The following insights from our sub-adviser, Wellington Management, feature the latest from their macro, multi-asset, fixed-income, equity, and commodities teams. Use the links below to jump to your area of interest.
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This page will be updated on an ongoing basis as events warrant, with the most recent insights at the top of each section.
Update on ECB Actions
Jens Larsen, Macro Strategist
March 30, 2020
- The European Central Bank (ECB) has shed most of the remaining constraints on purchases. It will be able to support an aggressive expansion of sovereign issuance this year.
- The eurozone’s fiscal response lags behind, but will catch up over the coming weeks as growth deteriorates.
- Eurozone political leaders will likely eventually endorse using the European Stability Mechanism (ESM), but will need to go further.
ECB’s Pandemic Emergency Measures
The ECB has published details of its €750 billion Pandemic Emergency Purchase Program (PEPP).
When the decision was made last week, the ECB stressed the flexibility of its implementation. This decision is the practical implementation of that:
- Greece is included in the program.
- The 33% limit on the share of eurozone members’ bonds that the ECB will hold under its existing programs does not apply to the PEPP.
- The ECB can buy across the yield curve, from very short maturities (down to 70 days) to very long ones.
- The ECB has accepted pari-passu* treatment in the event of a sovereign-debt restructuring.
Few Constraints Remain
The last three points were news, I believe, and demonstrate that the ECB will disregard past constraints in order to respond to the pandemic. The remaining constraint is that the purchase amounts are guided by the ECB’s capital key, which, in turn, reflects the size of the economies, rather than the size of the debt market or the current needs. That said, the ECB can temporarily deviate from that key and lean into specific markets if necessary.
Program Can Scale up if Necessary
With purchases of more than €1 trillion (>8.5% of GDP) before year end, the ECB has given assurance to the market that the sharp rise in debt issuance that we will see in the coming months will be absorbed. I think that is an important assurance that will keep sovereign spreads in check.
Challenging Debt Position of Many European Governments Remains
Many European sovereigns will see sharp rises in issuance and in debt-to-GDP as a result of this crisis. Italy has particularly challenging dynamics, but it is not alone. The ECB will end up holding much of that increase on its balance sheet, in all likelihood for a long time. By the end of the year, the ECB will likely hold more than 30% of GDP in its asset purchase programs. There is no reason why it should stop there.
ECB More Aggressive Than Political Leaders
Heads of government have so far failed to reach an agreement on how to approach the challenges facing the fiscally most vulnerable countries (as of March 27, 2020). I expect that they will eventually agree to use the ESM to support EU governments, whereby individual governments can draw up to 2% of GDP on credit lines with light conditionality. Any country can apply, but it is done on an individual basis, so it will still be debt. I don’t think EU leaders are ready to contemplate a ‘joint debt instrument’ that goes beyond the use of the ESM. Although such a solution would provide a helpful backstop, it would be politically challenging for many countries.
Support Required Beyond Italy
If a broad range of countries draw on the ESM for funding at low rates, which it effectively establish a practice of near-joint issuance of debt. All eurozone countries would be on the hook for much of this increase in debt, either via the ESM or, ultimately, via the ECB. That, I think, is the practical reality. The politics need to catch up.
Does This Go Far Enough?
Speaking only for myself, I think it does, for now. The ECB can act aggressively in the interest of the eurozone as a whole—that is what its mandate says. It is not surprising that the eurozone’s political leaders are focused on their own national crisises, and that they struggle with decisions that have deep political and fiscal implications.
The German and Dutch (and other) governments are not willing to give grants on a large scale. Imagine the politics of handing over hundreds of billions of euros to another rich country at a point of economic crisis. I think they will ultimately be willing to lend their credit and accept that the ECB acts as a backstop, but they are not there yet.
This Supports Eurozone Fiscal Response
In comparison to the US, the discretionary increase in fiscal spending may look less impressive so far. But in the eurozone, the automatic stabilizers—the rise in spending that comes about when revenues fall and unemployment rises—are much bigger, particularly when the GDP decline is big. The ECB’s decisions and the ESM measures will ultimately buy some room for this fiscal response.
* Pari-passu is a Latin phrase meaning "equal footing." In finance, "equal footing" means that two or more parties to a financial contract or claim are all treated the same. Pari-passu is common in bankruptcy proceedings as well as debts such as parity bonds.
The Fiscal Package Helpful, but Not a Panacea
Michael Medeiros, CFA, Macro Strategist
March 20, 2020
I think Congress will pass a large piece of fiscal legislation over the next month or so in response to the coronavirus fallout. Subsequent legislation is also possible, depending on the duration of the economic downturn. Given the ideological differences between Democrats and Republicans (and within the parties themselves), the legislative process could easily fail once or twice before ultimate enactment. Any legislation will need to be bipartisan enough to garner the 60 necessary votes in the Senate.
That said, I think Congress will pass something relatively soon, perhaps as early as this week, with an initial size of between 3%-5% of GDP (risks are skewed toward more). The speed with which equity markets have declined, especially over the past week, has sharpened the urgency within both the Trump administration and Congress. Going forward, Congress can and likely will do more, but perhaps only if markets and the economy weaken further. I expect legislators to continue to be reactive, not proactive.
It’s All About the Details
The details of the legislation will matter. Republicans are coalescing around a plan that would include three buckets: tax cuts/cash payments to individuals, small-business lending facilities, and industry support (notably for airlines). Democrats could support individual assistance (as long as it’s means-tested) and small-business lending support, but they’re also pushing for public health infrastructure (e.g., hospitals, supplies), expanded unemployment insurance, and some loan forbearance measures.
The industry-specific support, starting with airlines, could be a sticking point. If Democrats go along with it, they may push to add restrictions such as those suggested by Senator Elizabeth Warren, which include worker and consumer protections, as well as minimum wage stipulations and share buyback limits. It’s not clear if Republicans would agree to such restrictions, and I think the bar for industry bailouts is much higher today than in 2008-2009. However, if the two parties find common ground on this, it would open the door to supporting other industries too (not just airlines).
