April 16, 2020
The End of the Beginning
April 16, 2020
As every person on the planet knows, March was a watershed month. The COVID-19 epidemic turned into a global pandemic, engulfing the rest of the world, leading to rapidly rising deaths and infections, lockdowns of populations and the closing of economies. Economic data is setting records for the most precipitous collapse on record. Unemployment is soaring, and GDP is likely to fall at a double-digit annualized rate in Q2. We are in unprecedented territory, and March financial market performance reflected this. Volatility soared; yields went down; then up; then down again. Equities also experienced similar patterns, but with a more obviously downward trajectory. By the end of March, we had had both a bear market and bull market in the same month!
As March came to a close, bond markets across the world were “infected” and performed very poorly. Normally one expects bond yields of both high-quality government bonds and investment-grade corporate bonds to fall when economic data weakens. And yet, only U.S. Treasury yields managed to fall (and only by a small amount) over the course of the month. Investment grade corporate bonds, at one point, had a double-digit negative return. The global financial system experienced panic unlike anything seen since 2008 (if not worse this time around). But, instead of a run on banks, we had a run on stocks, bonds, and money market funds. There was a global rush to USD cash, resulting in position unwinds, forced selling, and funding stresses of unprecedented size.
The good news is that policymakers had a playbook based on lessons learned from 2008. The world’s central banks and governments dusted it off and went to work. The Fed cut rates to the lower bound and injected well over a trillion dollars of cash into the system, and pledged unlimited QE, a “whatever it takes” attitude. A new alphabet of programs were launched to stabilize financial markets, improve liquidity, and ensure flow of credit to the economy. Other central banks joined the Fed and launched significant QE programs after cutting rates to zero bound in record time. In most cases central bank purchases will cover all the financing needs of the government. The Australian central bank (RBA) also implemented a form of yield curve control (YCC). The European Central Bank (ECB) enhanced their toolkit by establishing a new program titled the Pandemic Emergency Purchase Programme (PEPP), which allows them to invest over one trillion in government bonds, in addition to the existing QE programs and with more flexibility.
Moreover, the U.S. Congress passed landmark legislation earmarking over $2 trillion to support the economy during its closure. As a result of the Fed’s and the rest of the world’s actions, markets and confidence are improving. Equity and credit markets rallied significantly the last week of March, and government bond yields moved down, in line with economic logic. It remains unknown how deep and protracted the economic downturn (recession) will be. We are hopeful that existing policy actions, and future policy actions (if current actions do not prove to be sufficient), will put a floor under the economy and allow things to gradually return to normal as the health crisis recedes. In the interim we are hostage to the path of the virus. We believe we are at the end of the beginning.
Note: USD-based performance. Source: Bloomberg. Data as of March 31, 2020. The indexes are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See below for index definitions.
Source: Bloomberg. Data as of March 31, 2020. Note: Positive change means appreciation of the currency against the USD.
Source: Bloomberg, JP Morgan. Data as of March 31, 2020.
Fixed Income Outlook
March was another schizophrenic month of extreme volatility, with yields and spreads moving up and down like yo-yos. There were three distinct regimes: The beginning of the month to March 6 was what one could call a normal bear market; March 6 to March 19 (marking the high in IG yield spreads) was more of a global panic; and then March 19th to end of the month we would call a relief rally. Of course, things were worse by the end. The first week of the month was a continuation of February. Bad news arrived but was largely in line with expectations. Equities weaker; credit spreads modestly wider, government yields, importantly, lower. 10-year U.S. Treasury yields fell over 50 basis points (bps) while U.S. IG yields were mostly unchanged. However, the explosion of infections in Europe and impending lockdowns in the United States over the weekend of March 7, along with the announcement that OPEC+ was about to start a price war instead of cutting output, sent markets reeling. There was a surge in demand for liquidity, USD cash in particular, and many investors had to sell whatever they could to get it. Money markets reeled, and foreign exchange and government bond markets behaved erratically due to investors’ pressing need to generate cash and limited liquidity for market counterparties. Equities collapsed and credit spreads (and yields) soared. The pace with which risky assets sold off into bear market territory (i.e., a decline of 20% or more) was the fastest on record.
