By Komson Silapachai
Inflation is moving lower, and while the labor market remains strong, it is exhibiting a decelerating trend. Rate markets are expecting one more hike in July, which we believe will be the final one given the trajectory of inflation data. Additionally, we remain cautious on our corporate credit allocation by focusing on defensive sectors and issues as default rates are starting to move higher while credit risk premiums are low. Risk/reward is better in duration or MBS, especially as a diversifier to the corporate bonds in a multisector fixed income portfolio.
- Inflation is on a Downtrend. June CPI (3.0% vs. 3.1% expected) and core CPI (4.8% vs. 5.0% expected) came in below expectations. Given the rollover in the slow-moving owner’s equivalent rent measure as well as Powell’s cited “super core” component of CPI, inflation is now squarely on a downtrend. Additionally, PPI came in below expectations as well, with PPI +0.1% YoY (vs. +0.4% expected) and Core PPI at +2.4% YoY(vs. +2.6% expected). The soft inflation numbers set up a “Goldilocks” risk rally in Q2 where risk assets performed well, while bond yields and the USD moved lower.
- Labor Market Strength Underpins the Economy. While the most recent job growth reading surprised to the downside for the first time in 14 months, the level of job growth remains consistent with an economic expansion, giving the market the appearance that the economy should be in for a “soft landing.” However, as jobs growth continues to decelerate, the unemployment rate is expected to start rising later this year.
- Corporate Bonds – Duration Over Spread. Investors continue to flock to credit to take advantage of some of the highest yields in 15+ years; however, most of that yield emanates from the high level of Treasury yields, while credit spreads have tightened to well below average levels. Given low credit risk premia and the FOMC priced to be largely done with hikes after this month, duration presents a better risk-reward than credit risk here, with IG spreads at 120 bps and HY spreads at sub-400 bps.
- Real Interest Rates are Elevated Versus History. Real interest rates, as represented by the yield on TIPS, are at a 15-year high, which present good value if the FOMC is largely done tightening. However, a high level of real interest rates could serve as tailwind for future growth. Elevated real rates mean a higher funding cost for the economy. The spread of GDP to real interest rates could start to bite if economic growth decelerates into the end of the year, which is our base case.
- MBS – Diversification versus Corporate Bonds. Last month, we illustrated the value that exists in MBS over corporate bonds. Another utility of MBS is its value as a diversifier in a multi-sector bond portfolio as it has a low or negative correlation to corporate bonds over time.
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