Performance Commentary

During the second quarter, ULST underperformed its benchmark, the Bloomberg US Treasury Bellwether 3 Month Index, largely due to its overweight allocation to duration. During the quarter, the Fed continued to increase the Fed Funds rate in the context of a strong labor market, high, but moderating, inflation, and the stabilization of the banking sector after two US bank failures, all of which led to an increase in short-term interest rates and tighter short-term investment-grade credit spreads. For example, the yield on the December 2023 Fed Funds Futures contract (a proxy for very short-term interest rates) increased by 98 basis points (bps) during the quarter, producing negative price returns, Bloomberg Floating Rate Note Index (FRN) spreads tightened by 30 bps during the quarter, producing positive price returns plus carry, the FRN credit curve flattened, with BBB FRN spreads 45 bps and 21 bps tighter versus AAA and AA FRNs, respectively, producing positive price returns plus carry, and the Bloomberg 1-3 Year Credit Index (1-3 Year Credit) tightened 25 bps, producing positive price returns plus carry, versus the fund’s benchmark.¹

Quarter in Review Commentary

During the quarter, the US economy continued to generate solid job growth and high, but moderating, inflation. In reaction to this combination of tight labor markets and high inflation, and signs of stabilization in the US banking sector, the Fed continued to increase Fed Funds rate with one 25 bps rate hike during the quarter. As mentioned above, continued strength in the economy and the stabilization of the US banking industry led to an increase in short-term interest rates during the quarter and tighter credit spreads. For example, during the quarter, the yield on the above-mentioned December 2023 Fed Funds Futures contract increased by 98 bps, the above-mentioned FRN Index spread tightened 30 bps, the above-mentioned 1-3 Year Credit Index spread tightened 25 bps, the Bloomberg US Credit Index spread tightened by 15bps, and the Bloomberg US High Yield Index spread tightened by 65 bps.² In terms of Fed monetary policy, the Fed Funds rate is now at a range of 5.00%–5.25% and the Fed’s balance sheet decreased by roughly $365 billion during the quarter, as the Fed’s ‘Plans for Reducing the Size of the Federal Reserve’s Balance Sheet,’ announced May 4, 2022, remained in full effect for the quarter. The following chart shows that the market believes that the Fed Funds Rate at the end of 2023 will be in the range of 5.25%–5.50%, suggesting one 25 bps rate hike from the current range.

Portfolio Positioning and Outlook Commentary

Our fundamental active fixed income investment process has three components: structural, cyclical, and tactical. Our analysis of structural economic growth trends, which includes demographic trends, the trend growth rate of the labor force, and the trend growth rate of productivity suggest to us a US trend real growth rate of roughly 2.0%. As a result, our structural analysis suggests that interest rates will remain historically low. One of the questions that’s being asked is whether inflation will be structurally higher due to recent global geopolitical disharmony, which would structurally increase nominal interest rates. Our view is that it is too early to conclude structurally higher inflation and we’ll be watching for signs of deglobalization in the coming quarters.

Our analysis of cyclical trends focuses on economic activity momentum as well as policies that can serve to either extend or contract the economic cycle. Economic activity momentum, as reflected in ISM Manufacturing and Services PMI surveys of business conditions, suggests that US growth momentum has slowed year over year. As mentioned above, the labor market is cyclically tight and inflation is high, but moderating. Based upon the readings of unemployment and inflation over the quarter, the Fed has achieved the maximum employment component of their dual mandate and continues to confront an inflation problem, which is why the Fed has raised the Fed Funds rate into restrictive territory, despite the announcement of two US bank failures, which we continue to see as a risk to economic growth and financial conditions in 2023. The current makeup of the US Congress suggests little support from fiscal policy in 2023 and 2024. High mortgage and auto loan rates are having an impact on activity in the consumer space and the expectation is that there’ll be a continued slowing demand for these large expenditure goods. Given the overall tightening of financial conditions and concerns about an economic slowdown, our expectations for private sector investment is modest at best, although green shoots are emerging in the area of domestic chip manufacturing, where significant investment has recently ramped up.

Given that monetary policy is in restrictive territory, i.e. late cycle monetary policy, we are positioned above the Fund’s strategic duration risk target of 0.50. The fund’s duration exposure closed the quarter at 0.65 years, an increase of 0.05 years quarter over quarter. Regarding our asset allocation strategy, we’re maintaining a conservative asset allocation exposure, with a higher than strategic target allocation to government securities and cash, and a lower than strategic target allocation to spread product. Our credit allocation to BBB-rated credit is at 30.3%, which is above our long-term strategic exposure for this strategy, but, importantly, the Fund’s BBB spread duration has declined quarter over quarter (due to repositioning), from 0.25 years to 0.23 years, which is just below the fund’s strategic exposure for this strategy, according to that metric. The strategy has a 0.60% allocation to BB-rated credit (which is an allocation used primarily for the optimal management of fallen angels). Asset allocation shifts during the quarter were limited to a moderately higher exposure to financials and a moderately lower exposure to industrials. The Fed’s achievement of restrictive monetary policy, in response to cyclically tight labor markets and high inflation, and classic signals of recession, such as the curve inversion of 3-month Treasury bills and the 10-year Treasury note, are likely to serve as headwinds to the economy and financial conditions into 2023. Given this outlook, we expect to remain above our strategic risk target for duration and below our strategic risk target for credit risk in the near term, which should leave the fund well positioned for opportunities in 2023.