Beyond August volatility: Outlook from our investment grade experts

In August, markets experienced a surge in volatility as Treasury yields declined and credit spreads widened in response to a series of adverse economic events — including disappointing jobs data. Stability has returned, with credit spreads narrowing and Treasury yields recovering from their year-to-date lows. Investors appear to have reassessed the situation, recognizing that the early-August volatility may have stemmed from a market overreaction after anticipation of a flawless economic outcome.

We answer questions about what the factors behind this volatility and our perspective on the investment grade bond market going forward.

Q: What drove the volatility that surprised markets in early August?

Matt: The stock and bond market volatility that started the month was centered around three things, in our view.

First, as we've been stating for a while, the Federal Reserve (Fed) switched its attention solely from inflation to inflation and growth, and growth has been more challenged lately.

The Fed seems more confident that it has gotten inflation under control. While there have been signs that lower-income consumers have been struggling, growth, has been resilient, even though it’s been slowing. The July employment report showed a shortfall in the number of jobs created (114,000) versus expectations, (170,000).¹ The unemployment rate also rose and markets worried that the Fed was behind the curve in loosening policy. The sense was that it should have already been cutting rates and that it needed to cut faster than previously anticipated.

Second was the unwind of the so-called “yen carry trade.” Basically, investors were borrowing cheaply in yen and using that money to invest at a higher return in other places around the world. When the yen appreciated, it made it harder to pay these loans back in yen and investors had to sell off assets around the globe, depressing their prices. It caught people off guard.

Third was that valuations of credit and stocks, especially in tech, have been stretched. There were already questions about whether valuations were a bubble, and market uncertainty fed that sentiment.

Based on our macro outlook, we don't think the Fed is drastically behind the curve. We think it has acknowledged that the next move will likely be a 25-basis-point cut at its September meeting. Does it need to do 50? We'll see. But overall, we believe the economy is still in good shape.

Q: Despite the August selloff, how are investment grade fundamentals?

Todd: The August selloff was largely a technical situation as Matt noted. With more than 80% of S&P 500 companies having reported earnings, year-over-year earnings growth is about 11%.² This is pretty strong, in our view, given that we are toward the end of the cycle.

Corporate balance sheets are healthy, and liquidity is good. Looking at the financial sector, which could have systemic implications, asset quality on banks’ balance sheets and fund conditions areis still good. Consumer balance sheets are also healthy. We don't see major fundamental concerns in the marketplace.

Q: Why has the market been interpreting bad news as bad news?

Matt: One of the interesting things about the selloff was that historically, bad economic news has been good for risk assets. This is partly because the market has expected the Fed to step in and support risk assets with rate cuts — the so-called “Fed put.” That's what happened over the past couple of years. But this time the market took bad news as bad news. Despite solid macroeconomic performance, we’re at a later point in the economic cycle, where bad news is likely to be treated as bad news.

I think we do want good news — and I think the market will reward it. A year ago, when we were concerned about inflation, and the re-acceleration of it, bad news was good news because it meant that growth was slowing. Now we want good news, to support the story that the soft-landing scenario can still play out. It’s our base case, and because the Fed has gotten inflation under control, we think it will cut rates three times between now and the year end

Q: Given the recent volatility, is now a good time time to jump back into investment grade?

Todd: That’ll depend on whether there are any fundamental problems, like if we head into a recession. In that case, we’d expect credit spreads to widen, That's not our base case. As of now, we favor taking advantage of new issuance in the US investment grade market. New supply includes high quality deals that are around 25 to 35 basis points cheaper than they were a short time ago. These deals are attractive because we favor credits that, even in a recession, are going to be able to survive and do well. They’re also selling at a discount. That's our playbook and we’ll be watching to see where volatility goes, as we approach the Fed’s key rate decision in September.

Q: The US 10-year Treasury yield declined to around 3.89%, which is below where we started the year. Do you think the move in rates has gone too far?

Matt: We believe inflation is going to continue to slow through the rest of this year and into next year. As we mentioned, we think that’ll allow the Fed to cut rates three times between now and the end of the year. We expect it to be very data dependent, however. I don't think the Fed will hesitate to cut more aggressively if it needs to. Our base case of three Fed rate cuts is starting to be priced into the market.

Once central banks start to cut rates, they typically don’t stop until they’re close to their terminal rate, in our view. As we near the start of the Fed rate cutting cycle, we expect more cuts to follow, and to see yield curves normalize. The US yield curve is still slightly inverted. We expect the front end of the curve to move lower, and ultimately longer-term rates could follow it lower too.

Overall, we’re excited about the credit opportunities going forward — and fixed income in general. We believe we could end up with high single-digit returns for the year, if things continue to play out as we expect, i.e., our base case of a soft landing. We think that's attractive.

Yes, yields have declined. But they’re still significantly more attractive than they’ve been for the last several years. Overall, we believe we’re still in a positive environment for fixed income.