Weekly Investment Update (08/09/2024)

It was a volatile week for markets as concerns about economic weakness drove market swings in the aftermath of last Friday’s weaker-than-expected labor market report. On Thursday, better-than-feared jobless claims helped to soothe fears of an imminent recession. By midday Friday, equity markets recovered roughly a third of the recent drawdown.

The VIX index, a measure of S&P 500 volatility implied from options contracts, reached 65.7 on Monday morning, a level not seen since the initial COVID outbreak in March 2020. Market volatility appears to have been exacerbated by several technical factors, including the unwinding of carry trades, stretched positioning, and low liquidity. While market pullbacks can be uncomfortable, especially when they occur rapidly, we note that the 8.5% drawdown seen in recent days is below the average drawdown of 14.1% experienced during a calendar year since 1986. We also are mindful that volatility is likely to remain higher as we approach a seasonally weaker period, with the upcoming U.S. elections and geopolitical risks lingering in the background.

While growth is slowing, economic fundamentals remain solid. The loosening in the labor market primarily has been driven by increasing labor supply rather than softening labor demand. Strong services PMIs remain consistent with a consumer that is still spending, and corporate earnings are growing ~10% year-over-year. Many companies have been able to fight revenue headwinds by cutting costs to maintain strong margins. Credit spreads have widened only modestly relative to equity volatility, and high-yield defaults remain low (detailed below). Importantly, we believe the Federal Reserve is still in position to cut rates, and several Fed speakers this week indicated these cuts are coming as soon as September.

We believe Bessemer portfolios are positioned to withstand volatility. Bonds have been protecting on the downside, outperforming cash, and our long-duration positioning has allowed portfolios to capture price upside in bonds as investors moved to price in additional rate cuts. In equity portfolios, our overweight to the U.S. as well as to the industrials and healthcare sectors, and our quality bias, have fared well from a regional, sector, and factor standpoint. For additional thoughts on the recent market volatility, please see our latest Investment Update and video.

Treasury Market Volatility and Fixed Income Positioning

What is happening: Volatility in the Treasury market has increased markedly since the Federal Reserve’s meeting in July. Earlier this week, the MOVE Index, which tracks Treasury market volatility, reached its highest level all year. Dovish comments from the Fed coupled with a softer-than-expected jobs report led the market to price in a more aggressive cutting cycle, pushing rates lower. Futures data now show over 100 basis points of rate cuts this year, up from 66 basis points prior to the Fed’s last meeting.

The volatility in rates was exacerbated as the Bank of Japan (BoJ) hiked its policy rate and signaled for more monetary tightening. The divergence in policy between the Fed and BoJ helped strengthen the yen, leading to an unwinding of “carry trades” in which investors borrowed in the low-yielding yen to purchase other higher-yielding assets. This unwind led to a flight to the safety of U.S. Treasuries and a steeper yield curve, with the spread between 2- and 10-year yields briefly un-inverted Monday for the first time since July 2022. However, yields unwound some of the move after stronger ISM Services data allayed fears of a sharper economic slowdown and dovish comments from the BoJ helped stabilize markets.

Why it matters: While the increase in Treasury market volatility was sudden, it did not reach a level sufficient to cause wider market disfunction. Volatility is likely to persist as uncertainty in the economic outlook shifts pricing on Fed policy, and divergences between central bank policies bring to light market leverage. However, we believe central banks remain sensitive to market disfunction and are better prepared to address any issues through their use of balance sheet policies or other tools. Interest rate decisions are more likely to be driven by domestic economic conditions. With inflation closer to 2%, the labor market near equilibrium, and policy rates in restrictive territory, the Fed has signaled a much greater willingness to cut rates to support its mandate of maintaining full employment. Our fixed income team has maintained a long-duration posture as the Fed continues to signal a more dovish reaction function.

Despite Fears of Contagion, Credit Markets Remain Insulated from Cross-Asset Volatility So Far

What is happening: Credit has remained remarkably insulated even as volatility reached year-to-date highs across multiple asset classes. High-yield bond returns are flat month-to-date, with losses of only 0.6% during Monday’s global selloff. High-yield spreads (the additional yield demanded by investors for increased default risk relative to Treasuries) increased notably from 325 basis points to a peak of 381 basis points. However, most of the increase reflected Treasury yields falling, not price declines in lower-rated bonds due to an increase in implied default risk.

While the daily change in spreads was historically large, absolute levels remain benign. Credit spreads have averaged 4.9% over the past 30 years. An increase from the overly tight levels experienced thus far in 2024 to 339 basis points by the end of the week is most likely indicative of spreads normalizing toward fair value levels, not elevated stress in credit markets.

Why it matters: The ability of businesses to finance themselves is a core function of any corporate entity, especially for lower-rated and less-cashflow-heavy companies. Given this reality, credit markets serve as a key indicator of the health of the U.S. economy. While equity markets can suffer frequent episodes of volatility, credit spreads tend to materially expand only during times of pronounced economic stress.

Currently, corporate fundamentals remain sound. Default rates in high yield fell to 1.78% in July, an 18-month low. Interest coverage and gross leverage ratios, which reflect the ability of high-yield companies to pay coupons and the total debt on balance sheets, remain at some of the strongest levels respectively in decades as companies took advantage of the previous low-interest-rate environment to refinance their capital structure. Taken together, these tailwinds have acted to dampen contagion from other asset classes and markets.

What could change this backdrop? A deterioration in economic fundamentals or stress in short term funding markets. While both these possible scenarios warrant monitoring, neither seem imminent. To note, U.S. high-yield exposure within Credit Income remains below-target weights and conservatively positioned, as the team looks to increase exposures at more attractive valuations, given the strong fundamental underpinnings.