During the third quarter, the global economy largely remained on a path of recovery characterized by above trend growth and labor market improvement. The U.S. economy continued to lead with GDP from the prior quarter registering at 6.6% and an unemployment rate which fell from 5.9% to 5.2%. After a slow start to the recovery, the U.K. and the euro-area economies grew faster than expected as consumers ramped up spending in the aftermath of lockdowns. Despite overwhelmingly positive news, investors still found themselves grappling with new uncertainties thanks to the rise of the COVID delta variant and a potential slowdown in China’s economy. Fears over the global impact of a Chinese slow-down were exacerbated by reports of new government intervention in the economy, most notably in the real estate sector, as well as the imposition of tougher restrictions on carbon emissions. This led to a sharp sell-off in Chinese equities and the default of a leveraged property development firm, Evergrande.
Given the substantial improvement in U.S. growth and unemployment over the past several months, the Federal Reserve strongly signaled that it would begin to taper its asset purchases and reduce the monetary stimulus it has provided to the economy. Barring a meaningful reversal in the labor market, it seems highly unlikely the Fed would not begin reducing its purchases in the fourth quarter. Globally, central banks are setting their own path, with the European Central Bank (ECB) taking a more cautious stance while Norway became the first major Western central bank to raise its policy rate. Though central banks may differ in terms of interest rate policy, all share in the same common belief that inflation will be transitory and moderate as the recovery continues and supply-chain issues subside. This has certainly been the case in the U.S. where price pressures have eased as supply has come online; however, shortages in key components, such as microchips, has kept prices firm which may be exacerbated by the holiday shopping season.
Global rate volatility, which was muted through much of the quarter, suggests that the economic recovery and positive news outweighed any uncertainties over the last 3 months. As a result, the 10-year Treasury yield traded in a tight range between 1.19% and 1.36% from mid-July to mid-September. However, the subdued summer came to an end abruptly as stronger growth and inflation fundamentals caused yields to break-out to the upside. In the waning weeks of the quarter, and in the aftermath of the Fed’s taper signal, Treasuries began a sell-off that pushed yields above 1.50% for the first time since June. Likewise, 10-year German bunds rallied from a mid-August low of -0.50%, though they still ended the quarter in negative territory at -0.20%. Fixed income spreads were also contained but the riskiest parts of the market did finish modestly wider than the previous quarter.
Third-Quarter 2021 Performance Highlights
- The Thornburg Strategic Income Fund UCITS (I shares, accumulating) achieved a positive return for the third quarter of 0.51%, outperforming the Bloomberg U.S. Universal Index, which returned 0.07%. Over a 12-month period, the fund gained 4.79% versus 0.20% for the index.
- Security selection within asset-backed securities (ABS) was beneficial and broadly supported by the continued positive consumer fundamental backdrop. Additionally, security selection in investment-grade and high yield corporates were additive to relative performance, as the latter outperformed Treasuries for the three-month period.
- The fund’s structural short duration position versus the index was a contributor to relative performance in an environment where interest rates broke higher from the tight range held during the summer. The 5- and 10-year Treasury yields ended the quarter 8 bps and 2 bps higher, respectively, at 0.97% and 1.49%. There were no material performance detractors for the third quarter.
Current Positioning and Outlook
The fourth quarter of 2021 is shaping up to be the Federal Reserve’s first test in threading the economic needle. Chairman Powell has offered the markets a level of transparency and consistency in messaging as he attempts to shift the FOMC’s monetary policy stance. The communication plan has been successful thus far, as the credit markets avoided the sell-off that occurred in 2013 when Bernanke’s comments on reducing asset purchases sent prices reeling. We believe that unless there is a geopolitical event or huge hiccup in the labor market recovery, the Fed will be steadfast in reducing its purchases in the fourth quarter. While the plan for tapering may be clear, the second step of raising interest rates is less so. The Fed does not seem overly concerned by inflation in the short term and medium term which has allowed them to focus instead on returning the economy to full employment. If the Fed is using the pre-COVID level of 3.5% as the benchmark it must attain to raise rates, then the labor market recovery is woefully inadequate thus far which may explain why Fed forecasts show rates rising as far out as 2024.
Our biggest conviction within spread sectors is in the securitized space. The U.S consumer balance sheet is very robust. Consumer defaults and delinquencies did not materially rise on an aggregate basis through the COVID shock, buoyed by a strong housing market and government stimulus payments. Though stimulus programs are ending, persistently low housing supply and still low rates gives us confidence the housing market will remain on firm ground and thus remain a bulwark for the consumer balance sheet. Additionally, consumer and housing lending standards remain prudent and as a result do not indicate excess or frothiness.
Within U.S. corporates, in both investment grade and high yield, we are more defensive, preferring exposure to names with less credit spread duration. We see select opportunities in floating rate notes within investment grade. Nonetheless, we are cautious overall as valuations are well through historical averages, and indeed a spread pullback remains a watchful risk. We have conviction in select emerging market corporate and quasi-sovereign issuers. Specifically, we find good relative value in export-oriented corporates and domestic utilities. Interest coverage and cash flow metrics for EM corporates have improved while large public sector debt loads are a headwind for sovereign debt. That said, we are finding value in a few individual sovereigns. The delta variant continues to pose challenges but developed market cyclical growth and low domestic cost pressure trends are favorable.
Thanks for your continued support and investing alongside us in Thornburg’s fixed income funds.