Within the taxable fixed income space, investors also receive a spread over Treasuries, meaning returns over the next year should be affected by any movement in spreads. We believe that any spread widening caused by a potential economic slowdown will be limited, as consumer balance sheets remain strong and business investment solid.
Additionally, corporate default rates are still below their historical average, which supports selectively taking on credit risk. We are finding attractive opportunities in securitized assets, preferred securities, investment grade corporate bonds and senior loans. With regard to investment grade corporates, their relatively longer durations offer compelling return potential if yields decline as we expect, and can be an effective way to add duration to a portfolio while seeking to minimize credit risk. As for senior loans, we emphasize an up-in-quality approach, as the lowest-rated segments may struggle if yields rise, while the asset class as a whole stands to benefit if rates remain higher for longer. And because senior loans are a floating-rate asset class, they may provide some protection if we are wrong about yields declining.
“We are finding attractive opportunities in securitized assets, preferred securities, investment grade corporate bonds and senior loans.”
Choosing municipals needn’t be a taxing allocation decision. On the tax-exempt side, AAA rated municipal bonds currently pay taxable-equivalent yields that are higher than Treasury yields across all maturities, starting at the 32% tax bracket. The AAA rated muni curve is significantly steeper than the Treasury curve, favoring an overweight duration allocation in portfolios. High yield municipals also merit consideration, given their strong underlying fundamentals and our view that credit spreads will remain stable in the medium term.
“The AAA rated muni curve is significantly steeper than the Treasury curve.”
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