Many investors, even professionals, are so fixated on present market conditions that they often miss the longer-term trends that could have a more meaningful impact on their portfolios.
This bias can create opportunity for those willing to lean against the crowd.
Lately, the market consensus seems to be that the Federal Reserve will need to keep rates higher for longer as it seeks to bring inflation to heel.
Inflation tends to pressure bond prices because it erodes the purchasing power of the fixed coupon payments received by bondholders.
But some of the key drivers of higher inflation, many stemming from pandemic‑related dislocations, appear to be in the process of normalizing:
Over a longer time frame—say, 2025 to 2030—productivity gains related to artificial intelligence (AI) could be a deflationary force.
A fast-food restaurant in Ohio, for example, has already tested an AI ordering system at its drive-through lane. Generative AI models have also emerged that meaningfully increase computer programmers’ efficiency.
Bottom Line: The bond market doesn’t appear to be pricing in the possibility that the Fed may not need to keep rates higher for an extended period to bring inflation closer to its stated target of 2%.
The yields on 10-year U.S. Treasuries strike me as relatively attractive when you consider the asset class’s historical resilience in difficult markets.
But the relative value in high yield bonds looks even more compelling.
Structural inefficiencies make BB rated credits and leveraged loans1 attractive hunting grounds for securities offering the prospect of strong risk-adjusted returns.
Rigorous research and a deep understanding of individual companies are critical to finding the jewels amid the junk.
Insurance brokerages are a good example:
The stock market’s valuation does not appear especially attractive.
However, pockets of opportunity exist for those who are willing to zig when the market is zagging.
Utility stocks are one area where we see opportunity.
The market does not appreciate the rate at which some utilities could increase their cash flows and dividends in the coming years:
(Fig. 1) Sector price returns for S&P 500 Index
Nine months ended September 30, 2023. Past performance is not a reliable indicator of future performance. Source: Financial data and analytics provider FactSet. Copyright 2023 FactSet. All Rights Reserved. See Additional Disclosure.
As for valuation, utilities were the worst‑performing sector in the S&P 500 Index over the first nine months of 2023 (Figure 1):
U.S. utilities also have minimal exposure to exchange rates. And some have exhibited lower volatility relative to the market.
Even if interest rates remain elevated, select utilities should be able to compound value through earnings and dividend growth.
Our process focuses intensely on company analysis and valuations.
Working with our research analysts, who are well versed in the industries they cover, helps to give us the conviction and selectivity needed to be contrarian when opportunities arise.
1 The credit ratings are provided by Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings. A bond is considered non-investment grade (or high yield) if it has a rating of BB+ or below from Standard & Poor’s and Fitch or Ba1 or below from Moody’s. Leveraged loans typically feature floating rates that go higher when the Fed raises the benchmark interest rate.
2 As of September 30, 2023, the S&P 500 Utilities Index traded at about 15x 12-month forward earnings, compared with a median valuation of 15.5x forward earnings for the trailing 20 years. Actual outcomes may differ materially from estimates. Source: Financial data and analytics provider FactSet. Data analysis by T. Rowe Price. Copyright 2023 FactSet. All Rights Reserved. See Additional Disclosure.
Dividends are not subject to change.
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