What’s in focus for fixed income in 2025?

Adam Abbas: This is the 800-pound gorilla. Will inflation persist?

But let's think about the fundamental. What will the fundamental story look like over the next 6 to 12 months? Well, we know labor supply is quite healthy right now, which should be good for wage inflation continuing to stabilize over the next year. We also think that shelter and owners’ equivalent rent actually point to low inflation, as the gauges like PCE converge with the-- they have a trailing 12-month lag. They're going to converge with the data that we are actually seeing today with rents, which imply a much lower rate of inflation. And the last point here is money supply has come down a lot. And if you're looking at one thing in a regression model on what will lead rates, above all else, that coefficient in front of money supply should be the largest. And money supply came down a lot over the last two years. It works with the lag. I think it will help to promote a ceiling on rates and provide a nice, stable deflationary force over the next 12 months.

Peter Palfrey: We do think that the shelter component on both headline CPI and PCE are going to be coming down in the subsequent quarters. It's just a matter of time. Likewise on services in particular, which is the other sticky point on both of those data points, and that's just a matter of time. A lot of it is elevated still because of auto costs. For instance, the storm's probably inflated the cost of used autos in the data that we got today. Some other things, insurance--it costs a lot more to fix a car today because it's a higher cost car. As time passes on, that $50,000 car that costs so much to fix versus the $30,000 car two years ago, it's not like that $50,000 car is becoming a $100,000 car tomorrow or next year or whatever. It's going to be kind of stabilizing there. So all that data, I think, does come down over time. And that's going to be a positive backdrop for the Fed to keep on moving towards something closer to what it considers to be a long run neutral.

Peter: I'd like to make two points on this slide. One is-- so what we've shown is our composite duration for our core plus product. That's keyed off the left scale and then the 10-year Treasury yield on the right scale. My two points are one, a lot of people-- most people, I think-- think of duration management as just moving your Treasury duration up and down. But I would argue it also the second derivative part of that is how much duration do you want from the other sectors-- so, outside of treasuries, which are directly affected up or down and price value if rates go higher or lower. What about spread duration? What about duration coming from your mortgage portfolio or securitized or from emerging markets or other markets that you might have? How about duration coming from short instruments such as the bank loan market or the CLO market where you have spread duration, but you don't have the interest rate duration? So there really are two components to understanding what the duration risk is of your portfolio. And the purpose of doing this slide is to show that in terms of where we think you can add value as a fixed income manager, you want to try to fade the moves in the Treasury market. So if the Treasury market moves very, very sharply higher-- let's say if we key in on the 21 to 22 period. Look at the blue line. It went up very sharply. As rates were rising higher and higher, this just shows how we lengthened duration into that sell off because it went from being very overvalued-- if you look at 2021, we had at trough levels about one-year short duration versus our bench. And we're allowed to go plus or minus 1 and 1/2 years. So we're very short versus bench. And so there's a chance to kind of play ranges depending on what your outlook is and what your Fed expectations are. In this instance, most recently, we've done that in Treasury space, and we've been keeping our credit duration contribution on the lower side.

Adam: My thoughts are very similar to Peter's in that I don't think you-- you want to get a lot of contribution from credit spread here in your overall risk book of your portfolio. I think it's certainly worth noting that we're inside the fifth decile in most of corporate credit, investment grade and high yield. And so that if you're creating a lot of your spread duration from corporate credit, you're taking what would be considered historically high risk. But there's still value in that all in yield. We've reset to where real yields are at 2 and 1/4%. Inflation expectations are another 2% to 2 and 1/4%. And we think we're closer to a fair value range. And therefore, we want to neutralize that bet for our investors over the Barclays Agg. It allows us to focus really on credit selection and asset allocation, where we think we can really create excess return when we don't think there's glaring, obvious value for us to try and get that specific macro call right on what real rates will be each quarter. And one more thing I'll mention is I do think the 5-to-7-year belly of the curve is a really good place to be. I think we are past the environment where it behooves investors to be on the front end and be on the back end. We call that the barbell approach. We are still in a relatively flat environment versus history. And if you're looking like we are for our investors to be at the optimal intersection of protecting capital, whether it be versus your other allocation in equities or your high yield allocation within your fixed income allocation or other risk assets, you want to be in that 5-to-7-year part of the curve but also creating good income. So that's the optimal place for us.

