June brought some continued relief as domestic markets showed greater optimism with respect to central bank expectations. The latest round of economic data backed up hopes for two full Federal Reserve (Fed) rate cuts by year end, which built further upon last month’s rally in the U.S. Treasury and equity markets. At the same time, the cooler data naturally pushed spreads wider on risk assets, given the potential of a slowing economy. All in, signs were encouraging as we reached the midpoint of 2024.
Right away, the market tone in the first week of the month was positive, as it felt like the tide was turning toward future easing. The European Central Bank (ECB) and Bank of Canada cut rates and the Institute for Supply Management (ISM) Manufacturing Index came in below estimates to suggest some economic slowing. Nonfarm payrolls (NFP) would temporarily cool the enthusiasm on the 7th, however. The report brought a large headline beat of 272k vs. a 180k consensus, beating all major estimates. Average hourly earnings were higher than expected but the unemployment rate actually increased with a small downward revision to the previous headline figure to boot. In all, the report was a bit of a setback, signaling to the Fed that they don’t need to run to cut rates, and Treasury yields climbed.
The NFP worry was short-lived, though, as the May Consumer Price Index (CPI) report on the 12th ignited a rally that reversed the previous move. CPI was lower than expected, with a flat headline number, which lowered the 12th month rate to 3.3% from 3.4%. Core CPI was up 0.2% which also lowered the trailing 12-month number. The report gave steam to the idea that some of the hotter CPI readings of this year may have been slight aberrations. Shelter and medical costs remained challenging, but a number of other areas showed improvement like autos, airfares and apparel. The recent trend in core CPI has been quite encouraging and the markets reacted in a big way. And over the next few days, friendly Producer Price Index (PPI) and consumer sentiment data reinforced the rate rally. Personal Consumption Expenditures (PCE) at month end would go on to do the same.
The June Fed meeting didn’t offer any major surprises. With inflation still at the forefront, the central bank’s dot plot suggested just one rate cut for the remainder of the year but added on to easing expectations for 2025. There was not a clear consensus from policymakers, as individual expectations ranged between zero and two cuts the rest of the way in 2024. In the statement, the notable change was an alteration of language to reflect evidence of “modest further progress” on the inflation front, whereas the prior statement noted a lack of progress. Fed Chair Jerome Powell said that the Fed is willing to keep rates where they are if inflation doesn’t improve while also saying the Fed is prepared to act if and when the labor market weakens.
“Tommy used to work on the docks, union's been on strike
He's down on his luck, it's tough, so tough
Gina works the diner all day, working for her man
She brings home her pay, for love, mmm, for love
She says, "We've gotta hold on to what we've got
It doesn't make a difference if we make it or not
We've got each other and that's a lot for love
We'll give it a shot"
Whoa, we're half way there
Whoa oh, livin' on a prayer
Take my hand, we'll make it, I swear
Whoa oh, livin' on a prayer”
-Jon Bon Jovi
We lived in Colorado for a while. Nice place. Enjoyed the weather a great deal. I don’t ski though and so never took my kids skiing. When people heard that they made it seem like I was their nominee for worst Dad of the year award. Falling down a mountain just never interested me. I did take my kids up to the mountains a few times in the summer. I assumed the drive up the side of a mountain would be more pleasant when there wasn’t snow and ice to deal with. One summer we packed up the family wagon and drove up to the Continental Divide. A geographic halfway point. The drive-up? Not quite what I expected. I didn’t realize the GPS’s ideal route was to take the road they shut down every year from November until June. I did once we got on it though. No doubt Ideal for a guy in the 1800s with a pack mule and getting ready to pan for gold; harrowing for a family of four in an SUV. A two-lane road with plenty of tight turns, no shoulder and no railings. At the halfway point was the Continental Divide, a halfway point itself. There you could pull over, step out and take a picture. It was a breathtaking view. Truly. Because you couldn’t really breathe, given you were 12,000 feet up. The worst part was climbing back behind the wheel and coming to the realization you were only halfway, and now you had to drive down the mountain. I have shown the picture of me and the family at the Continental Divide to others. I have been asked if I didn’t feel well that day. I assure those asking I surely did not feel well when the picture was taken.
