We are encouraged by optimism on both the medical and economic fronts. But while recent events are promising, we believe the road ahead will be a long one.
“Nothing in life is so exhilarating as to be shot at without result.”
- The enormity of the downward economic shock due to COVID-19 is without modern precedent, but the same is true of the scope of the monetary and fiscal policy response.
- While global GDP growth is expected to take a bigger hit than at any time since the Great Depression, optimism can now be seen that a global economic recovery is beginning to gain traction.
- Economic activity has responded sharply to the stimulus provided by policymakers. In the US fixed-income markets, both investment-grade and high-yield corporate bonds have been the biggest beneficiaries of stimulus.
- We believe that opportunistically positioning yield-curve flatteners, along with an overweight in corporate bonds, could provide an asymmetrically positive risk/reward proposition.
- We remain of the view that this is going to be a long, hard slog.
The COVID pandemic has taken an astonishingly exorbitant toll on humanity from both a medical and economic perspective. The financial markets have also come under extreme pressure, but have rebounded substantially.
The path of the virus holds the key to the outlook. So much is still unknown. Listening to a broad range of medical experts is not always reassuring. Their learned conclusions and predictions vary widely. Reasonable people can disagree about the medical state of affairs. The global case counts keep rising. Economic reopenings are invariably followed by renewed COVID cases. On the other hand, the death rate has started to drop sharply. The lower mortality rate for younger persons and better therapeutics are key reasons. The medical community has finally begun to get the measure of the disease, maybe simply by the trial and error of six months of battle. There seems to be substantially less fear of hospital and medical infrastructure being overwhelmed, which was the initial motivation for government-induced shutdowns. Of course, the game-changer would be a vaccine, and there is an increasing number of reasons for optimism in this regard.
On the economic front, the devastation has been immense. In the US, Federal Reserve (Fed) Chair Jerome Powell summarized the shock succinctly: “We went from the lowest level of unemployment in 50 years to the highest level in close to 90 years, and we did it in two months.” Globally, the decline in annual GDP is estimated to be more than -5%, the worst outcome since the Great Depression.
Indeed, the enormity of the downward economic shock is without modern precedent. And policymakers globally have responded with a Herculean amount of monetary and fiscal stimulus. Economic activity has reacted sharply, albeit from an extremely depressed base. So despite the tremendous circumstances, optimism is growing that a global economic recovery is gaining traction.
“…our portfolio strategy has centered on making corporate bonds, predominantly investment-grade, our cornerstone investment.”
Markets are forward-looking discount mechanisms. The optimism on both the medical and economic fronts, combined with ongoing policy commitment, has caused global risk assets to rally meaningfully. In the US fixed-income markets, investment-grade corporate bonds as well as high-yield corporates have been the biggest beneficiaries.
The overarching goal of US economic policy is to keep the corporate infrastructure intact to facilitate a recovery. This crucial objective led to allowing the Fed to buy corporate bonds directly for the first time ever. As we pointed out in our last note, the 2Q20 market commentary, our portfolio strategy has centered on making corporate bonds, predominantly investment-grade, our cornerstone investment.
As we also said in our last note, investment-grade yields have declined by the end of every US recession. Lowering high-grade borrowing costs is a crucial objective in sustaining the recovery. Additionally, providing plentiful liquidity to facilitate the borrowing needs of more challenged corporations has also been a bulwark of the Fed’s program. The Fed’s avowed commitment to maintaining an extraordinarily accommodative stance until a “vigorous” recovery is underway continues to bode well for this sector.
“The more persuasive fundamental arguments follow from our view that we remain in a highly disinflationary environment.”
Overseas investment is yet another source of demand for US corporate credit. With global policy rates more closely aligned, hedging costs for foreign investors have collapsed. Global fixed-income investors desperately need yield. Yet developed country policy rates are zero or negative, and there is little prospect of any increases for years to come. US corporate yields may be very low by historical standards, but they are much higher than in most of the developed world. These factors underpin global buying support for US corporate bonds.
