Voya High Yield SMA Quarterly Commentary - 3Q24

The labor market continued its path of normalization in the third quarter of 2024, with the number of job openings continuing to decline along with the quit rate reverting to pre-pandemic levels. This cooling was further evidenced by the Non-Farm Payroll (NFP) report, which missed expectations for both July and August. The substantial miss for July, reported in August, coincided with a controversial rate hike by the Bank of Japan (BoJ), unsettling markets and leading to a sharp widening of credit spreads. However, as investors digested the data, spreads eventually retraced, reflecting a more measured perspective on the total economy. 

This moderation in the labor market did not significantly hinder consumer spending, which continued to advance at a decent rate. With elevated home prices and strong equity performance, the wealth effect remained in play however the moderation in the labor market may have been responsible for more measured spending growth, relative to more recent quarters. More broadly, the economy continued to advance at a reasonable pace, as evidenced by 2Q24 gross domestic product (GDP) growth, which exceeded expectations at 2.80% and was later revised to 3.00%. 

Inflation continued its downward trend, with core Consumer Price Index (CPI) approaching 3.00% year over year, despite the shelter component remaining stubbornly elevated. Core goods prices remained in deflation, while core services inflation decelerated significantly, partially attributable to moderating wage gains. The U.S. Federal Reserve’s preferred measure, core Personal Consumption Expenditure (PCE), displayed an even more favorable environment, reading at 2.70% YoY in August. This disinflationary environment provided the Fed with the flexibility to shift its focus from inflation concerns to labor market conditions.

A pivotal moment came in late August with Jerome Powell’s speech at Jackson Hole, signaling a shift towards an easing cycle. The Fed, acknowledging the softening labor market, opted for a 50 basis points (bp) cut at their September meeting, larger than the previously anticipated 25 bp reduction. Powell’s influence was evident, with only one Federal Open Market Committee member dissenting. This decision underscored the Fed's proactive approach to preserving a healthy labor market and broader economic stability. 

Credit spreads began the quarter at tight levels, reflecting a macro environment that balanced disinflation with stable growth. Despite the early August volatility, driven by labor market data and the BoJ's actions, spreads finished the quarter at similarly tight levels as the disinflationary trend allowed the Fed to begin an easing cycle. Within high yield (HY), lower quality outperformed higher-rated credits, as positive idiosyncratic events benefited select CCC rated issuers. 

Yields rallied in response to continued disinflation, with front-end rates falling more significantly than long-end rates. This bull steepening of the yield curve was driven by expectations of the Fed's easing, which prompted front-end rates to aggressively rally, while a stable growth outlook translated to a more measured decline in the long end. 

In conclusion, the third quarter of 2024 was characterized by a gradual moderation in the labor market, further easing of inflation and a proactive shift in monetary policy by the Fed. These factors positively influenced market dynamics, resulting in a period of strong returns for fixed income investors.

For the quarter, the SMA Strategy underperformed the Index on a gross- and net-of-fees basis. The Strategy’s focus on higher quality bonds detracted from returns versus the Index, as lower-rated credits significantly outperformed during the quarter.

As we look ahead to the fourth quarter of 2024, we expect the theme of “normalization” to continue shaping the economic landscape. We anticipate growth will stabilize close to trend levels, remaining positive but likely decelerating from the robust pace seen in recent quarters. This dynamic will be driven largely by consumer spending, which, while expected to slow, will continue to be supported by a relatively strong (albeit moderating) labor market and a favorable wealth effect stemming from elevated asset prices. 

We project inflation will continue its decline, but at a slow pace and ultimately settling above the Fed’s target. Goods inflation is expected to remain at 0% or lower, as consumption growth moderates from historically high levels. Services inflation is likely to continue decelerating as the labor market continues to rebalance and wage growth eases further. Additionally, we anticipate that the shelter component of inflation will eventually align more closely with real-time indicators from sources like Zillow, Apartment List and Yardi, further contributing to the easing of inflationary pressures. 

While all this points to a soft landing, markets appear to have priced in this scenario with a high degree of certainty. Investment-grade corporate spreads are currently below 100 bp, while HY spreads hover around 300 bp. These levels suggests that markets are highly optimistic that disinflation can continue without a recession materializing. While we tend to agree this is a likely outcome, there remains a risk of more rapid deterioration in the labor market, particularly if corporate margins face further pressures. However, we remain confident in the fundamental factors that support the economy and are prepared to add risk where appropriate, especially in the face of market volatility stemming from data releases, Fed actions, elections and geopolitical developments. 

On the interest rate front, following the substantial rally in 3Q24—particularly at the front end of the curve—the market is now pointing to the Fed reaching its terminal rate roughly one year ahead of the most recent dot plot projections. We believe this reflects a skew of potential outcomes related to monetary policy. Specifically, we believe that the likelihood of reacceleration of inflation that prompts the Fed to reverse course is significantly lower than the probability of a faster cutting cycle if the labor market deteriorates more rapidly. 

In summary, as we enter the final quarter of 2024, our economic outlook is characterized by a continued normalization process, with stable growth supported by consumer spending and a moderating labor market backdrop. While we maintain a cautious optimism, we remain vigilant, ready to adjust our positioning in response to an evolving landscape.