We are halfway through the calendar year. The markets themselves are nowhere near as harrowing as my trip up the mountain that summer. Nevertheless, it’s time to start going down the mountain, and with the anticipation of rate cuts rising and the expectation favorable inflation data will get us there, there are still plenty to keep our focus. So let’s get out of our seats, stretch our legs, and see if we can get a picture of three things we are currently paying close attention to.
Yes, everyone pays attention to the consumer. Consumer spending is far too important to the economy not to. We’ve taken time in the past looking at the amount of debt being racked up by the consumer in this country. No need to reprint that again. It’s a lot. Worse, as we know, it was being done during a time when borrowing rates relentlessly rose. But the employment numbers and enough wage growth gave everyone some comfort that the consumer would be able to withstand the cost of carrying that additional debt load and keep spending. Well, it’s starting to look at little bit like the consumer is bending some. As illustrated below, the delinquency rate on credit card loans has hit a decade high. Giving the high balances being carried on what is typically a very expensive form of debt, that isn’t great news.
Source: Federal Reserve
More uncomfortable is that a majority of those same consumers are also borrowers who have the additional burden of carrying mortgage debt during this same period of rising rates. The story is similar. We are witnessing an uptick in mortgage delinquencies. Credit card delinquencies have ramifications of course, causing those consumers in trouble to typically step back from spending, so with the squeeze on the ability to pay negatively impacting financial firms balance sheets due to losses on the loans while at the same time negatively affecting corporate profits and their revenues. Mortgages is a whole other world of hurt. No need to revisit the Great Financial Crisis on this. We don’t feel we are headed there. Nevertheless, the impact of a downturn in housing can be far reaching, affecting multiple sectors in their wake. However you look at it, this is just another sign that the consumer and borrower are starting to feel the weight of higher for longer rates. The trend is troubling. And another reason for us to remain vigilant on credit overall.
Source: Bloomberg, Consumer Financial Protection Bureau
Halfway through the calendar, but where are we in cleaning up the commercial real estate problems? We spend a great deal of time watching this. We get asked a lot where we think we are in the cycle. Halfway seems about right. But like going to see the continental divide, if you think driving up to the midpoint was scary, wait until you start heading down the other side of the mountain. You don’t want to be in the position of hoping your brakes work. Knowing they will is always more comforting.
One of the bigger fallouts of this topic of late has been the headlines highlighting the fact that not only is commercial real estate still a major issue, but that it is negatively affecting commercial mortgage-backed securities (CMBS) transactions at the highest level of the credit stack. Typically, if a deal is structured properly and valuations are in-line, it is pretty rare that credit issues creep up even in the investment-grade part of the credit stack. What is happening in CMBS right now isn’t even close to typical. Indeed, the AAA-rated bonds in some poorly performing, and in most cases, heavy-office concentrated deals are not only get downgraded but are seeing actual impairments. Getting 75 cents on the dollar for a what was initially rated AAA security is disconcerting to say the least. Furthermore, with each occurrence and forced sells of buildings, valuations start to become clearer and that is sure to cause more dominoes to fall. There is more pain to come in the space. As illustrated below, the CMBS 30+ day delinquencies continue to rise, according to Bloomberg data. If we are halfway or so through, that still means plenty of fallout still to look out for.
Source: Bloomberg
One other concerning sign, there seems less than needed capital to come to the rescue. In the past, the SEC and the Fed had been eager to push risk off banks’ balance sheets and into the private sector. That works great of course until a pension fund who is in a private equity fund has a huge loss and it creates a headline. Nevertheless, in the Fed’s view, it is better than banks taking massive hits. Well, for commercial real estate, a great deal of this risk is still on the local lender, smaller regional and community banks. Worse, as illustrated below, and highlighted by a Bloomberg report, there is less and less private money available to help. I suspect that is partly due to the newfound allure of private debt in the private equity space. The good news is that there is still some $400 billion available to clean this up. The bad news is that isn’t nearly enough, and as these smaller banks turn desperate to shed the risk, the smaller pool of capital available will drive transaction prices and thus residual valuations lower and lower, further hurting those still holding the loans. We still have a long and hazardous road ahead.