Right now, here’s my sense of what is being proposed, including the upper end, in terms of cost, that could be agreed upon by both sides initially:
Individual support (US$500 bn)
- Some combination of tax rebates and individual checks (mailed in two tranches)
- Democrats likely to push for, and secure, means-testing for both rebates and checks
Automatic stabilizers (US$200 bn)
- Expanded unemployment insurance and Medicaid funding to states
- Republicans likely to push back on some spending, but Senate Democrats have leverage
Small business (US$250 bn)
- Small Business Administration (SBA) emergency lending
- Creation of a new small-business lending facility
Industry-specific support (US$50 bn – US$200bn)
- US$50 bn to airlines, if stipulations and conditions can be agreed upon
- Could lead to support for other negatively impacted sectors
- Of course, if the public health system gets overrun, then bailouts and the federal debt burden would grow materially.
Public health/other (US$400 bn)
- Public health funding to states
- Federal mortgage loan forbearance
- Student loan agreement modifications
While the proposed fiscal package is substantial and could even grow, so far it appears to be a combination of automatic stabilizers and temporary income assistance. Helpful? Of course, especially if Republicans agree to public health investments, but likely not a “cure-all.” That would require science and a more significant investment in public health infrastructure to attack the underlying nature of the crisis. More cash won’t make people go out and spend until the health threat subsides meaningfully.
In the medium term, the proposed bill would also worsen what is already a deteriorating public-debt backdrop. Federal debt as a percentage of GDP is already the highest since World War II. If we assume the pending fiscal package in the context of a recession, that figure would approach 150% of GDP over the next decade. Without any medium-term restraints on entitlement spending, this could have major implications for the fiscal premium in long bonds. It seems the market is already sniffing that out, despite the still historically low level of yields. In conjunction with recent actions of the Federal Reserve, MMT* type policy could be taking hold, without policymakers specifically calling it that.
Congress should eventually enact a fiscal package worth at least 3%-5% of GDP, but one geared toward automatic stabilizers and one-time consumer assistance. A panacea it is not. And the fiscal easing would come in the context of a rapidly worsening federal debt trajectory, with potentially big implications for longer-dated Treasuries.
* Modern Monetary Theory is a heterodox macroeconomic framework that says monetarily sovereign countries like the US, UK, Japan, and Canada are not operationally constrained by revenues when it comes to federal government spending.
How Does a Global Recession Turn into a Financial Crisis?
Eoin O’Callaghan, Macro Strategist, London
March 9, 2020
A coronavirus-driven global recession now looks likely. The longer the shock lasts, the bigger the risk it spills over into market stress given the high level of debt in the system and low level of global liquidity growth going into this shock. This is a critical risk we are monitoring along several dimensions:
- Global liquidity – There is a risk that the hit from coronavirus could turn into a global liquidity shock, compounding the drag on growth. Going into the coronavirus shock, global liquidity growth was close to 30-year lows. Both central bank liquidity (monetary base + foreign exchange reserves) and deposit liquidity (M2)* were starting to improve at the turn of this year but remained very low by historical standards.
- Funding stress – Some measures of stress have started to widen over the past few days. For example, the FRA-OIS spread^ (difference between 3-month London Interbank Offered Rate and the Overnight Indexed Swap rate) was up to 40 bps† as of this writing, the levels we saw last year before the US Federal Reserve (Fed) stepped in. But that is still only just over half the peaks we saw in 2012 (70 bps) and a fraction of the levels (140 bps) we saw during the global financial crisis.
- Global foreign exchange (FX) reserve growth – Global FX reserves could be particularly vulnerable to a significant slowdown. Weaker commodity prices, a faster contraction in global trade, and a stronger dollar would all put downward pressure on global liquidity. Recent weakness in the US dollar could be a positive development in that regard if it can continue, especially if it leads to stronger commodity prices. And if developed market central banks start to reaccelerate asset purchases/inject liquidity, it could provide a further offset. But I believe the risk is skewed toward a significant fall in FX reserves.
*M2 is a calculation of the money supply that includes all elements of M1 as well as "near money." M1 includes cash and checking deposits, while near money refers to savings deposits, money market securities, mutual funds, and other time deposits.
^Spreads are the difference in yields between two fixed-income securities with the same maturity, but originating from different investment sectors.
†A basis point is a unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indexes and the yield of a fixed-income security.
NEW The World Is Watching
Wendy Cromwell, CFA, Vice Chair, Director of Sustainable Investing, and Portfolio Manager, Boston
March 31, 2020
During this period of unprecedented upheaval and disruption, some companies will rise to the challenge of the moment, while others will not. In many cases, their most enduring actions—and the ones that help them survive—will include environmental, social, and governance (ESG) decisions as well as financial ones. How are companies ensuring employees’ safety? What benefits are they providing? How are they treating customers and communities? Are they evaluating the resilience of their supply chains?
During our engagement calls with executives and boards, we are asking questions like these to understand how each company is responding to the COVID-19 crisis and considering all its stakeholders. I’ve included a few of our investors’ insights here:
Carolina San Martin, CFA, Director of ESG Research
On a recent energy-company call, it was clear that the board and management have increased their focus on employees in light of the COVID-19 crisis. While they didn’t rule out layoffs down the road, their first capital expenditure (capex) cuts this week did not include any reduction in force. They plan no change in their commitment to their energy-transition strategy. In fact, management believes this crisis may accelerate action on climate change, because it has given the world a stark picture of what massive economic and societal disruption looks like. They cited a strong culture of collaboration among the board and management teams, who say functioning as a team is paying off during this crisis.
Michael Shavel, CFA, ESG Research Analyst
I think times of crisis help investors get a better sense of whether companies do what they say they do. It’s easy to publish a shiny sustainability report that highlights how employees are key assets, suppliers are partners, and customers are the lifeblood of the business. But during tough times, we get to see how boards and management view and prioritize various stakeholders. There’s no one right way to go about it, but we should at least be looking for consistency between the message we’ve been hearing and the actions being taken. A lack of consistency might suggest that we apply more skepticism to other elements of the business narrative.
