- Fixed Income Strategist
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While inflation has fallen from its 2022 peak, the US Federal Reserve’s (Fed’s) preferred inflation gauge, core personal consumption expenditures (core PCE), was 2.8% year over year in April (Figure 1). We believe inflation may level out near 3%, above the Fed’s 2% target. If inflation remains elevated, policymakers will need to decide whether to prioritize growth risks or their inflation-fighting credibility. We expect steady growth and labor market conditions, making it unlikely the Fed will meet market expectations for rate cuts this year.
Figure 1
Looking into the second half of the year, in the absence of major shocks, stable inflation should lead to lower interest-rate volatility, with US Treasury yields remaining relatively stable. Current yields in most developed markets offer an opportunity for investors to move out of cash. While money market rates are appealing, many bond portfolios currently offer higher yields than cash.
Investment implications: Seek value beyond traditional credit markets
Under the current environment, dispersion in valuations among fixed income sectors and regions will present opportunities for investors to take advantage of market dislocations. There are a few areas beyond traditional credit markets that where we are seeing compelling risk/reward opportunities:
- Convertible bonds: Compared to other high-yield sectors, convertible bonds look attractive, with the potential to perform in line with other asset classes in a bearish risk scenario and to significantly outperform in a bullish environment. Convertibles can also provide industry diversification to many fixed income portfolios, as they are exposed to sectors like technology and life sciences that are not well represented in traditional public fixed income markets.
- Agency mortgage-backed securities (MBS): MBS have attractive spreads relative to corporates and are likely to be supported by renewed demand from banks and stable interest rates.
- Auto loan asset-backed securities (auto ABS): We think auto ABS, particularly those focused on subprime auto loans, are an underappreciated opportunity in fixed income markets.
- Residential MBS (RMBS): The most important fundamental variable for RMBS performance is home-price appreciation. Structural supply shortages of housing and pent-up consumer demand for new housing in the US imply that home-price performance should remain robust.
What we are watching?
The upcoming US election and ongoing geopolitical tensions are likely to cause market volatility. We are optimistic about market resilience regardless of the election outcome and prefer to buy risk assets during bouts of preelection volatility.
Investors should remain vigilant and proactive, ready to capitalize on market dislocations as they arise. This environment calls for a flexible, dynamic approach that leverages diverse high-yielding opportunities and manages risks carefully. By staying nimble and strategically positioning portfolios, investors can turn market uncertainty into a powerful advantage, driving both yield and total return in 2024.
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