The Market vs The Economy
The Market vs The Economy |
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In the spirit of over-communicating during the pandemic, I want to share some thoughts with you on the reconciliation of downward spiraling economics with rising markets. At this point in time, market pricing is skewed toward the upside because it is widely believed that a market bottom has been set. And while there will likely be volatility along the way, it will ultimately be the pace and path of the virus, and the corresponding reopening – and ability to stay open – of the economy that will ultimately be the determining factors.
In short, the market outlook and the economic outlook are at odds. Remember, the market is a viciously efficient predictor of the future, always looking at the road ahead, while economic data is constantly peeking in the rearview mirror. Yes, economic demand exists, and the consumer wants to get out and buy, but the question is really about the pace and path at which it reemerges. Consensus is for a U-shaped recovery, but that’s not the whole story.
On one side, the Market Outlook is contingent on a combination of knowns and unknowns, in varying degrees:
- Known – We know the Fed will do “whatever it takes” to keep the economy out of a debilitating recession. We expect the Fed’s monetary policy transmission mechanisms and market support facilities will keep financial conditions easy (i.e., equity prices, credit spreads, interest rates, the USD).
- Emerging Known – We are starting to get a clearer picture of the path and pace of the reopening of the U.S. economy and, more importantly, its ability to STAY OPEN. But this is tricky given that the reopening will likely be staggered on a state-by-state basis.
- Unknown – No one knows, with any confidence, the path of the virus. “Second wave” is quickly becoming a part of our everyday vernacular.
On the other side, the Economic Outlook is contingent on the three points above, but with some important caveats:
- Consensus – The bad news is that Q2 economic data is expected to be Depression-like; the good news is that marked improvement is currently forecasted for the second half of this year.
- Emerging Known - The medical community, with help from responsible personal behavior (distancing, wearing masks, etc.) may be better prepared to handle the virus to the point where it may not overwhelm the entire medical system.
- The Great Unknown - The pace and path for increased demand/purchasing of economic goods and services. It is unclear when consumers will resume traditional purchasing patterns, and start to think about vacations, staying in hotels, eating out regularly, etc.
Regardless of the ultimate shape of the recovery, we think it will be a slow one, where earnings and defaults are clearly at risk. As mentioned, we should see some improvement in Q4.
In Fixed Income we see some tactical opportunities, where Investment Grade (IG) is an area we particularly like. But, with a big caveat; Selectivity. This is not the time to get IG exposure by simply buying an index. For example, we are not interested in the Retail sectors given the potential for prolonged distancing and consumers being uncomfortable around others in Retail settings. Amid all the uncertainty however, we think this is a “bond pickers” market, where active management has a clear advantage over a passive approach.
RISK CONSIDERATIONS
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks. Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities (“junk bonds”) are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).
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Managing Director
Global Fixed Income Team
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