Mark Whitaker, CFA, Equity Portfolio Manager
Will companies pay employees during the shutdown? How are companies prioritizing the safety of their workforce? My recollection is that after September 11, 2001, and during the global financial crisis, layoffs were broad and cold. While the subject of layoffs is always painful, I am heartened that thus far—this time, and in a small way—it feels different. When this period is over, will we be able to point to real differences? Will the view of certain corporate cultures be enhanced? I’ll be interested to see.
Prachi Shah, CFA, Global Industry Analyst
The key difference between my flow-through assumptions last week and what the company provided today, is that they will be paying some inactive labor. I think we can apply this assumption to other similar businesses. It is the right thing to do for society, and it will probably set a precedent.
Jessica Fry, Business Associate
We should keep thinking about how all companies in the portfolio interact with customers. This could be a differentiator, depending on consumers’ reaction. Many airlines and hotels are offering refunds for customers not wanting to travel. Grocery store chains are making it easier on shoppers with “elderly hours.” I think the effects on corporate culture and customer relationships are going to last a lot longer than the market impact.
Mark Mandel, CFA, Equity Portfolio Manager
One of the world's largest home-improvement retailers announced it is temporarily adjusting store hours to better serve customers and communities in response to COVID-19. The company understands that this action is essential to the communities it serves, and says it is committed to keeping stores open during times of crisis and natural disaster.
Eunhak Bae, Global Industry Analyst
On a call last night, the CEO highlighted various employee and community actions the company was undertaking. I thought it was a strong statement of its commitment to be a good corporate citizen and of confidence in its financial health. The actions included bonuses for lower-level employees, emergency-fund relief for employees facing financial hardship, supply-chain support for protective equipment, and help for small business vendors with liquidity issues. I plan to give management positive feedback when we speak to them next week.
The World is Watching
Wendy Cromwell, CFA, Vice Chair, Director of Sustainable Investing, and Portfolio Manager, Boston
Saints and Sinners
Mark Mandel, CFA, Equity Portfolio Manager, Boston
March 26, 2020
This crisis represents a seminal moment for responsible investing. To this juncture, many portfolio managers have understandably struggled to incorporate environmental, social, and governance (ESG) into their investing frameworks. ESG can feel steps removed from buy/sell decisions and seem arbitrary, as though conclusions are reached by applying personal values.
I see this changing right now. Starting with Wellington’s recent virtual Consumer Conference, and continuing over the past couple of weeks, we have had hundreds of touch points with company management teams. Those conversations have broached topics affecting a wide range of stakeholders:
- Is management working from home?
- Who is coming into your offices/stores/warehouses/factories?
- How are you dealing with employees?
- How are you accommodating customers?
- Are you building supply-chain resilience?
- What’s happening in your local communities?
These discussions have felt natural, because they are very relevant to long-term shareholder value. Stakeholders will remember companies’ actions during this crisis for a long time. The ability to hire, rehire, and retain talent will be shaped by reputations developed now. Brand loyalty may be gained, strengthened, or lost based on how customers are treated. If an investor is asking questions like these today and considering the inputs when making investment decisions, then ESG is part of their framework.
For better and for worse, the media is becoming more focused on corporate behavior. The Financial Times has added a “Saints and Sinners” section to its Moral Money newsletter, this week lauding a few producers of emergency healthcare supplies and criticizing a few online retailers, pharmaceuticals, and even professional sports teams.
Our colleague John Averill asked in Wellington’s Morning Meeting yesterday about best practices for treating employees during this crisis. I have learned that the answers are very case-specific. Some companies that have financial flexibility and benefit from strong current business trends can go a long way to help. Technology companies and grocery chains are two that come to mind. Some companies may want to do the right thing but are less flexible, hamstrung by the size of their workforce and the realities of the current environment. Hotel chains or food service companies are recent examples. Even companies that seem best-positioned to weather this storm may have to grapple with important employee welfare issues, including childcare, heightened stress levels, and, of course, illness.
In his recent book, Skin in the Game, author Nassim Taleb talks about via negativa; essentially, we know what is wrong with more clarity than we know what is right. I find this to be especially true about company actions today, and about ESG in general.
In sum, there is no one “right” approach for companies to take. Each must consider a matrix of options and stakeholders, including employees, customers, and shareholders. And their choices are constrained by their specific financial reality. Investors need to apply judgment, just as with traditional fundamental analysis: Is a company doing a good job reaching balanced decisions, given the multidimensional issues it faces? Are management’s choices consistent with its culture and strategy? Are these behaviors consistent with the reasons why you own the stock, and with your time horizon for investing?
We’re All in This Together
Michael Carmen, CFA, Co-head, Private Investments, Boston
March 24, 2020
I thought I would put a few thoughts out there, as we once again navigate a difficult market environment.
- During periods of extreme volatility, mistakes are inevitable. Right now, it may seem like every transaction we made before the market declined looks bad and every upgrade we’ve made since hasn’t worked out. Don’t look in the rearview mirror; the information is changing fast. Just focus on trying to make the right decision for your clients every single day.
- Maybe another way to say this is, don’t let a bear market (or a recession) go to waste. An old mentor of mine once said, “You might need to underperform in the near term in order to outperform in the long term.” Remember, while some of these prices will probably look amazing two years from now, they could still look horrible next week.
- Stay true to your investment philosophy because it will ultimately serve you well. The worst mistake I made during the global financial crisis was getting more conservative at the beginning of 2009. It was a bad decision and led to a period of disappointing performance.
- Stick to your guns, but always be flexible as new data arrives. A flexible mind is a sign of strength, not weakness. Don’t be afraid to adjust your “philosophy and process” if you believe there are ways to make it stronger. After that period of poor performance in 2009, we added our Up/Down valuation framework and we have never looked back. Time and again, it has been super helpful in giving us a much better quantitative view of the downside if a thesis didn’t play out.
- As our colleague Mark Whitaker likes to say, “Stocks can always go lower.” In 2009, the poster child was Las Vegas Sands, which dropped 99% from its high. Don’t anchor yourself into a specific price. The old adage that the market can remain irrational longer than you can remain liquid is true.
- Sleep! I know it is very stressful and I’m sure everyone has lain awake in bed at 2:30 a.m., wondering what could possibly be coming at us next. I know I have. But none of us can make good decisions for our clients if we are sleep deprived. And we don’t have to commute to work right now, so we have all that time back. In our tenet “client, firm, self,” self might be last, but it’s still a priority. Take care of yourself.
