Investment Review and Outlook

As late-quarter data indicated inflation moved closer to target, expectations of rate cuts increased.

Investors watched economic data throughout the second quarter, trying to assess if and when the Federal Reserve (Fed) might lower interest rates. A rise in inflation in April discouraged hopes for an imminent cut. The Federal Open Market Committee (FOMC) left rates unchanged after meeting in April and June.

In late-June more encouraging data arrived, with Core Personal Consumption Expenditures price inflation at 0.08% month-over-month (M/M) in May, bringing the annual rate to 2.6 percent. The Fed’s inflation target is 2 percent annually, according to the Bureau of Economic Analysis (BEA).

Personal spending, as measured by Real PCE rose more than expected, up 0.3 percent M/M, following a decline in the prior month, the BEA reported. In addition, the BEA increased its third estimate of Q1 gross domestic product (GDP) growth to 1.4 percent quarter-over-quarter (Q/Q) on a seasonally adjusted annual rate.

Higher corporate event risk is evidenced by 19 percent more U.S. mergers and acquisitions year-over-year (Y/Y) in the second quarter and the re-emergence of debt-funded deals, according to BBG data.

A careful monitoring of increasing geopolitical risk is warranted due to high profile elections globally that hold the potential for regime change and ongoing conflicts in the Middle East, between Israel and Hamas, and Europe, between Russia and Ukraine, all of which could affect economic outlooks and investor sentiment.

Breckinridge Investment Committee’s (IC’s) base case is that economic growth will slow in the second half of the year, in response to the Fed’s restrictive monetary policy, which has impacted small businesses and lower-income households. We expect the Fed to reduce the funds rate twice before year-end 2024, as core PCE inflation moves closer to the FOMC’s 2 percent target. 

With nominal bond yields still relatively high, we view IG fixed income as attractive. We are defensive due to still-tight valuations in most spread sectors, although we are seeing spread widening in certain areas.

Valuations

Corporate spreads were 4bps wider in the second quarter, closing at an OAS of 94bps. Spreads are in the 13th percentile of their 10-year range. 

 While there is certainly still room to widen further, June 2024 marked the first monthly widening of the U.S. Corporate IG Index OAS since October 2023, when the OAS hit 129bps, 8 bps wider than the prior month-end close.

Relatively compressed valuations argue for a defensive posture. Spreads may drift wider as tight Fed policy eventually slows the economy.

Technicals

Second quarter bond supply moderated from record levels in the first quarter. Fixed-rate, gross investment grade bond supply was $406 billion in 2Q24.⁵

Investment flows to long-term taxable bond funds⁶ also fell to about $78 billion, per Investment Company Institute data, as of July 3, 2024.⁷ Non-U.S. investors and insurance companies also continue to add to the IG corporate bond asset class.⁸

Fundamentals

We believe credit fundamentals are stable. U.S. investment-grade Agency rating upgrades exceeded rating downgrades in 1H24 and for FY23.⁹ Operating margins have improved, and earnings were up 6 percent in 1Q24 Y/Y. While interest coverage has declined notably (partially due to rates), leverage is steady. Commercial real estate remains an area of concern for Financial issuers.

FactSet analysts in aggregate predict the S&P 500 will report year-over-year earnings growth of 11.3 percent in 2024 and 14.4 percent in 2025. If these numbers are the actual earnings growth rates for these years, it will mark the third time in the past 15 years that the S&P 500 has reported two consecutive years of double-digit earnings growth, FactSet said.¹⁰

Late in the second quarter, various court rulings were issued that may impact mandates and the scopes of various regulators across different sectors.¹¹ Shifting regulations may present near-term profit opportunities and longer-term sustainability risks.

Sustainable Spotlight

Sustainability frameworks help to shape the work of Breckinridge security analysts as they assess the credit worthiness and sustainability of corporate, municipal, sovereign, and securitized bonds. The analyst team periodically updates existing frameworks and launches new ones as additional data and new methods of factoring data in security analysis are developed.

During the second quarter, Breckinridge implemented its commercial mortgage-backed securities (CMBS) framework. As with other Breckinridge credit research, material sustainability metrics are integrated in security analysis and are reflected in the frameworks. 

Recently, Breckinridge implemented a research framework that supports sustainability risk assessments for underlying loans comprising a conduit CMBS. 

Breckinridge’s CMBS research framework takes a climate-focused approach, considering physical climate risks to the properties securing underlying loans such as hurricane, wildfire, and flooding. 

The framework’s regional lens employs collateral mapping to geolocate properties. Third-party climate and loan data are integrated into the model. The framework enables analysis of the average total climate exposure at the deal level.

[1] The Bloomberg U.S. Corporate IG Bond Index is an unmanaged market-value-weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more. You cannot invest directly in an index.

[2] Bloomberg US Corporate Bond Index, Breckinridge, 6/30/24.

[3] Bloomberg Intelligence. Note: IG issuer trimmed mean (Bottom/Top 10%) financial data as of 3/31/24.

[4] Barclays US Investment Grade Corporate Update, June 2024.

[5] Barclays US Investment Grade Corporate Update, July 1, 2024.

[6] Mutual funds and exchange-traded funds (ETFs).

[7] Estimated Long-Term Mutual Fund Flows, Investment Company Institute, July 3, 2024.

[8] Financial Accounts of the United States, Federal Reserve Flow of Funds, First Quarter 2024.

[9] Moody’s Ratings, S&P Global Ratings, Fitch Ratings, U.S. IG rating actions, Bloomberg data, June 30, 2024.

[10] “Analysts Project S&P 500 To Report Double-Digit Earnings Growth for 2024 and 2025,” by John Butters, June 21, 2024.

[11] U.S. Supreme Court decision to overturn Chevron, U.S.A. vs. Natural Resources Defense Council, June 28, 2024.

BCAI-07072024-kgvgm7n0 (7/10/24)

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