Inflation is a scourge. We know it. The Federal Reserve does, too. And in response, they’ve been taking aggressive measures to remove some of the accommodative measures previously used to keep the economy afloat since the COVID-19 pandemic.

A series of aggressive rate hikes has been working to tame inflation to a large degree. The Core PCE Price Index, the Federal Reserve's preferred measure of inflation, has fallen to 4.1%, according to the U.S. Bureau of Labor Statistics. Still, this remains above the Fed’s target, so after pausing briefly after 10 consecutive rate hikes in May, the Fed hiked again at the July FOMC meeting. The Fed boosted the fed funds rate by 25 basis points, bringing it to a target range of 5.25% to 5.50%, which is the highest level since 2001.  

As we all know, this inflation fight has not been without severe ramifications. Both equity and fixed income markets suffered through a dreadful 2022 during the steepest of the rate hikes. As the Fed eased off the accelerator earlier this year, financial markets have been much more buoyant. But challenges remain in this new environment. For example, investors are grappling with an inverted yield curve whereby short-term yields are more attractive than 10-year Treasury yields. Does this suggest a slowing economy? Or is it just a point-in-time and the result of an unusual confluence of events? And what does it all mean for future monetary policy and the direction of interest rates, which we all know is historically difficult to predict.

Given this backdrop and the recent Fed rate decision, here is some perspective for fixed income investors looking out to the remainder of 2023 and beyond:

1. Yields are higher across the curve. Above all else, this should be constructive for new allocations, in our opinion. We contend that fixed income returns over time have been shown to be highly dependent on the starting yield, and thus the fixed income asset class as a whole appears attractive by this measure.
2. Fixed income valuations appear attractive relative to equities. For evidence, we point at a comparison of both Treasury bonds and investment grade bonds versus the S&P 500®. As of July 2023, the yield on the 10-year U.S. Treasury exceeded the dividend yield on the S&P 500, which in our view suggests that bonds may be cheap. This view is further supported by the fact that the yield on investment grade corporates has surpassed the earnings yield on the S&P 500.
   
3. Inflation remains a factor. Inflation has waned, but it is not necessarily licked. We would expect the push and pull of inflation, along with economic growth and employment data, to shape future Fed policy and drive bouts of volatility for the remainder of 2023.
   
4. Macroeconomic uncertainty abounds. We think the odds of a recession are elevated for the second half of 2023 or early 2024, particularly after the latest rate cut. The Conference Board Leading Economic Index® is down 4.2% over the six-month period between December 2022 and June 2023, signaling the likelihood of a recession within the next 12 months. The combination of inflation, recession risks, and Fed policy could revive market volatility during the second half of the year.
   
5. This environment is ripe for active management. During times of uncertainty, prices may dislocate from fundamentals, thereby creating opportunities in various sectors and sub-asset classes. For example, many corporates are entering this period of economic uncertainty on the tailwinds of strong earnings and relatively healthy balance sheets, but we’ve already seen turmoil in the banking sector and there is mounting pressure on other sectors, such as commercial real estate. This is where teams of credit analysts can dig into the details to determine if prices have dislocated from fundamentals, or if eschewing a certain sector is warranted.
   
   Active managers can also take on a defensive posture and/or tilt portfolios to certain segments of the fixed income market. For example, Asset Backed Securities (ABS) and Agency Mortgage Backed Securities (MBS) look attractive, in our view, relative to other fixed income asset classes. Meanwhile, we think corporate investment grade and high yield sectors look expensive, given macro risks.

These are interesting times in the fixed income market, but it’s certainly not all bad news in our opinion. To the contrary, we believe that that fixed income looks attractive on an absolute and relative basis, perhaps more so than in recent years. We are nonplussed by the Fed’s latest rate hike and believe that now is a good time to consider new allocations. Of course, it always depends on an individual’s ultimate investment objectives and risk tolerance.