US economic resilience and fixed income opportunities

This article was produced in partnership with Franklin Templeton

Despite the gloomy backdrop of 2022, the US economy demonstrated surprising strength. GDP growth exceeded forecasts, and the Federal Reserve approached the end of its interest rate hiking cycle. Market narratives fluctuated dramatically, oscillating between fears of an imminent recession and expectations of persistent, strong growth. These shifts led to significant changes in bond yields, yet the outlook for finishing off 2023 carries a tone of optimism.

In a recent US Core and Core Plus strategy update discussion, Travis Carr, CFA, Product Specialist for US Broad Market Strategies and John Bellows, PhD, Portfolio Manager, shared valuable insights into the strategic updates to the products’ fixed-income portfolios and how today’s backdrop of higher rates and moderating inflation affected Western Asset’s views regarding positioning and new opportunities.

Carr and Bellows also highlighted the renewed attractiveness of fixed income investments. With yields reaching levels not seen in years, the diversification benefits of fixed income are re-emerging. They expect bonds to resume their traditional market behavior (i.e., an inverse correlation to equities), and if so, would represent a compelling opportunity for investors.

Deciphering the drivers of bond yields

Bellows emphasized Western Asset's fundamental approach to understanding market dynamics. The primary drivers of bond yields are inflation and Federal Reserve policies. Contrary to some perspectives, inflation, which has shown considerable improvement over the last year, is not currently driving bond yields higher. The Core PCE (Personal Consumption Expenditures) measure of inflation has nearly halved from 5.5% to a three-month annualized rate of below 2.5%, signaling positive developments.^[1]

A critical factor affecting bond yields in 2023 has been the change in growth consensus. Early pessimism about the US economic outlook has been replaced by a more optimistic view, leading to a rise in bond yields. However, Bellows warns against making long-term assumptions based on the short-term positive growth trends, given the challenging financial conditions and high-interest rates.

Bellows says, “It would be incautious to take the good growth over the last few quarters and extrapolate that forward. To the contrary, we expect some softening of growth starting in the fourth quarter and beyond. The growth we've had has been based on things that are very difficult to sustain. Especially looking at the consumer part, where we've seen a very low savings rate as consumers try and navigate this environment of high prices and wages that haven't necessarily kept up. It's going to be difficult for the consumer to sustain that.

“We continue to have financial conditions in the United States that are tight. The upper limit of the Fed Funds Target Range is at 5.5%^[2] and mortgage rates are 8%^[3]. You must incorporate those conditions into your outlook. To us that suggests a slower growth picture going forward.”

Performance and expectations in fixed income markets

Looking at the past year's performance in fixed income markets, there has been notable volatility in bond yields. However, spread products have shown resilience due to better-than-expected growth. Investment-grade companies have demonstrated strong balance sheets, leading to outperformance in spread products. Income has played a crucial role, with higher-income, less yield-sensitive sectors outperforming.

“I want to emphasize, the rise in interest rates has certainly been a challenge, but it's come in the context of some very good performance in other parts of the fixed income market. In particular, as there has been an improvement in growth, we've seen pretty good performance from spread sectors that have a growth-related component.

“The places where there has been more income and less sensitivity to the rise in yields have clearly outperformed,” says Bellows.

Additionally, he also points out, there has been considerable focus on bond yields, especially treasury yields, which have experienced significant volatility. While this focus is justified, it's also important to acknowledge the strong performance in other parts of the fixed income market. Credit quality remains robust, and the income offered in some spread sectors has been a significant driver of performance this year.

A significant part of Western Asset’s strategy revolves around generating substantial income from high-quality spread products, such as investment-grade bonds and agency mortgage-backed securities. These securities provide a stable source of income, often yielding significantly more than treasuries. The firm emphasizes the compounding nature of income, which, although may appear modest in the short term, accrues significantly over longer periods.

Value identification in emerging markets and structured products

Value identification forms a critical pillar of Western Asset’s investment approach. The firm sees promising opportunities in select emerging markets and structured products like commercial mortgages. These markets offer a mix of favorable policy environments and attractive pricing. However, the firm also cautions that such investments require thorough due diligence and are not suitable for indiscriminate, broad-market investing.

Bellows says, “Another place where there's some value, that we're very thoughtful about, would be structured product and in particular commercial mortgages. There's a lot of concerns in the news and a lot of that's justified. When there's smoke there's usually fire, but there's also opportunity.”

The energy sector, particularly high-yield companies with strong balance sheets, was identified as a valuable area earlier in the year. While the appreciation in prices has somewhat reduced the value proposition, it remains an area of interest. This sector highlights the dynamic nature of value within markets and the importance of continuous reassessment.

Addressing the challenges with duration overweights

The firm’s persistent overweight in duration has been challenging, particularly with treasuries showing negative returns. Western Asset views this challenge as an opportunity to underscore the importance of having a multi-faceted approach. By not focusing a portfolio exclusively on a single idea, and instead spreading investments across various sectors and asset classes, the firm aims to mitigate risks and capitalize on different return sources.

The past year has demonstrated the importance of income in portfolio performance. The firm's approach to generating income, combined with their emphasis on identifying value, has been pivotal in navigating the difficult fixed income environment. The approach showcases the benefits of balancing immediate yield generation with long-term value investment.

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