Performance

During the fourth quarter, ULST outperformed its benchmark largely due to its overweight allocation to investment grade corporate credit and commercial mortgage-backed securities (CMBS). During the quarter, the US Federal Reserve (Fed) continued to increase the Fed funds rate in the context of a strong labor market and high, but moderating, inflation, all of which led to an increase in short-term interest rates and mixed results in 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 39 basis points (bps) during the quarter, producing negative price returns; Bloomberg Floating Rate Note Index (FRN) spreads widened by 6 bps during the quarter, producing negative price returns plus carry; the FRN credit curve steepened modestly, with BBB FRN spreads 10 bps wider versus AAA and 4 bps wider versus AA FRNs, producing negative price returns plus carry; and the Bloomberg 1-3 Year Credit Index (1-3 Year Credit Index) tightened 11 bps, producing positive price returns plus carry, versus the fund’s benchmark.¹

Quarter in Review

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, the Fed continued to announce jumbo rate hikes with a 75 bps rate hike in November, and a 50 bps rate hike in December. (To put these rate hikes into perspective, the Fed has not raised the Fed Funds rate at 50 bps or 75 bps increments since 1994.)² As mentioned above, these rate hike announcements led to an increase in short-term interest rates during the quarter and mixed results in credit spreads. For example, during the quarter, the yield on the December 2023 Fed funds futures contract increased by 39 bps, the FRN Index spread widened 6 bps, the 1-3 Year Credit Index spread tightened 11 bps, the Bloomberg US Credit Index spread tightened by 26 bps, and the Bloomberg US High Yield Index spread tightened by 83 bps.³ In terms of Fed monetary policy, the Fed funds rate is in the 4.25% – 4.50% range and the Fed’s balance sheet declined by roughly $240 billion during the quarter, as the Fed’s “Plans for Reducing the Size of the Federal Reserve’s Balance Sheet,” announced May 4, 2022, was in full effect for the quarter. The chart below shows what the market believes that the Fed funds rate at the end of 2023 will be in the context of the current 4.25% – 4.50% range. In other words, with the market still pricing in two 25 bps hikes in early 2023, the market believes that the Fed will reverse those rate hikes by year end.

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, suggests 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 there will be 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 is clearly slowing. As mentioned above, the labor market is cyclically tight and inflation is high, but moderating. Based upon unemployment and inflation readings over the quarter, the Fed has achieved the maximum employment component of their dual mandate and continues to confront a significant inflation problem, which is the primary catalyst for the above-mentioned rapid pace of US monetary policy tightening in 2022, which we 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.

Given continued market expectations of near-term additional Fed funds rate hikes, we are positioned below the fund’s strategic duration risk target of 0.50 years. The fund’s duration remained at 0.25 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 a lower than strategic target allocation to spread product. Our credit allocation to BBB-rated credit is at 27.7%, which is in the context of our long-term strategic exposure for this strategy. The strategy has a 0.70% 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 government securities and moderately lower exposure to financial institutions and utilities. The Fed’s rapid tightening of 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 to financial conditions into 2023. Given this outlook, we expect to remain below our strategic risk targets in interest rate and credit risk for the fund in the near term, with the aim of leaving the fund well positioned for opportunities in 2023.

ASSET ALLOCATION

CREDIT ALLOCATION