Performance
In the second quarter, the Lazard US Short Duration Fixed Income Portfolio (MUTF:UMNIX) rose 0.98% (net of fees), outperforming the 0.94% gain of its benchmark, the ICE Bank of America 1-3 Year US Treasury Index. The Portfolio’s allocation to US Investment Grade Corporates and Asset Backed Securities were contributors to relative performance versus the ICE Bank of America 1-3 Year US Treasury Index. The longer relative duration position hurt relative performance versus the index.
Strategic Positioning
Duration/Yield Curve – The Portfolio is targeting a modestly longer overall duration versus the benchmark, with a barbelled concentration in the 6-month and 3-year areas of the curve.
Sector/Credit – The Portfolio remains overweight US Investment Grade Corporates and US Asset Backed Securities (ABS). We are underweight US Treasuries.
Yield/Convexity Balance – Favor yield in US Corporates and ABS. Convexity remains positive.
Market Review
US interest rates continued their sell-off during the quarter, with the yield on the benchmark 10-year US Treasury note rising twenty basis points (bps). Optimism that the Federal Reserve would begin a monetary easing cycle in 2024 faded, and investors resigned themselves to interest rates staying “higher for longer,” as the latest data continued to suggest a robust domestic economy-underpinned by a solid labor market and resilient consumer spending-but also sticky inflation, complicating the Fed’s mission. Corporate credit continued to be well bid even though it lost some steam and slightly underperformed US Treasuries in the quarter. Intermediate and short maturities turned in the best relative performance as the yield curves steepened modestly.
Market participants continued to be confronted with a multitude of challenges that can significantly impact market behavior, including geopolitical risk, seemingly never-ending political brinksmanship during a presidential election year, and uncertainty in the outlooks for inflation and interest rates. Importantly, core inflation, which had been trending lower, had reversed course during the first quarter. This reacceleration of inflation proved challenging for US Treasury rates, which continued their rise for the quarter. At the same time, corporate credit spreads, which tightened through May, started to backpedal in June, as weaker economic data, combined with geopolitical risk, widened spreads modestly in the quarter. Interestingly, higher quality credit underperformed lower quality as BBB outperformed meaningfully. Even though spreads softened, there continues to be support to corporate prices as quarterly earnings remain solid and given that lower quality has outperformed, shows us that investors continue to add risk in corporate credit. Overall, we continue to believe markets now are at an inflection point for the interest rate regime, with direction determined by whether inflation has slowed enough to allow the Fed to cut interest rates or if price pressure is so persistent that it will force the Fed to limit or even abandon plans for rate cuts in 2024.
From the perspective of security markets, the quarter was not as constructive for risk assets, but was nevertheless supportive for prices, as elevated levels of debt issuance were met by robust market demand, orderly secondary market trading, supportive credit spreads, and a sustained inverted US Treasury curve. Borrowers continued to take advantage of historically low interest rates (minimal risk premia) and persistent market demand. Up until November of last year, there were reasons to believe that corporate bond market participants-both borrowers and investors-may be set to take a breather from the multi-year bond binge, as rising Treasury and inflation rates and economic risks translated into increasingly prohibitive financing conditions, negative returns, price volatility, and pockets of illiquidity. However, the Treasury yield rally in November and December significantly alleviated those tight financial market conditions, and the primary issuance market remains active and robust, despite the backup in yields thus far in 2024. Finally, within the securitized sector, fixed rate Agency mortgage-backed securities (‘MBS’) continued to underperform Treasuries as rates and interest rate volatility continued to apply pressure to the sector, translating into negative excess returns for the quarter and year to date of 9 and 23 bps, respectively.
Against this backdrop, corporate credit softened in the quarter. Excess returns were slightly negative, underperforming US Treasuries by only 4 bps. Within spread sectors, asset-backed securities (ABS) and commercial mortgage-backed securities (‘CMBS’), outpaced US Treasures by 17 and 24 bps, respectively, for the quarter. Interestingly, within the Bloomberg US Corporate Index, intermediate corporates posted excess returns of 23 bps while long corporates posted -57 bps of excess returns, showing the bifurcation of performance along maturities. Nevertheless, corporate credit is outperforming Treasuries by a large margin year to date, 85 bps.
