The Fund remains overweight in duration and focused on high-quality securitized products, anticipating a steeper yield curve as the economy slows.
Notwithstanding the (seasonally affected) early-year bump in the long and winding road towards its long-run target level, measured inflation moderated in the second quarter to fall back in line with the broader trend observed over the past twelve months. Both core CPI and core PCE - the latter being the Federal Reserve's (Fed's) preferred measure of inflation in the U.S. economy - fell on a year-over-year basis to levels not seen since 2021, clearly indicating some degree of success on the Fed's part after launching the most aggressive hiking cycle in decades. Indeed, the quarter closed with core PCE coming in at 2.6% annually, breaking through the 2.8% year-end floor projected by the Fed at its June Federal Open Market Committee (FOMC) meeting. Despite this progress, Fed officials continued to push back on expectations by preaching patience, emphasizing data dependency, and cautioning against easing policy too soon, for fear of reigniting inflationary pressures. With this, the prospect of a potential rate hike gained traction in April and caused an early-quarter surge in U.S. Treasury yields that was unable to be fully reversed by bond-friendly data releases in May and June, ultimately resulting in the 2-Year yield (US2Y) up 14 basis points (bps) over the period while the 10- (US10Y) and 30-Year (US30Y) increased 20 and 21 bps, respectively.
Though inflation and the timing of rate cuts have drawn the most attention, the other side of the Fed's mandate, employment, has quietly weakened in the background. Commonly referred to as "out of balance" by Fed Chair Jerome Powell throughout this cycle, the labor market has faded demonstrably in recent months with unemployment up over 50 bps from cycle lows to 4.0% and job openings, a key measure of labor demand, at the lowest level in three years. Further, wage gains - a hallmark of pandemic-related dislocations in labor markets as workers voluntarily left jobs for better pay - have slowed, with the voluntary quits rate falling along with it. Such developments heighten the risks of monetary policy decisions; what was once a tighten- at-all-costs approach to combat inflation and restore balance to the labor market is now a much more nuanced proposition given the rise in unemployment with inflation not yet at target levels.
Equity markets seemed unfazed by the potential downside en route to a 4.3% gain in the second quarter, bringing the year- to-date advance to 15.3% by the S&P 500 Index. (SP500,SPX) However, these gains have been largely driven by the top cohort of names in the Index, with the equal-weighted version down 2.6%, perhaps painting a more realistic picture of current conditions. Fixed income returns were more subdued, with the Bloomberg U.S. Aggregate Bond Index ("Index") up just 0.1% in the quarter, though the near 50 bps increase in U.S. Treasury yields across the curve from start of year levels dragged the asset class to a 0.7% year-to-date loss. Equity-like enthusiasm carried over into the corporate sector, however, as the high yield cohort notched a 1.1% gain for the quarter and led fixed income sectors on a duration-adjusted basis. Meanwhile, investment grade yield spreads reached new cycle-lows of 80 bps over Treasuries before softening somewhat to end the quarter at 88 bps, which combined with their longer duration profiles to drive a loss of 0.1% in the higher rate environment. In securitized markets, asset-backed securities (ABS) led with a 1.0% advance on continued strong new issue sponsorship, followed by commercial mortgage-backed securities ('CMBS') with a 0.7% gain as private label issues continued their run of strong performance. Finally, in residential MBS, the non-agency sector rode the tailwinds of sustained demand, limited net issuance and resilient home prices, while elevated yields and rate volatility weighed on agency MBS which produced total returns of just 0.1%.
