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Loomis, Sayles & Company

Extra Credit

By the Full Discretion Team 
As of July 15, 2024
Q2 Round Up: Deceleration in Economic Data, Unstable Inflation and the Potential for a Prolonged Rate Cutting Cycle

Fed Continues to be Data Dependent

The Federal Reserve (Fed) appears to believe the US is back on a disinflationary path, adjusting June’s Federal Open Market Committee (FOMC) policy statement to note that ‘modest’ progress had been made towards their 2% inflation objective. Recently, there has been some softening in economic data and supply/demand conditions in the labor market have continued to come into better balance. Further incoming data is likely needed to determine ongoing progress of the Fed towards their inflation goal, however, the Personal Consumer Expenditures (PCE) reading at the end of the quarter eased and is supportive to the Fed’s stance. Coming into the year, the market was pricing in six rate cuts from the Fed in 2024, however, as of the end of Q2, the market had shifted to two. Investors now seem to be grappling with a more shallow and drawn out rate cutting cycle than previously indicated by the Fed. During the quarter, investment grade and high yield spreads were slightly wider on a deceleration in economic data and interest rates moved higher as inflation data still remains stuck above the Fed’s target and the probability of a ‘no cut’ scenario has increased. 

Growth is Normalizing but Inflation Remains Unstable

In our view, the credit cycle is firmly in the ‘late cycle’ stage. Monetary policy still remains in restrictive territory and lending standards have tightened. The economy appears to be losing some momentum, with Q1 real gross domestic product (GDP) reported lower at 1.3% quarter-over-quarter. We have seen a small amount of marginal weakness in the consumer, however, the US labor market continues to underpin consumer spending. Corporate fundamentals still remain stable and are also supportive of economic activity. Looking forward, our base case calls for trend, or slightly below trend, US growth in 2024 consistent with a ‘soft landing’ scenario and we do not anticipate a recession. On a global basis, we see gradual improvement in European growth, led by improving business activity broadly in periphery economies, but there is upside risk to inflation that forces the European Central Bank to hold after just one cut. China is showing signs of gradual recovery, with business activity picking up, but we are mindful of persistent risks associated with a weak housing market.

We believe that inflation has peaked and positive real rates should have the effect of slowing growth and continuing to lower inflation over time. The market’s expectation for a ‘soft landing’ implies inflation continues, unabated, back to the 2% Fed target with growth holding up. Further progress on inflation requires lower wage and house price inflation. To accomplish that, the Fed likely needs to maintain high policy rates to slow demand, in our view. Current restrictive policy is leading to some initial signs of a moderating labor market with lower job openings and a lower quit rate, rather than lower payrolls. Our base case calls for ‘unstable’ inflation, meaning in the short-term inflation could remain sticky while over the long-term we believe it will be a recurring problem based on structural themes, such as deglobalization, decarbonization and the greenification of energy sources, aging demographics, and growing government deficits. We expect the path to 2% inflation to be a bit rocky and expect to see dips as cycles progress, but we also believe we are likely to experience higher lows than have been experienced over the last 15 years. As a result, we have moderated our view of future Fed cuts with the expectation that the cutting process will be more drawn out with less cuts in 2025 and a trough rate expectation of 3.50% to be hit in 2026.

Stable Corporate Fundamentals and a Benign Loss Environment

 

Corporate fundamentals appear stable and while there has been some recent weakness in broader fundamentals, factors such as leverage and interest coverage ratios continue to remain attractive in a historical context. Corporate profits are ticking back up and the rolling recessions that we have witnessed in technology, housing, profits, and manufacturing have seemingly come to an end. Our Credit Health Index (CHIN) suggests defaults/losses will remain relatively low, while slowly increasing to more normal levels associated with a ‘late-cycle’ environment. Technicals remain supportive, with investment grade issuance front-loaded in the first half of 2024, as corporations potentially tried to issue debt ahead of a volatile US election period. In addition, specific to the high yield market, fundamentals also look relatively healthy, defaults may have already peaked for this cycle and most signs of distress seem idiosyncratic, in our view. The high yield maturity wall also seems manageable through 2025, not posing a major threat after a wave of refinancing earlier in the year.

Carry May Drive Fixed Income Returns in 2024

We believe that long-term value has returned to fixed income markets with a combination of discount-to-par (positive convexity) and favorable yields. In our view, bond markets will likely be supported with strong demand as investors sit on record levels of cash that will be seeking yield as the Fed potentially cuts rates on the front end. We see long-term fair value in the 10-year US Treasury at 4.50% and believe the current range is 3.75% (soft landing scenario) to 5.00% (no cut scenario). We believe the belly of the curve presents the best risk/return trade-off. In a declining rate environment – based on lower inflation and Fed cuts – the belly offers investors the ability to capture most of the upside return of the long-end without the potential volatility. The US deficit and Treasury supply continues to be a topic of heavy discussion and will likely have a significant influence over long-end Treasury yields. Regardless of the US presidential winner, we believe the fiscal deficit is structural in nature and neither party will risk taking a hawkish stance on fiscal responsibility. This will likely lead to continued growth in the deficit and more Treasury issuance, which we believe could lead to increased volatility and a floor under long-term Treasury yields.

We are mindful of the risks going forward, such as tighter financial conditions, geopolitical risk, further decline in the commercial real estate market, and the upcoming US and global presidential elections. Although risks exist, spreads have moved to the tightest levels of this cycle. We are not surprised by how buoyant credit markets are these days – fundamentals are stable with the potential for losses to remain benign, and buyers are showing up with an almost insatiable demand. We feel 2024 will likely be an environment where returns are driven by carry and it will be prudent to maintain a balanced risk profile between interest rate and spread risk.

Important Disclosure

This marketing communication is provided for informational purposes only and should not be construed as investment advice. It is meant to offer a snapshot of select market developments and is not a complete summary of all market activities. Investment decisions should consider the individual circumstances of the particular investor. Any opinions or forecasts contained herein reflect subjective judgments and assumptions of the author and do not necessarily reflect the views of Loomis, Sayles & Company, L. P. Investment recommendations may be inconsistent with these opinions. There can be no assurance that developments will transpire as forecasted. Data and analysis does not represent the actual or expected future performance of any investment strategy, account or individual positions. Accuracy of data is not guaranteed but represents our best judgment and can be derived from a variety of sources. Opinions are subject to change at any time without notice.

Market conditions are extremely fluid and change frequently.

Commodity, interest and derivative trading involves substantial risk of loss.

Diversification does not ensure a profit or guarantee against a loss.

Any investment that has the possibility for profits also has the possibility for losses, including the loss of principal.

Past performance is no guarantee of, and not necessarily indicative of, future results.

For Institutional Use Only. Not For Further Distribution

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Meet the Managers

The Full Discretion team is made up of 28 professionals with 23+ years average of investment experience globally.

 

Meet the Managers

MattEagan

Matt Eagan, CFA

Head of Full Discretion, Portfolio Manager

BrianKennedy

Brian Kennedy

Portfolio Manager

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Todd Vandam, CFA

Portfolio Manager

Frozen, frothy, and everything in between.

The Full Discretion Approach to Credit Selection

During our decades as bond investors, we’ve managed through all sorts of credit conditions. And we have consistently observed that the market is inefficient at pricing-specific risk.

We use repeatable credit selection strategies to capitalize on this persistent inefficiency and drive excess return potential.

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