Overall, credit fundamentals are solid for now, namely for companies that have viable business models and ongoing access to capital markets. Over the past few years, borrowers took advantage of low financing rates and investors’ voracious appetite for corporate debt to strengthen their balance sheets and to term out their debt. This benign corporate credit environment could turn quickly though on potentially worsening fundamentals driven by an economic downturn, which so far has been elusive. We continue to see downside risks in segments of the global economy that are sensitive to events such as recessions and geopolitical risks. The viability and creditworthiness of companies will depend on how their business models and financing opportunities fare in a higher rate environment, for example. Accordingly, we have been avoiding companies and industries whose business models we expect will struggle to survive in a high-rate environment or a challenging economic setting, especially for those companies whose access to credit could be threatened by tighter financial conditions.
Therefore, we believe that risk assets are now priced too expensively relative to risks, particularly when considering the possibility of an economic recession. Negative outcomes do not appear to be reflected by credit spreads, and we are proceeding with caution in that arena as a result remain underweight corporate credit.
We continue to believe investors should focus on securities and obligors with attributes such as:
- serving an essential economic or financial function
- issuing under standardized terms and conditions
- offering in institutional markets and institutional lot sizes
- exhibiting established transition markets that enable transactions after ratings downgrades
- qualifying for inclusion in major market indices
Outlook
The first two quarters of this year have been marked by ongoing challenges facing the Fed and market participants, as a stronger- than-expected economy, combined with accelerating inflation data, adversely impacted price gains from the fourth quarter of last year. However, during the second quarter, there are signs of a labor market that may be weakening. Moreover, inflation prints have turned weaker than expected, and it seems to have resumed a weakening trend that, if continued, could prove to the Fed that meaningful progress has been made in slowing price increases. For example, the unemployment rate has started to tick higher and revisions to headline payroll data show weakness behind the headline number. In addition, the JOLTS Job Opening and Quits Rate is back to the pre-pandemic trend. Though not necessarily an alarm for employment, it could be a sign that the tight labor market experienced in the aftermath of the pandemic is over. The weaker than expected inflation data during the quarter has been a relief to the market, as the January and February data showed unexpected reacceleration after six months of welcome deceleration. All that said, the yield differential between 10-year and two-year Treasuries, which finished 2023 at -0.37%, ended the second quarter at – 0.36%, essentially unchanged over the last 6 months. The length of this inversion and continued demand for 30-year Treasuries continue to be impressive.
Because the US Treasury Department needs to continue to borrow to finance a spiraling deficit, we expect a significant supply of Treasuries going forward, putting upward pressure on rates. At the same time, the Fed seems poised to cut interest rates and has begun to taper its balance sheet runoff in Treasuries. These two offsetting forces are impacting the direction of interest rates.
Impressively, long term yields have continued find significant demand considering fears of either accelerating inflation and or heavy US Treasury issuance. Nevertheless, history suggests continued vigilance is warranted to guard against the risk of reaccelerating inflation, particularly given that fiscal stimulus is still working through the economy. Therefore, we continue to believe the yield curve will steepen and once again be positively sloped. We believe that whether the reshaping is driven by the Fed cutting short-term rates or by higher-than-expected inflation combining with an increase in term premium due to increasing Treasury supply, the Fed will keep rates higher for longer.
Economy Remains Resilient Despite Higher Rates
The Fed held interest rates steady at its May and June policy meetings, but it is clear from its messaging and Summary of Economic Projections (and “Dot Plot”) that the US central bank expects rates will be lowered by only 25 bps during 2024, which is 50 bps lower than they initially forecast. However, given the impressive economic data combining with stubborn inflation, the narrative has become less dovish. It remains our opinion that the Fed is at the end of its monetary tightening cycle and will cut rates more than once this year; however, we expect interest rates will be volatile, as fiscal, and monetary policy forces continue to affect inflation and Treasury supply demand dynamics.
While the Fed remains focused on taming inflation, employment has begun to show signs of deceleration or softening. Although the labor market remains strong despite the higher interest-rate environment, the U-3 Unemployment Rate has ticked higher from 3.8 to 4.1%. and total non-farm job openings, reAecting all jobs available but not filled on the last business day of the month, are now back toward pre-pandemic trends. While the labor force participation rate has been trending higher, it continues to struggle to reach pre-pandemic levels. Our view is that it appears labor is no longer tight and, if inflation comes down sufficiently, the Fed will have a green light to cut rates. We are impressed the Fed has thus far engineered an aggressive tightening of interest rates without sacrificing employment.