Adam: I think from an absolute lens the all in yields are attractive in fixed income. I think you need to think about the elevated yields, like I said before, versus your pre-COVID era where an Agg type, a core, or a core plus type exposure was giving you about 3% to 4% of income. Now, after 2022 and the reset, you can get a core, core plus exposure, and you can get 5 to 5 and 1/2% of yield. …We're going to come down, but we're not going to come down that quickly. And therefore, you can create some pretty attractive returns versus your other allocations just simply through collecting your income. A 4 and 1/2%, 5% income post-fee is quite compelling versus what we've been exposed to for most of the decade after the global financial crisis. Also, I think leveraged loans are a really interesting way to play a higher income environment in high quality assets. I particularly like BB and BBB crossover leveraged loans. These are going to float off the front end. So if you believe that—the survey said you guys believe in 1 to 2 cuts. That means you can average, over the next 15 months, you can probably average a 4 and 1/4% or 4 and 1/2% LIBOR or SBOR and then on a 200 spread. So you’re talking about a 6 and 1/2% carry or income that you can collect in that product if spreads are stable here. And that’s a pretty significant advantage over the high yield asset class. Plus, you’re in a senior position and you have collateral behind it.

Peter: And I would echo exactly what Adam said. We like the belly of the curve. If you want to own something that’s going to perform well if there’s some kind of economic mishap, you need to own the belly of the curve, and you need to own quality. And so we have the lion’s share of our Treasury exposure in that 5 to 10 year part of the curve because that’s going to be the most price sensitive to some kind of repricing of rate risk…Now presently, our base case scenario is for a soft landing. We’re pretty much on top of the market in terms of our expectations for future Fed policy. But we also see a not insignificant possibility that there’s some kind of economic mishap. Let’s say an escalation in terms of retaliatory tariff, tit for tat, or let’s say an explosion on geopolitical. We have two hot wars going on already. We’ve got an evolving Middle East situation that could become far, far more impactful. And so we would like to have some ballast in the portfolio. So, one of the things we’ve replaced our credit exposure with, we are underweight IG credit. We’ve replaced it with HC mortgage passthroughs. We think that they’re pretty compelling here. The average cost of the index is, what, wrapped around 92 less plus dollar price. A good portion of the index is discounts, so therefore has either far better convexity or less negative convexity than historically found in that market or even positively convex in some of the lowest coupon paper. So we think it’s an opportunity to get noncredit spread in the portfolio, which is also a nice way to kind of bide your time as the economic situation unfolds.

Adam: If you actually look at the data, we’ve always had geopolitical risks in the backdrop fairly consistently over the last two decades. And for the most part, they really aren’t affecting outcomes if you’re willing to look over a 5- to7-year time horizon like we do at Oakmark for both fixed income and equities. However certainly what’s relevant today is some of the flare up in the Middle East. Some would argue it’s much more than a flare up today. And what that might mean for barrels of oil supply globally, that’s something to consider over time and something we watch. We’re always watching Taiwan and Chinese escalation. There’s certainly a back and forth now with protectionism around your key intellectual capital. You just saw some moves on NVIDIA recently. How will that affect deglobalization if that accelerates? And then how will that affect wages, ultimately, if we need to source most of our jobs for some of those more higher tech jobs, value add jobs, and bring them back to the US or North America? That is something we’re watching. But I would say more generically, I think it’s important to remember that these geopolitical risks tend to get 90% of the attention, just like the election cycle did and oftentimes will not drive ultimate valuations if you're looking to pan out and look over a 5 to 7 year time horizon, which we think is appropriate.