Despite the early-quarter backup in Treasury yields, TCW Core Fixed Income Fund (MUTF:TGCFX) returned 0.01% (net of fees) during the second quarter of 2024 but trailed the Bloomberg U.S. Aggregate Index ("Index") by 5 bps. Duration positioning remained longer than the Index throughout the period, which benefitted relative performance in May and June but was a significant headwind in April amid the reset higher in yields, ultimately resulting in a negative impact for the quarter. Similarly, the sizable allocation to agency MBS was rewarded in May and June when yields moved lower, though these contributions were eroded by a drag from the position during the first month of the quarter amid elevated rate volatility, while issue selection contributed to relative performance, more than offsetting some of the drag from April. Non-agency MBS generally bounced back from weak performance in April to post positive returns for the quarter amid widespread demand for mortgage credit, contributing to relative performance. Meanwhile, contributions from positioning among other securitized credit sectors contributed notably. Issue selection in ABS focused largely on government guaranteed student loan collateral and higher quality CLOs. Floating rate student loan receivables performed well, outpacing duration-matched Treasuries by more than 30 bps during the quarter as floating rate issues were less negatively impacted by surging interest rates in April, while CLOs benefitted from strong market technicals as demand continued to outweigh supply. CMBS holdings, particularly private label deals, also contributed to performance given the emphasis on single asset single borrower (SASB) deal structures backed by high-performing collateral and/or sponsors, which helped to avoid some of the broader credit concerns in the sector that impacted conduit deals or SASBs with weaker collateral. Finally, investment grade corporates trailed Treasuries by 4 bps on a duration-adjusted basis due to underperformance in June, though financials outperformed, including banks, which are an emphasis in the Fund. Rising yield premiums and a move higher in prices provided the opportunity to continue trimming corporate positions that had reached fair value, including select banks during the second quarter.
Though the U.S. economy has seemingly defied all expectations throughout the course of this Fed hiking cycle, the impacts of 525 bps of Fed hikes and ongoing inversion of the yield curve cannot be fully discounted, even if they have thus far been held off. Indeed, the well-documented consumer spending of pandemic-era excess savings helped to blunt the initial impact, while 2023's continuation of the consumer dissaving theme with increased short-term credit utilization, including "buy now, pay later" schemes, helped further propel economic growth from the consumer side. However, credit comes at a cost, and the growing balance on consumer credit cards and other financing options comes at a time where the interest on those balances are at extremely elevated levels. For lenders, this has translated to growing losses on unsecured consumer loans and commensurate tightening of lending standards, which will only serve to further slow the economy once it turns. On the corporate side, businesses are now multiple years into an elevated interest rate regime and have likely exhausted the primary means of protecting margins, including price reductions, hiring freezes, and a furloughing of employees to part time work, with layoffs the final piece that loosens the labor market and pushes the economy into a recession. In this environment, the yield curve will re-steepen sharply as the Fed steps in to support the economy, shore up markets, and inject liquidity into the system.
Given expectations for a steeper curve, duration positioning remains overweight relative to the Index, finishing the quarter approximately 0.8 years long with an emphasis on front-end yields. Turning to sector positioning, exposures currently emphasize high-quality securitized product opportunities offering attractive risk-adjusted yields, where agency MBS represents the largest outright and relative position. Though nominal spreads for the sector have tightened from the wide levels observed in 2023, they remain cheap relative to both historical standards and other high-quality segments of the market, providing yield pickup without undertaking credit risk given the government guarantee. Non-agency MBS also exhibits good yields and solid fundamentals given years of amortization and housing price appreciation that has built up substantial equity in the underlying properties, incentivizing homeowners to remain current and insulating bondholders from potential losses. Meanwhile, CMBS represents a small and targeted allocation, focused on deals backed by trophy collateral and/or strong, experienced sponsors that can withstand any prospective volatility in the sector as it undergoes what is likely a slow-moving correction. ABS positions similarly reflect targeted allocations given the challenges weaker structures or those backed by unsecured collateral are likely to face in a slowing economy, with FFELP student loans and senior CLO tranches comprising the bulk of the exposure. Turning to corporate credit, current market valuations present an asymmetrical risk and reward profile; the likelihood of spreads compressing meaningfully from these levels is small, while the risk of significant widening as the sector reprices to a slowing economy is high. As such, the Fund capitalized on market strength to reduce exposure and migrate higher up the quality spectrum, with remaining positions emphasizing defensive sectors like communications, non-cyclicals, and those not typically prone to cyclical volatility.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.