The chances of more “lockdowns” in response to ongoing COVID-19 outbreaks cannot be ruled out. The enormity of the global debt load continues to be a serious risk. How do investors help balance a portfolio designed for a global recovery? In our webcast last month, we amplified our theme of opportunistically positioning in yield-curve flatteners. We believed this would be a powerful diversifying and hedging device for our overweight in corporate bonds. Theoretically, the key to using strategies with negative correlations is that they must be viewed as having asymmetrically positive risk/reward attributes. Otherwise, the question would be, “Why hedge when you could just simply reduce your exposure?” Our strongly held view is that this trade possesses these asymmetrical characteristics. We feel it is straightforwardly negatively correlated with spread sector performance. The asymmetry is judgmental, but rests on the proposition that while yield-curve flattening can be expected in a “risk-off’ environment, the overarching concern of policymakers to keep financial conditions from quickly or sharply deteriorating implies a reasonable probability of increased central bank long-maturity asset purchase defense. The more persuasive fundamental arguments follow from our view that we remain in a highly disinflationary environment. This strategy implicitly seeks to take advantage of rising rate expectations evidenced when the yield curve steepens. It is best utilized by investors, like ourselves, who believe any significant inflation threat lies far into the future. Exhibit 1 shows the experience of this strategy combined with an investment-grade corporate bond overweight since our last note.
Exhibit 1: 5-Day Performances of Investment-Grade and 30s/10s Spread Trades
Source: Bloomberg Barclays. As of 14 Aug 20. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
“In our view, policymakers are right to be completely focused on precluding a relapse.”
The aversion most investors have toward longer-term Treasury bonds is rooted in the fear that while possibly temporarily dormant, much higher inflation lies ahead. This is evidenced by the shape of the yield curve. Taking 10 years of Treasury duration risk affords only a 66 basis point (bp) yield. Yet the spread between 10- and 30-year Treasuries, a fully hedged duration trade, stands at fully 75 bps. In this world of very low yields, and the high probability that policy rates will stay “low for long,” we think this spread pricing helps provide an opportunity for defensive positioning.
The stronger inflation suspicion championed by many is that policy stimulus will persist long after recovery has been achieved and eventually lead to an inflation problem. But while this scenario is plausible, it appears to us to be at best far into the future. We think there are too many ifs. If the economic recovery can be sustained; if the recovery strengthens and broadens; if the deflationary impulse is truncated; if the policy stimulus remains every bit in force; then…maybe we see inflation pick up sharply. We believe this economic recovery is not even remotely out of the woods. In our view, policymakers are right to be completely focused on precluding a relapse. Interest rates and inflation may well be anemic for years. It will be a long climb out of this hole if all goes well.
We are extremely gratified that our optimism at the depth of the despair in the markets has proved warranted. But winning the battle being fought against the downward economic and price pressures is no foregone conclusion. Looking forward, the massive addition of global debt—already a huge problem before the crisis—will retard growth for years. We remain of the view that this is going to be a long, hard slog.
High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.
U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
One basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).
The Great Depression was the worldwide economic downturn that began in 1929 and lasted until about 1939. It was the longest and most severe depression ever experienced by the industrialized Western world, sparking fundamental changes in economic institutions, macroeconomic policy, and economic theory. Although it originated in the United States, the Great Depression caused drastic declines in output, severe unemployment, and acute deflation in almost every country of the world. Its social and cultural effects were no less staggering, especially in the United States, where the Great Depression represented the harshest adversity faced by Americans since the Civil War of the 1860s.
Gross Domestic Product (GDP) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
Investment-grade (IG) bonds are those rated Aaa, Aa, A and Baa by Moody’s Investors Service and AAA, AA, A and BBB by Standard & Poor’s Ratings Service, or that have an equivalent rating by a nationally recognized statistical rating organization or are determined by the manager to be of equivalent quality.
High yield (HY) bonds, also called junk bonds, are bonds with below investment-grade ratings (BB, B, CCC for example) and are considered low credit quality and have a higher risk of default.
The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.
Yield curve flattening refers to shifts in the yield curve such that the differences between shorter-maturity and longer-maturity securities decreases. Yield curve steepening refers to an increase in those differences.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
Risk-on risk-off refers to changes in investment activity in response to global economic patterns where trading activity is highly correlated. During “risk-on” periods when risk is perceived low, investors tend to prefer higher-risk investments. During “risk-off” periods when risk is perceived as high, investors tend to prefer lower-risk investments.
A spread is the difference in yield between two different types of fixed income securities with similar maturities; usually between a Treasury or sovereign security and a non-Treasury or non-sovereign security.
A 30s/10s spread trade refers to a trading tactic which intends to potentially take advantage of changes between bonds with 30-year maturities (“30s”) and those with 10-year maturities (“10s”).co
A long-short overlay refers to a trading tactic where one security is bought (i.e., long), and a second security is sold (“short”).
Correlation is a statistical measure of the relationship between two sets of data. When asset prices move together, they are described as positively correlated; when they move opposite to each other, the correlation is described as negative or inverse. If price movements have no relationship to each other, they are described as uncorrelated.
Duration measures the sensitivity of price (the value of principal) of a fixed-income investment to a change in interest rates. The higher the duration number, the more sensitive a fixed-income investment will be to interest rate changes.