In my 21 years at Wellington, even in the depths of these bear markets, I have always wanted to come to work because I knew I was sharing the experience with my colleagues. We are all in this together. I’ve now experienced three horrible, stressful, life-changing periods in the markets. It is awful. No one likes to lose money. No one wants to underperform their benchmark. But as another veteran investor, retired portfolio manager Ed Owens, once said, “Betting against the survival of the universe has been a bad gamble for millions of years.”
Preparing for Even More Volatility
David Lundgren, CMT, CFA, Director, Technical Analysis, Boston
March 17, 2020
Other than direction, what distinguishes uptrends from downtrends is their different return and volatility profiles. Uptrends are the result of investors’ steady confidence in their market outlook, which is constantly reinforced as the market marches higher. This momentum feeds on itself, emboldening investors to buy every dip. As a result, uptrends provide strong returns and low volatility, producing a very attractive Sharpe ratio.*
Downtrends are quite the opposite. Uncertainty about the market outlook materially undermines investor confidence, flipping the behavior from buying dips to selling rallies. From time to time during downtrends, we get multi-standard-deviation rallies. These are often headline-induced gyrations that ultimately fail, repeatedly dashing the hopes of investors. Eventually, a new sort of confidence returns to the market, where investors are “confident” that the world is going to end so they proceed to sell everything, regardless of price. Then we bottom. This combination of progressively lower prices and extreme intermittent volatility results in a very unattractive Sharpe ratio.
The current downtrend is no different, and investors need to prepare for an even more volatile period. In the autumn/winter of 2008/2009, after September’s 20% decline from all-time market highs was already on the books, multi-standard-deviation rallies of 5%–10% became “normal.” Each one was driven by hope, triggered by some unprecedented government intervention or exciting headline. In all cases, my personal bottom-identifying checklist of trend change never indicated an actual change. In other words, the trend remained down despite these voracious rallies. Worse, the ensuing percentage decline to ultimate crisis lows was still at least another full bear market, or -20%, away.
This is not a forecast, and I’m not suggesting we doubt every rally, but until the trend shifts from down to up, there is little reason to chase hope-fueled upticks that run the risk of failing.
In 2008, we referred to the investor fear that spread through markets as “contagion.” Today, in addition to the actual contagion of the coronavirus itself, we are dealing with investor contagion that is responding to policy contagion. As leaders try to stem the spread of this virus by canceling events, closing attractions, and declaring states of emergency, the pressure increases on private-sector leaders to respond similarly or risk indictment, in hindsight, for doing nothing. We are hearing questions like, “Is it too soon to buy?” and “Is it too late to sell?” Both queries share a tinge of hope that the lows are in. Both are essentially asking “Are we going lower?,” implying that the panic button has yet to be hit. If consensus was that the market had farther to fall, these questions would be different. People would be asking, “How much cash should I withdraw?,” “How safe is my money market?,” or “Which should I stock up on, soup or beans?”
I do not have the answers, but that is mostly because, as a trend follower, I don’t ask many questions. Trend following is about identifying what is happening and doing that until it is no longer happening—without making forecasts as to when conditions might change. It’s not perfect. One criticism we often get is that trend-following strategies only do well over the long term because of “crisis alpha,”^ meaning they protect capital when things really go bad. Guilty as charged. If compounding is about digging small holes during downtrends and fully participating during uptrends, then I believe trend-following potentially offers a solid, repeatable approach. In the current environment, digging small holes is paramount until better market conditions return.
* Sharpe Ratio is a measure of the excess fund returns per unit of risk, as measured by standard deviation.
^ Alpha is the measure of the performance of a portfolio after adjusting for risk. Alpha is calculated by comparing the volatility of the portfolio and comparing it to some benchmark. The alpha is the excess return of the portfolio over the benchmark.
Factor Insights: A Drawdown Comparison to the GFC
Gregg Thomas, CFA, Director of Investment Strategy
March 17, 2020
I have heard many comparisons between the current crisis and the global financial crisis (GFC). To me, this shock feels similar in terms of uncertainty, but somewhat different from a factor perspective. We compared the first two months of the GFC and the four weeks ended March 13; these two periods equated to about a -25% market decline. Several high-level observations stood out:
- Key takeaway: The worst-performing factor was clearly solvency risk, followed by value. We think the market has been engaging most on companies that might not pass the “going concern” test in the face of the first real growth shock we’ve seen since the GFC, and that these companies are seeing a massive increase to their discount rates. Our definition of solvency looks at the relative distance to a default (similar to the model used by credit-rating agencies), identifying distress at the individual company level by considering the interaction between capital structure and stock-price volatility. For capital structure, we look at leverage on the balance sheet and add back fixed-cost structures such as lease obligations, pensions, etc.
- This isn’t just a reaction to leverage. Looking across our factor returns, there is a direct correlation between a factor’s exposure to solvency risk and excess return. Leverage is much less explanatory. Overall, the market is pricing high solvency risk nearly three times more than high leverage.
- Unlike the first hit of the GFC (September and October of 2008), this time around there is not as much on the other side from a style perspective to cushion the blow (e.g., low volatility and profit stability factors are ahead, but not by much).
- Up to now, the weakness in value factors has far outstripped the gains in defensive and quality factors. During the GFC, this was more balanced.
- Dividend yield has not protected like it did in 2008, largely because the highest yielders are in energy and financials, which have higher exposure to solvency risk.
Given continued high uncertainty, we are being thoughtful about factor exposures, solvency risk, and stock-specific risk, and when in doubt, we are taking the defensive side.
Thoughts on a Complicated Crisis
Vera Trojan, CFA, Equity Portfolio Manager, Boston
March 13, 2020
As a longtime emerging-markets investor, I have faced more than one major crisis. The current environment, however, strikes me as more complex than any I have seen.
It is developing as an interplay between a health crisis, a further unraveling of the post-World War II geopolitical order, uncertainty caused by climate change, a potential financial crisis, and a fundamental rethinking of the role of business and the investment industry in society.
