Core Plus Bond Insight: Growth, Inflation and the Fed

Absolutely. While on the surface it may look like an uneventful quarter, there’s more to discuss including some volatility. Three key fixed income drivers – the economy, inflation, and the Fed – help frame the picture. Starting with the US economy, disappointing growth, as reflected by gross domestic product (GDP), is expected to land at about 1.5%–2% for the quarter, far short of the 8%–9% that was forecasted.

Clearly the Delta variant slowed growth particularly in July and August by delaying the economic reopening, though we’ve seen some of that activity bounce back recently, which is encouraging and supports our reopening theme. Economy-wide shutdowns in China also weighed on growth, as did stress in their real estate sector. And of course, supply chain disruptions dampened economic activity and pushed up prices.

With core CPI¹ above 4% in July, August, and September, the transitory question remained front and center. In the transitory inflation camp, the Fed gave no indication of wavering in plans to scale back quantitative easing (QE)² in the not-too-distant future. We expect they’ll scale back QE in 2021 and think it’s reasonable to interpret that they leaned a bit hawkish. Nonetheless, we expect they’ll remain accommodative in efforts to fulfill their mandate of maximum employment and price stability, and let inflation run a bit hotter than usual, which should bode well for risk assets relative to Treasuries.

We see the Fed on track to begin tapering asset purchases in November or December and raise the fed funds rate in late 2022 / early 2023. We believe they expect transitory reversals but not enough to push inflation below their 2% long run target. Inflationary pressures, like housing, could also build in the pipeline and show up in the inflation indicators with a lag. We think it’s likely that the Fed has soft-checked the box on the inflation side of the equation and is focused on the employment side.

We see potentially transitory issues there as well. With 1.5 million new jobs in Q3 and the unemployment rate dropping below 5% from a pandemic peak of nearly 15%, the labor market is clearly improving. Despite progress, things are far from normal, particularly given roughly 5 million people yet to return to the labor force. High consumer savings from deferred spending and federal government programs enable workers to postpone their return, not to mention lack of childcare resources, lower immigration, and seemingly accelerated retirement by older workers. The timing and numbers of returning workers raise implications for wages and back to the ever-present inflation discussion. Wages have risen and worker shortages remain, and our best guess is for a steady return to work as the economy fully reopens. This could be slow going and we may not even return to the pre-Covid labor force level, which could keep wages and inflation structurally higher.

Yes, we aim to deliver the best combination of safety and yield through the cycle – we like to call it the best of the bond market. We think we’ve transitioned to the expansion phase, which is exemplified by steady, sustainable economic growth and building inflationary pressure, but also a virtuous self-reinforcing cycle of increased business and consumer spending bringing job creation, higher incomes, and more spending.

That said, every cycle is different, with its own unique themes. This one is no exception, characterized by considerable upside from the reopening supported by significant fiscal and monetary accommodation. On that note, we expect Congress to pass some type of fiscal package, which is wrapped up in politics with both timing and size to be determined. Nonetheless, given our constructive view on the cycle, we expect inflation to remain elevated, with interest rates inching higher. We’re tilted to emphasize generating yield and being defensive against rising rates and favoring sectors and securities that should benefit from a global economic recovery.

Going forward, we don’t see much value in the core sectors, the biggest being treasuries, with yields well below pre-Covid levels. Given confidence on our view of the cycle, we expect to emphasize yield, favoring plus sectors³ as we see continued support for high yield by a solid economy. We also like high yield bank loans, benefiting from seniority in the capital structure, and a floating rate aspect – a hedge against higher interest rates. Non-dollar foreign currency-denominated debt is attractive, specifically in Mexico and Uruguay government bonds, which we think offer attractive yields and good fundamentals. We like mortgage-backed securities for high quality carry and good liquidity. Overall, we see better value moving down the quality spectrum to BBBs and we like high quality securitized credit opportunities.