Source: Bloomberg, Preqin
In the past we have discussed targeted issuers and potential performance upside opportunities. Carnival Cruise Lines (CCL) was one such issuer. Two years ago, we highlighted the issuer as a solid target for performance purposes. Battered by Covid fallout, the cruise line operator, which was once investment grade (IG) rated, found itself getting its credit ratings shredded and having to borrow at wide credit spreads even when issuing debt on a secured basis. With some faith in management and an expectation that coming out of the pandemic lockdowns pent-up demand would be unleashed, we liked the credit for a bounce back. As illustrated below, that proved to be a reasonable assumption and the credit has done well. Furthermore, Standard & Poor’s (S&P) has rewarded management efforts by upgrading the company’s unsecured credit rating. Knocked down to single B in May of 2022, today the company is rated BB by S&P.
Source: Bloomberg, Federal Reserve
CCL’s current credit spreads, as defined by its option-adjusted spread (OAS) properly reflect its current rating level. We have some exposure to this credit*. We anticipate despite the headwinds discussed above with regards to the consumer, that with rate cuts and their strengthening credit fundamentals, CCL should be able to refinance debt and fund itself at more attractive levels, mitigating the impact of those headwinds. More importantly, how we look at the credit in terms of its place in the portfolio shifts as well. Once targeted for its upside in terms of performance, CCL has entered a different phase. It becomes more desirable for its liquidity and diversification benefits, as well as its reliable income. It’s a prime example of how issuers’ attributes evolve over time and how we determine what “buckets” we think of them in. We continue to focus on credit, liquidity and diversification. An issuer that can exhibit improving fundamentals are obviously more preferred, especially those providing additional benefits such as liquidity and diversification. As credit softens, we expect an ability to identify these types of firm strengths, characteristics, and attributes an opportunity to not only strengthen portfolio performance, but also important in maintaining the levels of liquidity and diversification we seek.
I made it down the mountain that day. Better yet, I also figured out a different route home. And that is kind of where we are right now. We’re halfway through the year, and maybe a little further than halfway in the cycle of some of the things we are keeping an eye on. There can be little guard rails when cycles shift, so it is important to make sure we stay focused on the road and make sure we remain true to our targets. And when the circumstances demand it, identify a better route.
It would seem softer economic data has finally begun to make a dent on the collective thought with regards to rate expectations. May was defined by the capitulation that rates will stay higher for longer stance, but the hope of rate cuts has gradually pushed forward and by the end of June we were witness to positive momentum. While the overall movement in the 2-year treasury wasn’t significant in terms of overall numbers, the idea that it traded within a relatively tight band, with a slight overall rally for the month was encouraging. The 2-year treasury started June with a yield of 4.81% and ended the month at 4.75% yield. The 10-year treasury was a bit different, with overall movement very little from beginning of the month to the end of the month, but in-between had days where it rallied as much as 6 or 7 bps mixed in with days of selling off as high as 15 bps. The consistency of the tighter band in the short end of the curve was helpful, as it promoted some sense that the market is coming to a consensus on where expectations sit. Additionally, the volatility on the longer end of the curve provides opportunity if one is willing to sell and buy at the proper moments. The Fed continues to be content to let things stay as they are. Our expectations have not wavered, and a consistent viewpoint can be helpful especially on days the 10-year treasury becomes irrationally volatile. Our view remains steadfast with previous expectations and continue to position ourselves in a manner that focusses on a one to two rate cut future. As a result, the portfolio remains positioned in a manner that best reflects those expectations and in order to best take advantage of the best opportunities for potential overperformance prior to and once a rate cut occurs.