As I think about all these factors, crisis investing 101 is an obvious place to start:
- Be wary of illiquidity and debt.
- Take advantage of opportunities to upgrade your portfolio.
- Avoid banks and other leveraged financials.
- Be prepared for extreme volatility.
- Take shelter in stable businesses with solid balance sheets in economically and politically stable countries.
The other framework I am using is time horizon: What will be the shortest- and longest-lived aspects of the challenges currently upon us? Arguably, the coronavirus itself will be the first to pass, with consumer fear abating. Quality names in the most impacted sectors, such as travel and entertainment, may be the first to recover. Longer term, a financial crisis is a real risk, given the leverage, volatility, and illiquidity already in the system. Banks, which will be at the center of any storm, are already suffering due to record-low interest rates and slower growth. In my view, even the highest-quality banks will not be spared if a real crisis unfolds.
Geopolitical discord will also be with us until a new order emerges. The challenges of a multipolar world are myriad, and in my mind, the seeming unraveling of OPEC is a symptom. As it is difficult to imagine the players coming together again, it may be prudent to underweight oil. While most of Asia benefits from structurally lower oil prices, the stresses in the Middle East will become more acute and destabilizing.
As China and the US are the two pillars of a multipolar world, they also are likely to be key components of long-term investment strategies. China has been the first country to bring the coronavirus under control and its stock market has performed relatively well in a global context. Attractive ideas potentially include top internet players, consumer cyclicals, and service providers. Outside of China, we are looking for idiosyncratic structural growth businesses, such as certain research-driven pharmaceutical companies and various technology names.
US Dollar—Transient Headache
Henri Fouda, Portfolio Manager, Investment Boutiques, Boston
March 26, 2020
Why Has the US Dollar Spiked?
I have long believed that the carry advantage of the US dollar was unsustainable. The coronavirus crisis has precipitated the collapse of that carry advantage. The world, especially the developed world, is flat, with no real carry-trade advantage in evidence anywhere.
If monetary and fiscal policies were the only variables affecting the exchange rate, the effective dollar exchange rate would be lower as a result of the relative actions of jurisdictions across the globe. Instead of dropping, however, the dollar’s effective exchange rate has spiked sharply. Market commentators have advanced several theories as to why: liquidity, uncertainty-driven dollar hoarding, risk aversion, the US having the strongest army in the world, the dollar as a reserve currency, margin calls, and so on, all of which may be contributing.
The common underlying theme seems to be the anticipated contraction of the world economy subject to a dual supply and demand shock, with economic activity coming to a standstill in some sectors. Such discontinuities are not usually incorporated into standard economic models. Harvard University Economist Dr. Kenneth Rogoff recently likened the current situation to a war in economic terms.
Will Currency Markets “Self-Heal”?
Daily exchange rate fluctuations represent not only investment and speculative demand, but also the day-to-day demand that supports commerce, tourism, and all other economic activities. Disruption, or the anticipation of disruption, of those activities could lead to sharp movements in exchange rates. Those disruptions, in my opinion, should be transitory rather than permanent, because exchange rate excesses are “self-healing.”
An example in recent memory is the Swiss franc. It was brutally “unpegged” from the euro during the European financial crisis. This sparked a sharp revaluation. But given the reality that Switzerland was competing directly with its EU neighbors, the exchange rates had to adjust quickly the other way to reflect Switzerland’s less competitive situation.
Look For a Correction
Likewise, when normal economic activity resumes—or economic agents anticipate its resumption—it will become apparent that the dollar’s effective exchange rate at the current level is crippling the US and world economies. The dollar will correct and potentially overshoot in the opposite direction. In fact, a sustainable correction of the dollar’s effective exchange rate might be an early sign that activity is “normalizing.”
Bank Loans at an Attractive Discount
David Marshak, Fixed Income Portfolio Manager
Jeff Heuer, CFA, Fixed Income Portfolio Manager
March 24, 2020
Over the past few weeks, growing concerns around the coronavirus and its potential impact on the global economy have caused steep declines in financial markets. The bank-loan market has not been immune from this weakness: The average dollar price of the S&P/LSTA Leveraged Loan Index* was 78.4 as of March 19.
Current index price levels imply that roughly 45% of the bank-loan market is going to default.^ To put that in historical context, the highest trailing 12-month default rate actually experienced by the bank-loan market was just above 12% in November 2009.†
Using a medium-term outlook, it is our view that the bank-loan market is oversold at these levels. While we do expect the default rate to increase, primarily in the commodity-sensitive sectors, we don’t believe it will come anywhere near 45%. As a result, we believe the current bank-loan market offers attractive price appreciation and total-return potential for bank-loan investors with a longer time horizon.
And history is on our side: If investors had bought bank-loans at similar prices to today’s in the past, including at the height of the global financial crisis, they would have enjoyed double-digit returns in the following 12 months. In fact, investors who were contrarian during the oversold conditions of 2008 were rewarded handsomely when the market snapped back and returned over 51% in 2009!
* The S&P/LSTA Leveraged Loan Index is a widely used measure of the bank loan market.
^ Estimated default rate calculation based on current market pricing. Assumptions: Any defaulting loan will have a recovery of 60 and performing loans will return to a price of 95.
† Source: Moody’s US loan default rate, November 2009.
The ECB Acts—Now It’s up to Governments
John Butler, Macro Strategist, London
March 19, 2020
The European Central Bank (ECB) has taken much-needed action, targeting yields and spreads and providing full monetary financing of “whatever it costs” to address the coronavirus crisis. Now European governments need to deliver an appropriate fiscal response.
Late last night, the ECB announced an additional asset purchase program:
- It includes €750 billion of extra purchases.
- This will run at least until the end of the year but potentially beyond if the coronavirus crisis persists.
- Although over the duration it will adhere to the capital key (which reflects each country’s share of the European Union’s population and GDP), the ECB can front load or deviate from the key for a particular country for a period of time.
- The purchases will include Greek assets.
- It will widen the eligible assets under the corporate-sector purchase program to include non-financial commercial paper.
- The ECB will consider dropping the 33% issuer limit.
- And the ECB stands ready to expand the program further.