In many ways this was a classic liquidity squeeze. The world wanted U.S. dollar cash; nothing but USD cash would do. This elicited an unprecedented response by monetary authorities worldwide. Rates were cut to the effective lower bound (if they were not there already) and trillions of dollars were injected into money markets and bond markets. New programs were begun with a whole new set of acronyms (TALF, MMCP, CPFF). These helped significantly to calm markets, particularly in government bond markets where yields, unusually, rose, as the demand for cash liquidity overwhelmed the more normal safe haven bid for (default risk-free) duration assets. By March 19, U.S. Treasury and other global government bond yields began to fall, as markets started to normalize, signaling success for the Fed’s first objective: stabilizing money markets and lowering the risk-free interest rate. Importantly, the rapid fall in U.S. Treasury yields allowed IG yields to fall as well, lowering funding costs for the embattled private sector. The U.S. fiscal stabilization program, embodied in the CARES Act, although not yet implemented, is the missing link in providing support for household and business income while we wait for the infection rate to abate and the economy to reopen.
Unfortunately, stabilization does not mean recovery. The world economy is experiencing a slowdown of a pace that is unprecedented in modern times, as governments globally have ordered businesses to shut and people to stay at home. How long the shutdowns will last is unclear, with only some Asian economies moving tentatively to normalize economic activity. Macroeconomic data is likely to be awful in April, but we think this may trouble markets less than usual, as, first the dramatic slowdown is already expected and, second, the data will tell us little about how economic growth will evolve going forward, as this depends more on the COVID-19 epidemic and how quickly governments can re-open the economy. We believe any sign that the economy/cash flow/earnings are doing better than expected will lead to better performance of risky assets. The economy was in reasonably good shape before the COVID-19 outbreak, so economic activity could normalize quite quickly, assuming containment and social isolation measures can be lifted rapidly without the threat of secondary waves of infection. The good news is that the policy response is really big.
In the interim, a lot of unknowns remain, which make us cautious. Can economies simply be reopened, like turning on a light switch? Will there be lasting damage? Will unemployment come down quickly? Which industries will survive intact? Will travel and leisure industries ever be the same? So many questions, so few answers.
Given these questions, this is what we think is an appropriate investment strategy. Government bond yields are now at unprecedentedly low levels, and at record rich levels on some valuation measures. But it is not obvious that they will rise anytime soon, even with unprecedented deficits in the U.S. and the rest of the world. There is still scope for them to fall further if the economy deteriorates, which is not hard to imagine given the uncertainty around the virus shock. Central banks will use their balance sheets to provide “infinite” QE, meaning they will do whatever is necessary to make sure credit flows to all solvent companies/industries. Fiscal agents will help support incomes and employment where possible to prevent aggregate demand from collapsing now and when the pandemic is over. This implies one should focus investments, for now, on those companies/assets that can benefit directly from government help. Government bonds, investment grade credit, agency mortgage-backed securities should all be direct beneficiaries. Of these, only investment-grade credit looks fundamentally cheap, offering potential higher returns to patient, long-term investors. High yield also presents good opportunities for those willing to assume greater risks. While this crisis is in many ways different from previous periods, high yield has proven itself to be resilient and has provided strong total returns following periods of extreme spread widening. While defaults are likely to rise sharply in certain high yield sectors, we believe the widening of high yield spreads to date mean this is already in the price. Sector and company differentiation will also be crucial, as some sectors are worse affected than others, and not all businesses will be bailed out by governments. Identifying quality management teams and business model flexibility will be key to generating investment returns.
Securitized credit is an area that performed particularly poorly in March, especially given the perception of it as a relatively low risk asset. We believe this is because of forced liquidations and loss of financing that led to distressed selling. Much of the cheapening was not because of deterioration in structure or asset performance, although a prolonged economic shutdown will obviously impair asset quality. We thus expect spreads across most securitized sectors to bounce back in April, although they may remain materially wider than pre-coronavirus levels, given the elevated economic risks from the virus. We believe the current market environment may represent a great entry point for new investors and an opportunity for recovery for current investors.
