May 15, 2020
The Long and Winding Road
May 15, 2020
The calamitous events of March quickly receded into memory as markets recovered dramatically in April. In fact, we had 18 months’ worth of bear/bull markets (credit and equities) compressed into those fateful weeks, beginning in mid-March. The S&P 500 was up 13%, its best month since January 1987, while the Bloomberg Barclays US Corporate Index returned 5.2%. We had some of the best days and weeks and some of the very worst all in March/April. Interest rate volatility collapsed and is now close to pre-crisis levels. Yet the world also experienced the worst economic data ever seen, at least over such a short period of time. Every data release in Europe and the U.S. was worse and worse, more often than not exceeding already depressed forecasts/expectations. Yet markets rallied.
Policies responded: monetary policy, fiscal policy and, just as importantly, health policy responded (or showed strong signs of working). On all three fronts, policy actions were unprecedented. The U.S. Federal Reserve (the Fed) added over $3 trillion to its balance sheet in a matter of weeks. The U.S. Congress passed unprecedentedly large fiscal support packages designed for direct income support and credit support for the corporate sector, partnering with the Fed and banking sector to distribute trillions of dollars of support. In fact, estimates have been made that, as a result of all the policy actions in the U.S., national income (as defined in GDP accounts) will actually be up this year. As with any war -- and this is a war with a virus -- overwhelming firepower frequently wins the day. And, so far policymakers seem to be winning.
Our commentary title last month, “The End of the Beginning,” seems very appropriate. The economic policy war has been won, in that enough support and confidence has been injected into the economy at large to give health policy a chance to slow infection rates to low enough levels to reopen economies. The good news is that this is happening and will likely support asset prices. The bad or uncomfortable news is that we do not know if it will work in North America, Europe and in many emerging countries. First-in-first-out China may provide some clues as to what to expect in terms of recovery patterns. So far the evidence points to sluggish (though potentially bottoming) behavior in the services sector (amid soft consumption), and a more convincing rebound in manufacturing, recently tempered by weak export data (due to falling external demand). The potential for a second wave of infections could also jeopardize a more decisive recovery in economic activity and needs to be monitored. Given all the imponderables surrounding the near future, but taking into account the progress made, cautious optimism is warranted. While we may indeed be on a “long and winding road” the longer your investment horizon, we believe the more confident you should be.
Fixed Income Outlook
After the roller coaster and depressing series of events in March, April was a welcome relief. Policy actions were of unprecedented size and structure, showing a degree of coordination (if indirect) of monetary and fiscal policy not seen since the 1940s, helping money markets, government bonds and credit markets to stabilize. Risky assets rebounded and, importantly, government bond yields fell. A synchronized collapse in global economic activity corresponded with a synchronized policy response with implicit messages: “we will do whatever it takes” and “failure is not an option,” wartime slogans appropriate for today’s COVID-19 war.
As the news flow improved, we could characterize unprecedented weakness in economic data and negative oil prices as positive, in the perverse sense that what is at zero can only go up. The combination of massive policy actions on monetary/fiscal/health fronts with the sense -- and it is only a hunch -- that economic activity is reaching a bottom in April/May is leading to better asset market performance. We believe that government bond yields (in general, maybe not for every country) in developed markets, equities and oil bottomed in March/April, and employment will bottom in May. But, where do we go from here after the strong April rallies?
We expect QE to continue in an unlimited way in the coming months across developed markets, even if at a reduced pace given the frenetic interventions in March and April. It is still too soon to be able to tell the ultimate impact that the coronavirus will have on the economy and global markets. Will reopenings cause a second wave of infections? Will travel and leisure activities return to “normal”? What shape or contour will the economic recovery have? V shaped? Not likely, unless there is a miracle healthcare development, given the severe disruptions to the global economy and persistent impact on consumer behavior. Will it be a checkmark recovery, with rebound not as sharp as downturn? Or could it be an L, or a W? We do not know. We do believe risk-free government bond yields will remain low, an unlikely source of return going forward, and that inflation will not be an issue. Because of this, we believe central banks will continue to be accommodative indefinitely, or even expand stimulus to new heights.
A consolidation of the improved risk sentiment observed during April may benefit risky assets. For instance, while the economic and health outlooks look a lot better now, and volatility has retreated, government bond prices and investment grade spreads generally reflect that; that is, a short, sharp recession but no depression. In order to see further compression of corporate bond spreads, whether investment grade or high yield, the economy will need to emerge from lockdown in an orderly fashion. Government support of incomes at their recent pace is probably unsustainable past the summer. The Fed’s TALF program is expected to terminate at the end of September, for example. This of course does not mean programs and support cannot be renewed or expanded, it is just that the medium term cost in terms of debt, lost productivity, lost income and lower future living standards (hopefully only relative to previous expectations) are potentially very high. Therefore, while spreads are still wide of pre-crisis levels, a relatively large amount of near-term optimism is discounted.