This is clearly a move in the right direction, fundamentally changing the message from the ECB’s previous press conference. It is prepared to finance the cost of tackling the crisis and is now targeting yields and spreads, which need to compress hard. The additional asset purchases for this year amount to €870 billion. Together with the existing program, it will buy €1.05 billion of assets in the remainder of 2020. This is the fastest monthly pace of purchases the ECB has ever done, equivalent to 7.3% of GDP. The ECB can target a sovereign spread and is considering dropping its self-imposed limit on purchases of an individual issuer.
These are helpful and necessary steps. But now, the fiscal authorities need to use the space created by the ECB. This shock is about permanent losses in income. Unless the fiscal authorities can make those losses minimal, there will be a sharp spike higher in unemployment, protracted weak demand, and a period in which households and corporates need to rebuild their balance sheets. This monetary response alone will not prevent a deep and long economic hit. The euro-area fiscal response has to be on an appropriate scale, not the 1% on average of fiscal loosening currently announced. We await the next step.
Fed Unleashes Stimulus to Combat Economic Hit
Jeremy Forster, Fixed Income Portfolio Manager
March 18, 2020
Over the weekend, the US Federal Reserve (Fed) took a series of extraordinary measures to support the economy and help ease financial conditions in the wake of the coronavirus pandemic. Specifically, the central bank took the following actions:
- A 100-basis-point* cut in the Fed funds rate to a range of 0%–0.25%
- Quantitative easing^ from US$700 billion purchases of US Treasuries and agency mortgage-backed securities (MBS)
- Coordinated foreign-exchange swap lines with other central banks
- Improved discount-window borrowing terms
- Regulatory relief, including scrapping reserve requirements and inserting capital and liquidity buffers to support lending
- Forward guidance that rates will remain low until the Federal Open Market Committee (FOMC) is “confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”
Some have speculated that the Fed could take policy rates into negative territory as other central banks have done, but in his post-meeting press conference, Fed Chair Jerome Powell pushed back on that notion. We believe further easing will come from the bank’s commitment to keep rates low for even longer, increased asset purchases (potentially establishing a yield-curve control framework), and possible new funding programs and vehicles, including for commercial paper. The Fed is doing all it can, and while its measures should help the economy, the impact from the coronavirus will be profound; we do not expect monetary policy to have the same multiplier effects that it normally does.
Fears about the virus will persist, weighing on consumer confidence. However, low interest rates and low energy prices may help consumers move past their fears and shift from saving more to spending more. We expect to see pent-up demand for many activities and experiences that are nearly impossible to do today (with good reason). And although the unemployment rate is likely to rise in the near term, the longer-term income shock could be mitigated by Congressional actions. At present, proposed fiscal-relief measures appear to include extending unemployment benefits, mandating paid sick leave, expanding Medicaid health services, and providing additional help for hourly workers, potentially via direct cash payments.
We firmly believe that, like other crises, the economic distress caused by the coronavirus will eventually abate, and markets will look forward to better data. As the US and the rest of the world come out on the other side, we could see a relatively robust rebound in growth as inventories are replenished and more people are able to return to work.
* A basis point is a unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indexes and the yield of a fixed-income security.
^ Quantitative easing is a form of unconventional monetary policy in which a central bank purchases longer-term government securities or other types of securities from the open market in order to increase the money supply and encourage lending and investment.
ECB Response to COVID-19 Underwhelming
John Butler, Macro Strategist, London
March 18, 2020
On March 12, the European Central Bank (ECB) announced a disappointing package of measures in response to the COVID-19 outbreak. Despite noting a “considerable worsening in the outlook,” the ECB just doesn’t have the tools to resolve or offset this crisis.
Some of the fundamental assumptions that have underpinned asset prices are myths, including the central bank “put” and the ECB president stating that it “will do whatever it takes.”
In its March 12 statement, the ECB said, “Governments and all other policy institutions are called upon to take timely and targeted actions to address the public health challenge” and ECB President Christine Lagarde said, “We are not here to close spreads.”
This response is in stark contrast with the appearance of coordinated action in the UK. The Bank of England surprised markets on March 11 with an intra-meeting announcement of a series of actions, the same day the UK government committed itself to substantial and sustained fiscal loosening in its latest budget.
The ECB expanded its asset purchase program by €120 billion (€13 billion a month) until year end, skewed to corporate, announced more and generous liquidity facilities for small- to mid-sized enterprises (SMEs), and eased the capital and liquidity buffer for banks. It decided not to cut interest rates.
The ECB cannot offset the economic shock ahead. That requires fiscal and healthcare responses. However, the message the ECB sent was:
- The ECB is prepared to underwhelm market expectations—either because of its new membership or because it just doesn’t have the tools.
- The ECB views this as temporary. The long-term refinancing operation is temporary and quantitative easing (QE)* will extend until year end, so the ECB has reverted to making additional QE time dependent rather than state dependent.
- The ECB is irrelevant. It can’t cut rates. The additional QE is only €10-€13 billion a month, whereas the market assumed it would be €20 billion.
There is a high probability we will soon be exploring the tail risks for the euro area.
We know this shock isn’t about rate cuts, QE, and liquidity. Italy could be squeezed out of the markets over the coming days and weeks. The issue then becomes whether neighboring countries are willing to share risks, or not, unconditionally. This could be the moment when the eurozone needs to answer this question, which has been left unanswered since the start.
The way the region has responded to the question to date is by setting up an infrastructure that forces a neighbor to adhere strictly to a program (European Stability Mechanism), which will be monitored. For a democratic country, that will feel like punishment. And this is the type of shock where terms and conditions that feel like punishment could backfire.
We are a giant step closer to understanding that former ECB President Mario Draghi’s promise that the “ECB will do whatever it takes” was a myth that provided a powerful blanket over the region for eight years. Ultimately, it is a political decision. Yet no one can be confident about how politicians will answer that question because they themselves don’t appear to know. And, relative to 10 years ago, Europe’s politicians appear weaker and more divided.
The COVID-19 crisis could result in each country exposing its voter base to the liabilities of its neighbors. The coronavirus outbreak might then go down in history as the external shock that made the euro sustainable. Alternatively, it could result in national governments protecting and insulating their nations, which could ultimately fragment the single currency.
