Work/life balance is a challenge for investors, what with 24-hour-a-day global business news coverage and a bevy of budgets, tariffs, geopolitics and related data to consider. Although summer is still a time when market participants take some time off, it’s also a good time to consider recent trends and where markets are now. Both equity and fixed income markets have been volatile this year, even as the Federal Reserve (Fed) has remained paused on interest rates, and views on economic direction are mixed.
Order restored
It’s a bit hard to believe that we’re now more than three years from the beginning of the US Federal Reserve’s dramatic rate-tightening cycle in response to not-so-transitory inflation. The unusual and extended period of close-to-zero interest rates post global financial crisis, and the subsequent period of yield-curve inversion, have given way to what might be called an old normal. Rates have remained elevated across the curve, providing fixed income investors with attractive coupons for some time now, in spite of recent risk-on/risk-off volatility.
If there has been a theme that should be discussed more, it’s nuance. US Treasury yields have not moved in a straight line recently, and consensus on when interest rate cuts will resume, and to what extent, remains mixed. For bond investors, we believe it’s not time to be on the sidelines, but also important to be diversified and not lean too far as the known unknowns play out longer term. We also feel that security selection, as credit sectors have retightened and as deregulation plays out, will be a key way to add value.
Current macro considerations
Jobs and labour
- The US labour market is at equilibrium, although with some signs of deterioration below the surface. As the range of outcomes from fiscal policy narrows and visibility improves, will companies begin hiring again? Or will tariff pressures prompt layoffs? Equilibrium is uncomfortable and not akin to euphoria.
- Changes in immigration policy, resulting in a smaller labour force and, in turn, less employment growth, ultimately leads to lower GDP growth, about 0.3-0.4 percentage points as estimated by the American Enterprise Institute.
Balance this decline in labour supply against an aging demographic, and unemployment could remain in the ~4% area or lower. Can AI quickly protect and enhance productivity? - The consumer’s ability to tolerate price instability is key.
The consumer’s ability to tolerate price instability is key.
Fiscal policy
- Tariffs – Higher levels announced after the initial 90-day pause than perhaps expected, but always difficult to know whether US President Donald Trump will ultimately back off. If he doesn’t, will economic impacts accelerate on the negative side?
- Earnings – Do management teams have more certainty on policy to begin to provide forecasts and hints of long-term plans?
- Deregulation – A shift in bank regulation likely brings some opportunity but not necessarily a one-size-fits-all approach to capital allocation, so the near-term impact on US Treasury yields could be muted. Across other industries, reduced costs from regulation and a shift to less regulatory oversight could prompt merger and acquisitions (M&A).
The Fed
- Why cut now? Maintenance is working – rates are restrictive relative to inflation but are not impeding growth…yet. While full employment and price stability are the dual goals of the Fed, a third might be to avoid going to zero again because of a misstep.
- Problems at the top. While much is in the headlines about the next Fed chair, it takes more than one to effect policy change, regardless of who the new chair is next year. Ultimately, the long end may reflect more of the change.
With 20% of Treasury debt outstanding in Treasury bills and maybe moving higher, the terminal rate matters to the administration as it seeks to reduce interest costs.
- Does the Fed influence the long end of the curve? This is an active debate. The long end may continue to price in the myriad of risks (inflation and tariffs, political tensions at home and abroad, and rising debt and deficits) and stubbornly hold in the current range rather than paralleling the policy rate moves.
- Ultimately, a lowering of the Fed policy rate could bring less interest income to corporations and money fund yield to investors, while the US 10-year holds in its current range and the 30-year mortgage holds above 6.5%. That is not an optimal situation for consumer and business confidence.
Sectors in summer
While the market seeks to be forward looking and incorporate as much as possible into current prices, the environment remains ripe for volatility. The underlying fixed income sectors seem to be priced to perfection at the moment, with the spread widening of April giving way to spreads now tighter than at the beginning of the year.
With the economic outlook appearing stable in the near-to-intermediate term, we consider any weakness as an opportunity to refine or add to positions rather than to retrace further underweight. That said, quality counts and we do not see a need to stretch too far down the credit rating spectrum in a quest for yield. Taking the asset classes in turn:
- Mortgage-backed securities (MBS): Supply is quite manageable given affordability issues and elevated mortgage rates. Demand is the question as money managers are overweight while banks are on the sidelines. Volatility has fallen while valuations are in-line with long-term averages although still attractive relative to corporate credit.
- Asset-backed securities (ABS): Supply of new-issue ABS has been strong and credit spreads in prime autos have almost completely reversed from April’s tariff-related widening. High used car prices, which are up 15% over the last four years, and a low unemployment rate of 4.2% are contributing to solid ABS performance.
- Corporate bonds: For the investment grade portion, spreads are in the tighter part of their historical range, but could remain fairly static in the face of reduced supply and still strong yield-driven demand creating a favourable environment. In high yield, spreads are at or near extreme tights and we believe the risk/reward dimension is not favourable.
- Emerging markets (EM): Valuations are not compelling but the backdrop remains interesting. Local markets are attractive, in our view, and remain our choice over sovereigns for expressing positions. Similarly, on the US dollar, we view any retrace higher as an opportunity to sell and position for further weakness.
The economic calendar as a guide
- Tariffs: August 1 is the new July 9 (or April 2).
- July 30: Federal Open Market Committee (FOMC) meeting and Q2 GDP flash.
- August 21-23: The Federal Reserve Bank of Kansas City hosts their annual symposium at Jackson Hole, Wyoming. This year’s theme is ‘Labor Markets in Transition: Demographics, Productivity, and Macroeconomic Policy.’
- Inflation – a few more looks: mid-July and August for CPI and PPI and end of July and August for PCE.
- Labour: Nonfarm payrolls on August 1 and September 5.
- September 17: FOMC meeting.
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