Two sectors underperformed in the April rebound. Emerging Market (EM) debt and securitized credit. The simple reason is that neither benefitted directly from all of the monetary and fiscal support policies announced and implemented in March and April. Therefore, attractive valuations, stabilization in commodity prices, and progress on funding/debt relief initiatives directly targeting EM economies could combine to provide a boost to EM debt in the near term.
Securitized credit also failed to rebound as much as developed market credit (or agency mortgage backed securities) for the same reason as EM. For this reason we believe there is more room for securitized credit to catch up to corporate credit in the months ahead as there is more room for spreads to compress as economies come off the floor, so to speak. New issuance remains very light and secondary selling has slowed substantially, while demand appears to be steadily increasing. Spreads are unlikely to quickly return to pre-COVID-19 levels (but neither are credit spreads in general) given the elevated economic risks from the virus, but we expect spreads to continue to tighten in from current levels.
While we remain optimistic that the worst is over, so do financial markets, meaning that a second wave of infections requiring a second wave of lockdowns could be deleterious to risky assets. China did not relax its lockdown until it had essentially defeated the virus, and even now social distancing measures and travel restrictions remain in place. Europe and the U.S. are attempting to relax lockdowns while still trying to reduce infections, a much harder battle. Sweden is conducting an experiment of not locking down the economy and absorbing the infection costs with only a focus on social distancing. Is this a harbinger that unlocking economies before the virus is well under control is possible? As every country has its own social norms and is experiencing different infection and mortality rates, we must be careful about generalizing the experience(s) of one country to others. We will know more over time and our investment strategy will adjust to changing facts and valuations.
In April, market conditions seemingly began to revert to more “normal” levels as massive government stimulus measures began to work across the developed markets, mainly in the United States. The VIX fell by 19 percentage points after reaching as high as 83 in March.1 Over the month, changes in developed market government 10-year bond yields were mixed. Central bank action remained the driver, with yields falling more where central bank easing was more aggressive and not doing as well where they were less aggressive.
Overall, we expect continued monetary policy accommodation across developed markets in the coming months. Having eased aggressively in March and seen market conditions stabilize, it is understandable that most central banks waited to see if further accommodative measures are necessary. This will depend on market conditions and developments in the underlying economy. But, with (upward) inflationary pressures very weak and economies hit by a severe exogenous shock, there is every reason to believe central banks will be ready to ease further, although most will have to do so via unconventional policy measures (e.g. QE and liquidity provision measures) given policy rates in most DM economies are already at the lower bound.
EM assets rallied in April as the impact of monetary and fiscal stimulus from global authorities worked its way through financial markets. EM dollar-denominated corporates led the way in performance, driven by the high yield segment, as well the industrial, consumer, and metals and mining sectors. Domestic debt followed corporates as local bonds rallied and EM currencies strengthened versus the U.S. dollar. Dollar-denominated sovereigns brought up the rear as Latin American countries lagged.2
Following the incipient stabilization observed in April, market attention will focus on the gradual easing of lockdown measures in the developed world. First-in-first-out China may provide some clues as to what to expect in terms of recovery patterns: so far the evidence points to sluggish (though potentially bottoming) behavior in the services sector and a more convincing rebound in manufacturing, recently tempered by weak export data. The potential for a second wave of infections could also jeopardize a more decisive recovery in economic activity and needs to be monitored.
The key driver of credit spreads in April was a more optimistic expectation for markets as the coronavirus debate moved to strategies to exit the lockdown and the policy response intensified with additional liquidity support for corporates and fiscal grants for labor furloughed as a result of the “shuttering.” The month can be broadly split into two stages, an initial rally from the wide spreads of March, followed by a consolidation toward month-end when spreads rebounded to levels seen in February 2016, when oil was last below $30 per barrel and the base case expectation was for a demand driven recession.3
We frame the outlook for credit a simple question: Is now the time to buy? Fundamentals have consolidated, with the optimists citing advances in the path to a vaccine and plans to exit lockdown with the economy supported by the level of policy stimulus/support, while pessimists focus on the risk of reinfection and the economic cost seen in the current weak economic data. Valuations seem to be fair for the current backdrop.
The securitized market partially rebounded in April, with spreads tightening to varying degrees, although remaining materially wider across all sectors than pre-COVID-19 levels. There was a clear tiering of recovery, with higher-quality assets and securities receiving support from the Fed and recovering most significantly, while more credit-sensitive securities languished. Fundamental credit conditions remain challenged, with U.S. jobless claims over the last six weeks totaling over 30 million.4
We expect to see spreads continue to tighten across most securitized sectors in May. New issuance remains very light and secondary selling has slowed substantially, while demand appears to be steadily increasing. Spreads are unlikely to return to pre-COVID-19 levels given the elevated economic risks from the virus, but we expect spreads to continue to tighten in from current levels. We believe the current market environment represents an attractive investment opportunity, as we believe that current spreads overcompensate for actual credit risks.
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