Once the market downgrades the value of the ECB’s shield, it will find a way of asking the question. Experience has shown that politicians only give an answer when the eurozone is dangling on the edge, not pre-emptively. We may be close to having to price in that question.
* Quantitative easing is a form of unconventional monetary policy in which a central bank purchases longer-term government securities or other types of securities from the open market in order to increase the money supply and encourage lending and investment.
Technology: The Future Is on Sale
Brian Barbetta, Global Industry Analyst
March 18, 2020
In recent comments, my colleague David Lundgren, director of technical analysis, challenges the notion—proliferated of late by TV talking heads and social media feeds—that the stock market swoons over the past couple weeks have created a “can’t-miss” buying opportunity that equity investors should seize upon now (or soon), before it’s too late.
To be clear, David believes (and I agree) that the recent market selloff has created an attractive buying opportunity for long-term investors as markets recover when the coronavirus crisis subsides, although we are clearly not there yet.
However, he also astutely calls out the technology sector as a notable outperformer—a bright spot amidst all the market gloom—that looks likely to sustain its recent outperformance as consumers and businesses continue to leverage technology in all its forms:
“I would be remiss to not highlight how well the tech sector has been performing since this crisis began. This is impressive and warrants a continued overweight, in my judgment, unlike all other cyclical areas.”
As a technology analyst, I'd like to build on that last point. I, too, expect the sector’s recent outperformance to continue, driven largely by some key trends that all appear to be accelerating along curves that were already pointing upward, including:
- Streaming consumption replacing linear TV
- Digital advertising replacing linear models
- E-commerce replacing brick-and-mortar retail
- Digital goods consumption replacing physical (e.g., video games)
- Cloud collaboration tools replacing face-to-face interaction
- Online education replacing the traditional classroom
- Direct-to-consumer replacing legacy supply chain/middlemen
A number of stocks with exposure to these and other trends have sold off indiscriminately with the broader market and are now trading at what I consider attractive relative and absolute valuations. Accordingly, I believe this is an opportune time to initiate longer-term investments in select tech names (or to add to existing holdings).
Like David, I don’t expect to be able to perfectly call the market bottom, but look at it this way: Hypothetically speaking, if the markets were to close tomorrow and then reopen once the worst of the crisis was over, what would you want to own? I believe the future is on sale, and I think investors should consider buying.
Oil: From Short-Term Demand Concerns to Structural Supply Disaster
David Chang, CFA, Commodities Portfolio Manager, Boston
March 9, 2020
There’s no two ways about it: the OPEC meeting on March 6 was a disaster that could end the Vienna Agreement, reverse the market-balancing efforts of OPEC+ since 2017, and lead to an all-out price war. Amid the shock caused by the coronavirus, oil demand is currently contracting at its fastest pace since 2008. Demand was originally expected to grow by one million barrels per day (bpd) in 2020. Now, we think demand growth could be negative for the year.
Prior to the meeting, the Saudis suggested further cutting production to shore up the price of oil in response to the recent coronavirus shock. Russia refused to cut, as this would cede market share to US shale. The Saudis, as in 1986 and 2014, decided they would not go it alone, so no cut was announced. Over the weekend, Saudi Arabia sought to demonstrate its resolve, lowering its official selling price (OSP) by US$8/barrel, the largest reduction in over 20 years. This decision will affect approximately 14 million bpd of exports that compete with exports from Asia, Europe, and the US. As a result, while the market had widely anticipated production cuts of one to 1.5 million bpd by OPEC+, we now could see additional surpluses, driven by a protracted price war.
Potential market fallout
Amid potential production increases from OPEC and Russia, it is important to remember that this is the most oversupplied market of the last two decades, given long-planned production increases from offshore fields in Guyana, Brazil, and Norway, coupled with the recent virus-related demand collapse. While Saudi Arabia is likely to boost production from 9.7 to 10 or 11 million bpd, most other OPEC members are already effectively producing at capacity. The market is in no condition to absorb another million-plus bpd. This move is effectively the Saudis saying that they are unwilling to support the market on their own.
What about US shale?
While US shale production could materially decelerate under US$40 West Texas Intermediate (WTI) crude prices, it would take six to 12 months for the lower rig-account activity to flow through to lower production. In this environment, for prices to stabilize, lower production is required immediately, meaning the oil price will have to fall to cash costs before producers are encouraged to shut in their wells.
Additional concerns and risks
- The global economy. Does this raise the probability of a recession? Low oil prices clearly benefit the consumer. However, below a certain threshold (I’ve generally assumed around US$40), low oil prices can disproportionately negatively affect the global economy in a much broader sense. Low oil prices stress export and fiscal revenues among several emerging markets and further pressure fragile US industrial activity.
- US energy (production, equities, and credit). In contrast to 2014 to 2016, US producers have less latitude to reduce costs and enjoy more limited access to capital markets. Meanwhile, this disruption is happening when financial markets are already roiling.
- Currencies. With a floating ruble, Russia is in a much better position than Saudi Arabia to absorb a price shock. Will Saudi Arabia address this situation through a devaluation or floating of the riyal?
- Inflation expectations and quantitative easing. As this development potentially extends the duration of low oil prices, might we see even lower inflation breakevens, allowing for additional central bank action?
- High oil inventories and negative carry. Overproduction will translate into rising oil inventories and a steep contango* in the futures curve. This will likely generate a negative roll yield that can invite further systematic selling of oil and extend the price slide.
If there is a tiny silver lining, in the longer term, this decision has the potential to rebalance the oil market by accelerating a slowdown in non-OPEC production, from the US and the rest of the world. OPEC’s restraint since 2017 has allowed non-OPEC production to grow and capture incremental gains in global demand. While we may see this trend reverse, it could be a long process. The focus for now will be on the more immediate consequences of Friday’s debacle in Vienna.
*Contango is a situation where the futures price of a commodity is higher than the spot price (the current price in the marketplace at which a given asset can be bought or sold for immediate delivery). Contango usually occurs when an asset price is expected to rise over time.
US Consumer “Recession” Ahead?