Both investment grade (IG) corporate risk and high yield (HY) corporate risk continue to be a battlefield defined by tight credit spreads. It’s a segment-by-segment basis in terms of weakness, but atmosphere and investor demand results in historically tight bands when looking at overall credit spreads. This in the face of economic activity that indicates a cooling economy and some stress occurring, especially at the sub-prime consumer level, due to the longer for higher rate environment. In addition, as we discussed previously, we have also been seeing a rise of demand in some of the more esoteric asset-backed securities (ABS) segments. These seem to indicate to us that credit is being priced to perfection and a trusting investor has an overexuberant appetite for credit risk. We are wary. This is generally a sign that under the wrong geopolitical or unexpected credit stress there is sure to be an immediate negative response in the credit markets. In response, we continue to prefer staying higher up in the credit stack and focused on our targeted issuer universe. We remain convinced there is far more value in those spaces and that they provide some protection if economic conditions shift to a more negative tone.
Even entering the summer vacation part of the calendar hasn’t slowed the new issuance market. Heavy corporate issuance continues, with a pick-up in both HY issuance as well as Latin America sovereigns issuance. As such, demand remains strong for primary issuance and deals continue to be defined by tight spreads and heavy oversubscription. On occasion that has led to some deals, however, being launched too tight and we have begun to see some blowback in terms of secondary market activity as there is less demand for certain deals and they have seen some giveback when accounts try and sell them as soon as they get them. The demand for ABS, as noted, remains strong, with some deals starting to be launched with anchor investors and preplaced orders creating the sense that not only will those deals expect heavy investor interest but surely they will be issued at tighter spreads. This is creating at least an initial illusion of heavy interest, but on the esoteric deals, that strategy has hurt investors in certain deals as secondary activity does not match what the primary issuance would seem to indicate. Furthermore, dealer inventories continue to grow. This is a strong sign as it aids liquidity overall and provides a strong market depth for bid and offer activity. However, it is also worth monitoring, as a dealer slowdown in this area could push pressure on the secondary market. Nevertheless, overall market liquidity remains strong and allows for easy repositioning of portfolio holdings and the ability to transact in a targeted manner if opportunities present themselves.
We continue to find favorable market conditions in the fixed income space overall. Credit is seemingly in a strong position, but we remain vigilant for slippage. Liquidity market depth remains helpful and deep, allowing for seamless execution when needed. A soft landing continues to seem likely, but clear cooling in the economy is occurring. The market eagerly anticipates a near-term rate cut.
Noted asset sector target or bias this month includes:
Rates continue to be in a holding pattern. But recent economic data is beginning to apply pressure to the Fed in support of their reducing rates. Credit continues to be priced to perfection, reducing wriggle room for any missteps. We expect with a cooling economy and more fallout from retail names and commercial real estate impact that pressure on credit spreads are more likely than not. We continue to expect at least one rate cut before year-end, and with a slightly cooling economy, some give in credit spreads. As a result, we continue to prefer to be defensive, strengthening credit, reducing risk and moving to more liquid exposures. The front end of the yield curve (the 1-3 year maturity area) is the area that we expect to see the most value, and the area of the curve most likely to overperform in the near-term. Longer duration is targeted in an effort to capture wider current yields in certain targeted highly liquid names, which should overperform in most rate rallies and possibly certain credit events in our view. We have moved duration out, targeting specific targets as we anticipate small rallies in rates over the near-term and as a means to lock in higher yields at favorable pricing for a longer period of time.
*As of August 31, 2024, no Yorktown Funds fixed income fund has exposure to these firms.
*Yorktown Funds currently has 0.95% exposure to CCL in the Yorktown Multi-Sector Bond Fund, as of June 30, 2024 and based on current market value. Holdings are subject to change and do not constitute a recommendation or solicitation to buy or sell a particular security.
Definition of Terms
Basis Points (bps) - refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%, or 0.0001, and is used to denote the percentage change in a financial instrument.
Curvature - A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity.
