Glimmers of Optimism

Market commentary

Glimmers of Optimism

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.”
Winston Churchill

Key Takeaways

  • 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.”
Western Asset

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.”
Western Asset

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.”
Western Asset

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.

Definitions:

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.

Top

Important Information

 

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is approved for distribution in those countries and to those recipients listed below. Note: this material may not be available in all regions listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

All Qualified Investors in Switzerland:
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH. Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All investors in the UK:
In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People's Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC's commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC's commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (109) Jin Guan Tou Gu Xin Zi Di 016; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC.

All Investors in Australia and New Zealand:

This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827).  The information in this document is of a general nature only and is not intended to be, and is not, a complete or definitive statement of matters described in it. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

The aforementioned Legg Mason entities are wholly owned subsidiaries of Franklin Resources, Inc.