Uncovering income opportunities

Inflation, labor markets and the Fed

Before delving into income opportunities, it's crucial to address the current state of inflation, as it remains a central focus for the markets. Over the past year, significant strides have been made in managing inflation rates. The core personal consumption expenditures index (PCE), the Federal Reserve's (Fed’s) preferred inflation gauge, has decreased from a peak of 5.6% in early 2022 to approximately 2.6% today. While initial progress in reducing inflation was anticipated, the final steps toward reaching the Fed's target are proving to be challenging. This difficulty has led to market fluctuations and adjustments in expectations regarding interest rates and the timing of the Fed’s rate cuts.

It’s important to remember the Fed operates under a dual mandate: to ensure price stability through inflation targeting and to promote maximum employment. The labor market is gradually returning to what we consider a more normalized state. In 2023, the unemployment rate experienced minimal fluctuations, moving from 3.5% to 3.7%. However, the first half of 2024 saw a more significant increase, reaching 4.1% by June. Other indicators, such as job openings, quit rates and consumer sentiment, have nearly returned to pre-pandemic levels. The Fed is likely reassured by these signs that the labor market disruptions caused by COVID-19 are subsiding.

Prospects for rate cuts in 2024

Expectations for interest-rate cuts have shifted dramatically over the past 6-9 months. At the end of 2023, the markets anticipated a series of rate cuts in 2024. However, as disinflation slowed, these expectations were adjusted. A few months ago, the futures market was predicting only one rate cut for 2024. Recent developments in inflation and labor market softening have once again altered this outlook. It's important to note that the Fed's transition from tightening to easing doesn't need to be immediate. There is potential for a gradual shift to a more neutral or normal stance, as gross domestic product growth slows, labor market conditions soften further, and inflation goals are nearly met. This sets the stage for potentially 4-6 rate cuts by the first half of 2025. We anticipate Fed policy normalization will be beneficial for more rate-sensitive plays within the equity as well as fixed income markets.

Equities and market broadening

Interest-rate expectations have influenced market dynamics. In a tight-rate environment with a slowing economy, companies that have consistently delivered growth outperformed. This trend has resulted in a narrower equity market dominated by a few large-cap growth stocks, often referred to as the "Magnificent Seven" (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla). However, with a reduced likelihood of a US recession versus last year, there's potential for broader market leadership across various sectors. Approximately 40% of S&P 500 companies are currently trading more than 10% below their recent highs,¹ highlighting opportunities for sector diversification in financials, technology, energy, health care, and utilities. We also see potential for diversification through common stocks, convertibles and other hybrid equity investments.

The second-quarter earnings season is underway, and the bar has been set fairly high. As we think about equity investing, we will continue to watch earnings and expectations going forward. We see a bit of a conflict between decelerating growth, a Fed that seems to be cautious about normalizing and cutting interest rates, and the very robust earnings expectations many analysts have. 

Fixed income opportunities

The last 12-18 months offered yield levels, spread levels and overall prices of investment-grade securities that were quite attractive. In many instances, yield opportunities were the most attractive for high quality fixed income than we've seen over the past 10 or even 15 years, during the period where interest-rates were much lower overall, close to zero lower bound. These attractive opportunities were mostly within corporate credit, particularly investment-grade corporate bonds and high-yield corporate bonds.

But over the past year or so, we've seen yields come down. We've seen spreads tighten pretty dramatically within the corporate credit space. The market has returned once again to more of a fair value posture, in our opinion.

If we were to see interest rates gradually move down across the yield curve, we would still view that as positive from an investment standpoint. But, in our view, the real attractive relative value is not as appealing today as it has been for most of the past 12-18 months.

That said, credit exposure remains an area that we like; investment-grade and high-yield corporates are still generating yields that remain fairly attractive. However, we are being more selective today. We want to ensure we are adequately compensated for the incremental risk we take, particularly in a period where we think it's reasonable to assume there will be moderation or deceleration of economic growth. Many companies within the high-yield space did well within the low-rate environment of the past and are now facing maturities and the prospects of refinancing debt at much higher rates. So, we're going to be a little more selective and cautious there.

A nimble strategy in uncertain times

With US economic growth likely to decelerate and significant events such as the upcoming presidential election on the horizon, we believe adopting a flexible investment strategy is essential. Our approach balances equities and fixed income, adjusting dynamically based on market conditions and yield opportunities. This nimble strategy is crucial for navigating potential volatility and capitalizing on income opportunities in uncertain times.