Mortgage-Backed Security (MBS) - A mortgage-backed security is an investment similar to a bond that is made up of a bundle of home loans bought from the banks that issued them.
Collateralized Loan Obligation (CLO) - A collateralized loan obligation is a single security backed by a pool of debt.
Commercial Real Estate Loan (CRE) - A mortgage secured by a lien on commercial property as opposed to residential property.
CRE CLO - The underlying assets of a CRE CLO are short-term floating rate loans collateralized by transitional properties.
Asset-Backed Security (ABS) - An asset-backed security is an investment security—a bond or note—which is collateralized by a pool of assets, such as loans, leases, credit card debt, royalties, or receivables.
Option-Adjusted Spread (OAS) - The measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option.
Enhanced Equipment Trust Certificate (EETC) - One form of equipment trust certificate that is issued and managed through special purpose vehicles known as pass-through trusts. These special purpose vehicles (SPEs) allow borrowers to aggregate multiple equipment purchases into one debt security.
Real Estate Investment Trust (REIT) - A company that owns, operates, or finances income-generating real estate. Modeled after mutual funds, REITs pool the capital of numerous investors.
London InterBank Offered Rate (LIBOR) - a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans.
Secured Overnight Financing Rate (SOFR) - a benchmark interest rate for dollar-denominated derivatives and loans that is replacing the London interbank offered rate (LIBOR).
Delta - the ratio that compares the change in the price of an asset, usually marketable securities, to the corresponding change in the price of its derivative.
Commercial Mortgage-Backed Security (CMBS) - fixed-income investment products that are backed by mortgages on commercial properties rather than residential real estate.
Floating-Rate Note (FRN) - a bond with a variable interest rate that allows investors to benefit from rising interest rates.
Consumer Price Index (CPI) - a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them.
Gross Domestic Product (GDP) - one of the most widely used measures of an economy's output or production. It is defined as the total value of goods and services produced within a country's borders in a specific time period—monthly, quarterly, or annually.
Perp - A perpetual bond, also known as a "consol bond" or "perp," is a fixed income security with no maturity date.
Nonfarm payrolls (NFPs) - the measure of the number of workers in the United States excluding farm workers and workers in a handful of other job classifications. This is measured by the federal Bureau of Labor Statistics (BLS), which surveys private and government entities throughout the U.S. about their payrolls.
Net Asset Value (NAV) - represents the net value of an entity and is calculated as the total value of the entity’s assets minus the total value of its liabilities.
S&P 500 - The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on exchanges in the United States.
German DAX - The DAX—also known as the Deutscher Aktien Index or the GER40—is a stock index that represents 40 of the largest and most liquid German companies that trade on the Frankfurt Exchange. The prices used to calculate the DAX Index come through Xetra, an electronic trading system.
NASDAQ - The Nasdaq Stock Market (National Association of Securities Dealers Automated Quotations Stock Market) is an American stock exchange based in New York City. It is ranked second on the list of stock exchanges by market capitalization of shares traded, behind the New York Stock Exchange.
MSCI EM Index - The MSCI Emerging Markets Index captures large and mid cap representation across 24 Emerging Markets (EM) countries. With 1,382 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
Nikkei - The Nikkei is short for Japan's Nikkei 225 Stock Average, the leading and most-respected index of Japanese stocks. It is a price-weighted index composed of Japan's top 225 blue-chip companies traded on the Tokyo Stock Exchange.
Shanghai Composite - is a stock market index of all stocks (A shares and B shares) that are traded at the Shanghai Stock Exchange.
Bloomberg U.S. Agg - The Bloomberg Aggregate Bond Index or "the Agg" is a broad-based fixed-income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.
MOVE Index - The ICE BofA MOVE Index (MOVE) measures Treasury rate volatility through options pricing.
VIX Index - The Cboe Volatility Index (VIX) is a real-time index that represents the market’s expectations for the relative strength of near-term price changes of the S&P 500 Index (SPX).
Dow Jones Industrial Average - The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry.