Many emerging countries are in the same position, where a general retreat from the asset class has led to forced selling and asset price declines that do not necessarily match changes in fundamentals. Governance, balance sheet strength, and economic growth will be key in identifying those countries which will perform well in the months ahead.
March was an extraordinary month for DM rates and FX markets, as corona virus concerns caused risky assets to plummet, all assets to struggle from the subsequent volatility and liquidity shock, before central banks and governments intervened aggressively to a more orderly footing. In the U.S., the Federal Reserve (Fed) announced several significant policy responses: It slashed the Federal Funds rate to a range of 0.0% to 0.25% and the discount window borrowing rate was lowered to 0.25%; it “encouraged” banks to use the discount window as a source of funding to meet client needs, which removed the stigma of using it as a source of funding.
The global outlook is contingent on the coronavirus’ path and pace at which it spreads in the coming weeks and is key in determining its global impact, both in the short- and long-run. However, given the downside risks, central banks are likely to remain accommodative for an extended period. A key differentiator for asset performance going forward is likely to be how well the pandemic has been handled, with more successful economies likely to see their asset prices benefit.
Extraordinary times were matched by extraordinary price action across markets, and movements in EM debt were no exception as risk markets registered new historic lows in March. The combination of the global slowdown, resulting from fighting COVID-19, and the drop in oil prices, related to both demand destruction and the ongoing friction between Saudi Arabia and Russia, has been challenging to say the least.
While we do not know when this will end, we can say that the numerous monetary and fiscal policies being put into effect by governments and central banks around the world are having a stabilizing effect. The illiquidity the stress generated cuts both ways, and we have seen dramatic and quick recoveries in many assets when risk sentiment turned positive (albeit assets are still lower than at the beginning of the month). Within EM, we believe some countries are positioned to withstand the current economic pressures while others are far more vulnerable. The changes to the global supply chain that were prompted by the recent trade wars will only be accelerated in the post-virus market as countries look to build their health and medical defenses.
March saw corporate spreads widen in the U.S. and in Europe. The key drivers of credit spreads in March were the uncertainty created by the coronavirus and the level of credit selling. Other factors that caused volatility include a breakdown of the OPEC discussions about managing supply, central banks’ responses to the crisis including provisions of liquidity and programs to buy corporate bonds, large supply as weakness in short term funding markets pushed high quality issuers to the public corporate market and rating action, particularly in sectors directly impacted by the weak economic activity.
The economy (and asset prices) have been hit by the containment measures necessary to halt the spread of the coronavirus and the related fall in oil prices following the breakdown of OPEC discussions. Markets are looking for clarity over (1) the length of time isolation policies will remain in force and (2) the time it will take to identify a vaccine. Hopes of a V-shaped rebound are no longer the base case as questions over the assumption that warm weather will reduce the impact of the virus and health experts warning that a vaccine is months and not weeks away are re-pricing markets. The reality is a base case no longer exists with the limited credible data.
The positive fundamental credit environment in both the U.S. and Europe quickly turned negative as large segments of the economy shut down, and the backdrop of low unemployment quickly changed with a surge of service-sector layoffs. Governments and central banks have responded swiftly with unprecedented stimulus, including massive Central bank purchases and direct cash payments to tax-payers, as well as support for small businesses and industries particularly affected by the coronavirus. These measures should help cushion the impact from the pandemic, but the effects will still be significant and will vary across different sectors.
We expect spreads across most securitized sectors to bounce back in April. The distressed selling and forced liquidations that took place in March seem to have subsided, and new capital appears to be flowing into the market. Spreads will likely remain materially wider than pre-coronavirus levels, given the elevated economic risks from the virus, but should tighten in from current levels as some of the market overreaction and forced selling pressures dissipate. We believe the current market environment represents a great entry point for new investors and opportunity for recovery for current investors.
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. 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. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. 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. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. 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). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.