In conclusion, it seems likely that the Fed is now prepared to start cutting interest rates if sufficient progress has been made to achieve its long-term inflation target of 2%. If the Fed is right, it has orchestrated policy in a manner that helped drive inflation lower while protecting its employment mandate, and credit markets have responded accordingly. Currently, the risk for market participants is either a recession due to a longer lag from the impact of rising interest rates on the economy, or sticky reacceleration of inflation. Our view is that, while the probability of recession is materially less likely, it is still too early to declare victory. Because this is a presidential election year, we are paying attention to fiscal policy, which could provide a tailwind for economic activity. Of course, this complicates the Fed’s task because inflation could prove stubborn, limiting rate cuts or taking them oP the table altogether. Finally, we expect interest rate volatility to remain elevated based on this interaction between fiscal and monetary policies.
Important Information Please consider a fund’s investment objectives, risks, charges, and expenses carefully before investing. For more complete information about The Lazard Funds, Inc. and current performance, you may obtain a prospectus or summary prospectus by calling 800-823-6300 or going to www.lazardassetmanagement.com. Read the prospectus or summary prospectus carefully before you invest. The prospectus and summary prospectus contain investment objectives, risks, charges, expenses, and other information about the Portfolio and The Lazard Funds that may not be detailed in this document. The Lazard Funds are distributed by Lazard Asset Management Securities LLC. The performance quoted represents past performance. Past performance does not guarantee future results. The current performance may be lower or higher than the performance data quoted. An investor may obtain performance data current to the most recent month-end online at www.lazardassetmanagement.com. The investment return and principal value of the Portfolio will fluctuate; an investor’s shares, when redeemed, may be worth more or less than their original cost. Different share classes may have different returns and different investment minimums. Information and opinions presented have been obtained or derived from sources believed by Lazard Asset Management LLC or its affiliates (“Lazard”) to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the published date and are subject to change. Please click here for standardized returns: https://www.lazardassetmanagement.com/us/en_us/funds/mutual-funds/lazard-us-short-duration-fixed-incom e- portfolio/F275/S73/ The allocations mentioned are based upon a portfolio that represents the proposed investment for a fully discretionary account. Allocations and security selection are subject to change. Mention of these securities should not be considered a recommendation or solicitation to purchase or sell the securities. It should not be assumed that any investment in these securities was, or will prove to be, profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. There is no assurance that any securities referenced herein are currently held in the portfolio or that securities sold have not been repurchased. The securities mentioned may not represent the entire portfolio. An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond’s maturity, the greater the impact a change in interest rates can have on its price. If you do not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of default, which is the risk that the issuer is unable to make further income and principal payments. Other risks, including inflation risk, call risk, and pre-payment risk, also apply. High yield securities (also referred to as “junk bonds”) inherently have a higher degree of market risk, default risk, and credit risk. Securities in certain non- domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one’s home market. The values of these securities may be affected by changes in currency rates, application of a country’s specific tax laws, changes in government administration, and economic and monetary policy. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in these countries. Derivatives transactions, including those entered into for hedging purposes, may reduce returns or increase volatility, perhaps substantially. Forward currency contracts, and other derivatives investments are subject to the risk of default by the counterparty, can be illiquid and are subject to many of the risks of, and can be highly sensitive to changes in the value of, the related currency or other reference asset. As such, a small investment could have a potentially large impact on performance. Use of derivatives transactions, even if entered into for hedging purposes, may cause losses greater than if an account had not engaged in such transactions. The ICE BofAML 1-3 Year US Treasury Index tracks the performance of the direct sovereign debt of the US Government having maturity of at least one year and less than three years. The index is unmanaged and has no fees. One cannot invest directly in an index. The ICE BofAML US 3-Month Treasury Bill Index is composed of a single issue purchased at the beginning of the month and held for a full month. The issue selected at each month-end rebalancing is the outstanding Treasury Bill that matures closest to, but not beyond, three months from the rebalancing date. The index is unmanaged and has no fees. One cannot invest directly in an index. Certain information contained herein constitutes “forward-looking statements” which can be identified by the use of forward- looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “target,” “intent,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events may differ materially from those reflected or contemplated in such forward-looking statements. |
Original Post
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
Read the full article here