Fixated on Fixed-Income

We believe that the Fed can conduct monetary policy from a good place right now given that the Central Bank is beyond its heaviest pressure to combat unacceptably high inflation through a series of aggressive rate hikes and has the flexibility to pause at an individual meeting should the data offer support. During last week's press conference, we saw clear acknowledgement from Chair Powell of the downside risks that may accompany an overly restrictive policy campaign, perhaps elevating the Central Bank’s desire to engineer a soft landing as the risks seem evenly weighted on both sides of the tightening argument. As part of Mr. Powell’s narrative, prospects for recession have been fairly remote with the idea that tight monetary policy does not necessarily have to lead to economic contraction, yet a broad cooling in labor market conditions with wage growth moving in line with 2% inflation would be acceptable. Overall growth could be moderate with expectations for a period of below trend expansion and labor weakness. Between now and the September FOMC meeting, market stakeholders will receive 2 more jobs reports and two more CPI prints and while that meeting is certainly live, the new rounds of data points could give rise to another pause and may even be part of the calculus that completes the tightening sequence. While the Treasury yield curve remains heavily inverted, the 10-year yield has demonstrated resistance of late to spending much time with a 4-handle, and we continue to make that observation even though domestic economic reports, UST supply pressure, and global events have intermittently sent the 10-year into 4% territory.

Although available cash flow has supported both consumer and business participation, we continue to posit that such available liquidity may recede at some point in 2024 as the impact of higher interest rates and tighter lending practices deepens. Further slowing in wage growth, which is targeting most sectors and which is illustrative of wage disinflation, can be expected through the balance of 2023 and into next year given our outlook for softening economic performance and a general easing of inflationary conditions. With the next FOMC set for September, participants will be looking for evidence that the supply/demand labor market imbalances have improved during the inter-meeting period. All-in-all, the post-FOMC economic data points reflect an economy that appears to be distancing itself from any near-term recessionary drag and that would tend to bolster the hawkish argument among those Fed policymakers calling for additional tightening measures. The consumer, while slowing down somewhat, has been at the heart of keeping recession at bay, and although we can envision additional consumer displacement, acknowledging that payments on student loans are scheduled to resume in October, recession is not imminent. While the FOMC will not be meeting in August, the annual Kansas City Fed-sponsored economic symposium held in Jackson Hole, Wyoming will provide global Central Bankers with an opportunity to elaborate on monetary policy and to provide market stakeholders with a broader perspective on economic conditions.

Fitch’s downgrade on U.S. sovereign debt from “AAA” to “AA+” comes 12 years after S&P took similar action and lowered our nation’s debt to “AA+” from “AAA”. While this surprise action will likely elicit heavy response and criticism, we do not expect meaningful alterations to fixed income investment strategies. Analytically, we must question Fitch’s timing as there is no looming crisis, the U.S. economy has emerged from the COVID-driven shutdown with strength and resiliency, and quite frankly, debt ceilings and the threat of a government shutdown have been consistent participants among fiscal and budgetary deliberations for a very long time. A debt rating is meant to measure statistical probability of default incorporating a set of financial and non-financial inputs, and so it is unclear as to what has altered Fitch’s view. Admittedly, it is fairly easy to argue that the fiscal and budgetary processes at the Federal level routinely get caught up in political theater, yet the impact upon credit ratings assessment is open to debate. We must also recognize the swelling debt burden and the overall debt to GDP standing of the U.S. among global counterparts, which is a primary consideration in any sovereign credit analysis. Against this backdrop, we do not foresee substantive impact upon municipal credit or municipal market efficiency at this time. However, we cannot rule out methodology shifts from the rating agencies at some point in the future that draw parallels between U.S. and state sovereign debt practices and political behavior. Having said this, with limited exception, states are required to maintain a balanced budget and states typically engage with effective cash management practices and also benefit from statutory safeguards that help to support credit quality.

In our view, 2023 will be the year of fixed income given the extremely compelling yield and income opportunities that have made re-assessments of asset allocation highly appropriate for many portfolio strategies. Municipal bonds in particular, have demonstrated their effectiveness as a defensive investment in a rising interest rate environment designed to derail out-sized inflationary pressure. Thanks to much better paying cash flows, munis have now earned their place beyond a portfolio diversifier on a tax-adjusted, risk-adjusted, and even on a performance-adjusted basis and the more predictable income streams could offset risk-asset volatility for a growing base of natural fixed income buyers. We think the allure is now more apparent given the improving trajectory of inflation, the nearing conclusion of the Fed’s tightening campaign and the loftier Treasury yields. The tax-efficient nature and relatively strong credit attributes, underscored by low-defaults and higher recoveries relative to corporates, of muinis offer unique benefits for conservatively-biased portfolios. The vagaries of monetary policy and the dynamics of economic data points ended July performance mixed across key fixed-income cohorts, with munis taking the lead and finishing in the black thanks to a very supportive technical backdrop. Historical performance data would tend to suggest that Munis are capable of weathering the effects of a Central Bank tightening cycle with perhaps less sensitivity to higher rates relative to other asset classes while providing a predictable revenue stream for both tax-exempt and taxable investment portfolios. Bloomberg data indicates that muni returns across the curve were largely positive during the past few tightening periods with higher absolute yields offsetting associated price erosion. We are not suggesting that higher muni yields are the only driver of performance as credit and market attributes comprise important components to the mix. We have witnessed some contraction of credit spreads and have seen longer-duration munis generally outperform given the richness on the short end of the muni curve. We have also been dwelling on the supportive technical environment underlying the municipal bond market, a key performance factor.