Strategic Income Opportunities Fund Monthly Insight

Managing fixed income in a hot economy

Sep 25, 2018

An exceptionally strong labor market and reasonably firm inflation have the Fed monitoring the heat in the
U.S. economy.

The economy is creating new jobs at an impressive rate, and wages have begun to shift higher. The September employment report is the latest of the greatest run of job gains in U.S. history, with 19 million new jobs created since 2010 and an unemployment rate below 4%, which has been seen only twice before within the last 60 years.

Inflation is still running at a reasonably firm rate and although we’re witnessing a modest degree of pricing power in certain industries, there are dynamics at play that could serve as equilibrators. Higher wages, higher input prices, higher interest rates and diminishing forward stimulus from the tax cuts are forces that suggest the economy will eventually moderate and inflation will be relatively muted as compared to prior high-growth cycles.

For now, we believe rates can continue on a moderate upward progression, with the Fed moving another 25 basis points (0.25%) at its September meeting and probably another 25 in December. Still, unless there is some other exogenous stimulus that turns the flame higher again on the domestic economy, inflation could be seeing its strongest days today – unless tariffs lift the prices of consumer goods and other input costs.

We’ll be keeping a close eye on trade developments, but it should be noted that precisely estimating the upstream impact on downstream consumer prices before they materialize poses substantial data obstacles and hence greater uncertainty around the path for interest rates in 2019.

Outperformance with lower volatility

Outperformance with lower volatility chart

Source: Morningstar as of 8/31/18. Returns are from 8/31/17 through 8/31/18. Volatility is measured from 8/31/17 through 8/31/18 using daily returns. For standardized performance of the BlackRock Strategic Income Opportunities Fund, click here.

In the Strategic Income Opportunities Fund, we hold the majority of duration in the 0- to 5-year part of the yield curve, although we recently added to duration in the 7- to 10-year space where we believe rates are approaching the upper end of their current trading range. We slightly reduced the fund’s inflation protection positions (in breakeven form) on the front end of the curve given our view that inflation may decelerate in the coming months.

Outside the United States, we reduced the fund’s short position in Italian rates, which have come down from their year-to-date highs seen in July. We continue to hold limited exposure to European banks as we believe the sector could ultimately benefit should rates in the region move higher amid continued economic growth and the tapering of central bank stimulus.

We tactically reduced the fund’s allocation to investment grade credit given an anticipated period of heavier primary issuance in the coming months as merger and acquisition activity picks up. We continued to reduce the fund’s emerging market exposure as a stronger dollar, global trade tensions and local political uncertainties are headwinds for the sector. However, we are being tactical as weakness has created value in the space, and we continue to hold select positions in China, Argentina and Indonesia.

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