Hang Seng - The Hang Seng Index is a free-float capitalization-weighted index of a selection of companies from the Stock Exchange of Hong Kong.
STOXX Europe 600 - The STOXX Europe 600, also called STOXX 600, SXXP, is a stock index of European stocks designed by STOXX Ltd. This index has a fixed number of 600 components representing large, mid and small capitalization companies among 17 European countries, covering approximately 90% of the free-float market capitalization of the European stock market (not limited to the Eurozone).
Euro STOXX 50 - The EURO STOXX 50 Index is a market capitalization weighted stock index of 50 large, blue-chip European companies operating within eurozone nations.
CAC (France) - is a benchmark French stock market index. The index represents a capitalization-weighted measure of the 40 most significant stocks among the 100 largest market caps on the Euronext Paris (formerly the Paris Bourse).
U.S. MBS Index - The S&P U.S. Mortgage-Backed Securities Index is a rules-based, market-value-weighted index covering U.S. dollar-denominated, fixed-rate and adjustable-rate/hybrid mortgage pass-through securities issued by Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC).
Duration Risk - the name economists give to the risk associated with the sensitivity of a bond's price to a one percent change in interest rates.
Federal Open Market Committee (FOMC) - the branch of the Federal Reserve System (FRS) that determines the direction of monetary policy specifically by directing open market operations (OMO).
United States Treasury (UST) - the national treasury of the federal government of the United States where it serves as an executive department. The Treasury manages all of the money coming into the government and paid out by it.
High Yield (HY) - high-yield bonds (also called junk bonds) are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds. High-yield bonds are more likely to default, so they must pay a higher yield than investment-grade bonds to compensate investors.
Investment Grade (IG) - an investment grade is a rating that signifies that a municipal or corporate bond presents a relatively low risk of default.
Exchange Traded Fund (ETF) - an exchange traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset, but which can be purchased or sold on a stock exchange the same as a regular stock.
Federal Family Education Loan Program (FFELP) - a program that worked with private lenders to provide education loans guaranteed by the federal government.
Business Development Program (BDC) - an organization that invests in small- and medium-sized companies as well as distressed companies.
Job Opening and Labor Turnover Survey (JOLTS) Report - is a monthly report by the Bureau of Labor Statistics (BLS) of the U.S. Department of Labor counting job vacancies and separations, including the number of workers voluntarily quitting employment.
Sifma - The Securities Industry and Financial Markets Association (SIFMA) is a not-for-profit trade association that represents securities brokerage firms, investment banking institutions, and other investment firms.
Duration - A calculation of the average life of a bond (or portfolio of bonds) that is a useful measure of the bond's price sensitivity to interest rate changes. The higher the duration number, the greater the risk and reward potential of the bond.
Trust Preferred Securities (TruPS) - hybrid securities issued by large banks and bank holding companies (BHCs) included in regulatory tier 1 capital and whose dividend payments were tax deductible for the issuer.
Treasury Inflation-Protected Securities (TIPS) - are a type of Treasury security issued by the U.S. government. TIPS are indexed to inflation to protect investors from a decline in the purchasing power of their money. As inflation rises, rather than their yield increasing, TIPS instead adjust in price (principal amount) to maintain their real value. The interest rate on a TIPS investment is fixed at the time of issuance, but the interest payments keep up with inflation because they vary with the adjusted principal amount.
You should carefully consider the investment objectives, potential risks, management fees, charges and expenses of the fund before investing. The fund's prospectus contains this and other information about the fund and should be read carefully before investing. You may obtain a current copy of the fund's prospectus by calling 1-800-544-6060.
Fixed income investments are affected by a number of risks, including fluctuation in interest rates, credit risk, and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall.
Past performance is no guarantee of future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. There is no guarantee that this, or any, investing strategy will succeed.
Diversification does not ensure a profit or guarantee against loss.
Yorktown funds are distributed by Ultimus Fund Distributors, LLC. There is no affiliation between Ultimus Fund Distributors, LLC and the other firms referenced in this material.