Harvesting opportunities: Income diversification for uncertain times

Key takeaways:

• The Fed continues to hold interest rates steady as it focuses on the totality of economic data before it begins to cut rates. Meanwhile, the markets now expect the Fed to cut rates only once toward the latter part of this year.
• Corporate bond spreads have tightened as the probability of a US recession has declined compared to a year ago.
• As the Fed eventually lowers interest rates, we believe corporate bonds, especially investment grade, could offer opportunities for both income and total return.
• While the broader equity market has been somewhat resilient, it has been fairly range-bound as many companies in different sectors have failed to meet earnings expectations.
• In our analysis, there are interesting opportunities in equities as the market overreacts to the short-term disappointments of high-quality companies we believe have longer-term potential.

Evolving inflation and interest-rate expectations

Looking back at these past six months, hotter-than-expected inflation data has shifted market expectations for interest-rate cuts in 2024. Going into the most recent Federal Open Market Committee Meeting (FOMC) meeting, some market participants were actually concerned we might see a hawkish Federal Reserve (Fed) and some talk of fed funds rate hikes coming. However, Fed Chairman Jerome Powell put these worries to rest and stressed that policymakers are looking at the totality of data and not just pieces of economic data that might not be pointing in the same direction.

In our opinion, the Fed’s March summary of economic projections, as shown in Exhibit 1, is about as good as it gets. The Fed expects gross domestic product (GDP) growth to remain resilient and maintain a level above longer-term expectations. Similarly, Fed policymakers do not foresee unemployment rising materially over the next several years despite the tightening they put in place. In our opinion, with initial jobless claims increasing to the highest level in quite some time, comprehensive labor market surveys may be overstating job growth. Thus, the labor market will be a key focal point for us in the near term.

Turning to inflation, the latest reading of the year-over-year Core Personal Consumption Expenditure Index (PCE) was around 2.8%, which is at the upper end of the Fed’s projections and within reach of its 2.6% median. The Fed expects core PCE to go down to its target at which point it will gradually normalize the fed funds rate over the next several years. The Fed’s projected fed funds rate by year-end is 4.6%–5.1%.¹ We will certainly watch how the Fed’s projections will change—the next release is in June—and what these will tell us about monetary policy going forward.

As of now, we believe the Fed will likely stay on hold through the end of the summer and possibly start cutting rates thereafter. The market, which was pricing in three—and even as high as six or seven—rate cuts through the end of 2024, is currently pricing only one cut this year.

Tighter corporate bond spreads and still-elevated yields

Relative to a year ago, we’ve seen a substantial spread contraction in both the investment-grade corporate bond (as measured by Bloomberg US Corporate Index) and the high-yield corporate bond (as measured by the Bloomberg US Corporate High Yield Bond Index) universes.² Spreads were wider a year ago because the probability of a US recession was significantly higher then than it is today.³ This scenario gave us a nice opportunity in terms of yields. As the recession probability has declined and corporate fundamentals have remained resilient, we’ve seen spreads contract to levels that are closer to historical tight ranges. Investment-grade corporate bonds, which were around 150 basis points (bps) over comparable maturity US Treasuries a year ago, are down to around 100 bps. High-yield bonds, which were around 500 bps, are now down to around 300 bps.⁴ As long as corporate fundamentals remain intact, to us this isn’t cause for alarm as we’ve historically seen spreads stay at similar levels for extended periods of time. And, these yields are priced off of still-elevated US Treasury yields.

As shown in Exhibit 2, corporate bond yields declined to historical lows in 2020 (resulting in very high bond prices) and then yields rose to elevated levels in 2022 (resulting in bond prices falling precipitously). Since then, yields have been what we consider very attractive relative to what we’ve seen in the last decade and a half. For instance, coupons for investment-grade corporate bonds (currently our preferred sector within fixed income) have been around 5.5%.⁵ In our opinion, this could provide a good opportunity, particularly as we think about extending duration and potentially benefiting from a longer-term normalization in interest rates.

Right now, cash and short-term fixed income assets offer what we consider an attractive income level. However, as the Fed eventually lowers interest rates in the next 6-18 months, we believe the differential between shorter-term fixed income and longer-duration corporate securities will be substantial, in addition to the latter’s total return opportunity.

Additionally, as we look at these ranges of yields, especially combined with the average bond prices in each of these universes, they're still around 8%–10% below par value.⁶ This presents the opportunity to buy bonds not only with attractive yields but also below their face value.

Broader opportunities in equities

While the Magnificent Seven⁷ companies were an important driver in the equity market last year, there has been some broadening as well as some divergence so far this year. Based on the most recent earnings season that has largely wrapped up, many companies in different sectors have failed to meet expectations and thus, have been unable to move the broader indexes to a higher level. So, while the broader equity market has been somewhat resilient, it has been fairly range-bound. For instance, the Standard & Poor’s 500 Index has largely gone sideways from around 5100 in early March to 5200 in early May.

In our analysis, with overall market expectations still high for the rest of the year and into next year, underneath the surface more than 40% of the broader universe of stocks have declined (see Exhibit 3). These are the areas we believe we can find some interesting opportunities. In fact, we’ve been able to move some of our income strategies away from fixed income, particularly non-investment grade, toward some of these opportunities in equities.

Through the rest of this year, we expect to gradually pursue a bit more balance between equity and fixed income. Our equity focus is on companies with good long-term potential, and where we believe there are attractive valuations and income potential. This includes dividend-paying common stocks, convertibles, traditional preferred securities and equity-linked notes (ELNs).⁸

We believe it is important to maintain diversification across sectors. Within equities, we’ve moderated some of our exposure in financials as valuations in the bigger US banks have recovered. Conversely, we’ve increased our exposure to health care, energy and utilities. We’ve also found opportunities to participate in the artificial intelligence (AI) revolution through some technology companies’ ELNs, as more companies are adopting AI to improve their operations and as the energy and electric utilities sectors begin to benefit from AI’s increasing power usage. 

Conclusion

While there is some uncertainty on the forward path of the economy and monetary policy as well as the impact that the US elections could have as we get into the latter part of this year, our strategy is to maintain a highly diversified portfolio and employ a dynamic approach across all asset classes.