Amid disappointing growth, continuing questions on inflation and the Fed’s actions, Loomis, Sayles & Company’s Core Plus Bond PM Richard Raczkowski considers the fixed income outlook for the expansion phase of the credit cycle and seeking value in plus sectors.

Although bond markets, as measured by treasury yield, were basically flat for Q3, we suspect there’s much more to say about the fixed income environment?

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.

Why the disappointing growth?

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.

Which leads us to the ongoing question of inflation, and the Fed’s next steps.

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.

When might they start raising rates?

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.

Can you say more about the employment picture?

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.

We know that credit cycle analysis is a key aspect of your approach at Loomis Sayles. Where are we now in the cycle, and what does that mean for your portfolios?

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.

What’s your outlook for fixed income sectors?

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.
1 Core CPI is a measure of price changes and an inflation indicator.
2 Quantitative easing is a monetary policy whereby a central bank purchases predetermined amounts of government bonds or other financial assets in order to inject money into the economy to expand economic activity.
3 Plus sectors offer enhanced yield potential and diversification benefits, and may carry a higher risk profile.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed are as of October 19, 2021 and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted, and actual results may vary.

All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.

Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.

Credit risk: is the risk that the issuer of a fixed income security may fail to make timely payments of interest or principal or to otherwise honor its obligations.

Currency risk: Currency exchange rates between the US dollar and foreign currencies may cause the value of the fund's investments to decline.

Foreign and Emerging Market Securities risk: Foreign and emerging market securities may be subject to greater political, economic, environmental, credit, currency and information risks. Foreign securities may be subject to higher volatility than US securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets.

Interest Rate risk: is a major risk to all bondholders. As rates rise, existing bonds that offer a lower rate of return decline in value because newly issued bonds that pay higher rates are more attractive to investors.

Below Investment Grade Securities risk: Below investment grade fixed income securities may be subject to greater risks (including the risk of default) than other fixed income securities.

Inflation Protected Securities/TIPS risk: Inflation protected securities move with the rate of inflation and carry the risk that in deflationary conditions (when inflation is negative) the value of the bond may decrease.

Mortgage-Related and Asset-Backed Securities risk: Mortgage-related and asset-backed securities are subject to the risks of the mortgages and assets underlying the securities. Other related risks include prepayment risk, which is the risk that the securities may be prepaid, potentially resulting in the reinvestment of the prepaid amounts into securities with lower yields.

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