Evan Hornbuckle, Global Industry Analyst, Boston
March 9, 2020
While the US consumer entered 2020 on firm footing, based on what I know today, I think it’s probable that confidence gets hit hard enough to drive at least a few months (and maybe 6+ months) of discretionary spending declines. In such a fast-changing environment, this is clearly impossible to prove today, though we have seen deceleration in the most recent week of our consumer credit card panel data.
Importantly, a large minority of US consumer spending stems from the wealthiest 10% of households. Consumer confidence and household net worth (which correlates highly to equity markets) are big drivers of spending for this cohort, and both are taking heavy enough punches now to suggest overall consumer-spending declines. Depending on how broadly the virus spreads (my base case is a broad outbreak), US jobs could also eventually take a hit, which would disproportionately hurt the lower-income cohort, whose savings rate is perpetually at ~0%. It’s possible the Fed pulls more rabbits out of its hats to counter these pressures, but I’m skeptical; conversely, we could see fiscal measures like payroll tax cuts, which could be a bigger spark to spending.
Sectors that could be hit hardest include cruise lines, airlines, hotels & casinos, restaurants, and malls, among others. Sectors that could be most immune include home & personal care (HPC), food & beverages, beauty, housing, and e-commerce, among others. Some stocks in the “hit hardest” category have already gotten hammered 20%–40% so I’m not suggesting there are no good stocks in that bucket, even if fundamentals are about to roll over. In fact, I don’t find the above delineation (“hit hard” vs. “most immune”) overly helpful for forward-looking stock picking because I’m focused as much on assessing what’s already embedded in the stocks as who has the highest/lowest earnings-per-share risk. I’m also cognizant that the market will eventually look through the virus-related disruption (likely well before the virus disappears), and I think the consumer rebound could be sharp if a cure is found quickly. So overall I have adopted a conservative mentality, but I am still looking for opportunities to play offense where the market is over-/under-shooting.
A Tailwind for US Housing
Nate Kieffer, CFA, Global Industry Analyst, Boston
March 9, 2020
Despite the knee-jerk reaction of many investors (economy bad = housing bad), I think US housing can potentially be a safe haven if the coronavirus pushes the US economy toward a recession. It is hard to overstate the impact of the sharp decline in rates. Historically, when trailing six-month mortgage rates are up or down >50 bps, that has tended to trump all other factors in housing.
Of course, it will take some time for mortgage rates to catch up with the 10-year Treasury yield. As it stands today, the spread is already at a level we haven’t seen in over 30 years excluding the global financial crisis. But I think it is fair to say that the powerful mortgage-rate tailwind that we have seen over the last seven months has at least 13 months to go, which could potentially lead to fundamental outperformance versus other cyclicals.
Asia Tech as the “Canary in the Coal Mine”
Anita Killian, CFA, Global Industry Analyst, Tokyo
March 9, 2020
The coronavirus turmoil is just another in a long string of challenges faced by the Asia tech sector over the past two decades. First up was the Asian financial crisis, followed by the bursting of the tech bubble, the SARS scare, the global financial crisis, the Thailand floods, the Japanese earthquake, the US-China trade war, and now COVID-19. I think it’s fair to say that Asia tech companies have grown quite resilient in the face of hardship. I call them the “Navy Seals” of the global economy.
I see no reason why the current crisis should be much different from past episodes. Asia tech stocks may have led the way into the storm, but if history is any guide, they (especially the hardware stocks) may also lead the way out of it. This is because technology is so pervasive in the global economy that it has become nearly 100% coincident with what is happening in real time. Asia tech can be thought of as the “canary in the coal mine,” so to speak, meaning it may be a good place to be positioned for an eventual recovery.
I would not necessarily rule out a second-half rebound in sector fundamentals. I believe the situation on the ground is much better than might be expected:
- Demand actually appears to be pretty strong or at least “delayed strong,” meaning the intentions are there, even if not fully acted upon yet.
- Many factories are nearly fully back in operation as of this writing, while utilization rates are high and inventories low.
- Prices for many products have been going up and should rise again in April when new second-quarter contracts are signed.
I believe this relative strength and optimism is being driven by trends and forces I highlighted earlier in the year: 5G equipment and handset demand, inventory restocking, memory market recovery, China localization, Chinese semiconductor development, and migrating supply chains. The only area that looks dubious to me is the auto market, but that could change dramatically if China stimulus comes through. My bottom line: I think COVID-19 is having a sharp, but likely a fairly short-lived, impact on business in Asia “tech land.”
NEW Update on Currencies – Euro and US Dollar Uncertainties
John Parsons, Currency Portfolio Manager
March 31, 2020
What Would Winston Churchill Say Today?
It would be interesting to hear Churchill’s thoughts on the current crisis. Sadly, we will never know, but we do know he didn’t think much of currency traders:
“There is no sphere of human thought in which it is easier for a man to show superficial cleverness and the appearance of superior wisdom than in discussing questions of currency and exchange.”
With those stinging words ringing in my ears, here are my thoughts on currencies in the current environment.
The Euro Faces Existential Threat
I think the euro will face an existential moment in the coming weeks. That can be avoided if the eurozone countries move to risk-sharing and towards a full fiscal transfer mechanism. Since adopting the single currency, Italy has hugely underperformed (30% below the average level of GDP of other member states, as we enter this crisis) and has suffered high social costs as a result.
Today, Italy does not just need a credit line or a central bank buying its debt, nor does it need conditionality—it needs a cash transfer. At the end of this year, real GDP growth in Italy going back to 1995 will be close to zero and unemployment could be above 15%. No loans will change that. The eurozone will very soon need to make a decision on this.
US Dollar Uncertainty
The dollar has rallied strongly recently, benefitting from its reserve-currency status and a scramble for dollar liquidity. With the help of the US Federal Reserve, that has begun to fade. The dollar will now be judged on public health policy and fiscal policy over the next few months. Both fronts entail uncertainty and risk.
Given there is so much we do not know, the future for the dollar is unclear, with many unanswered questions.
- What will the US-China relationship look like in five years?
- What does the end of independent central banking and the potential introduction of ‘Modern Monetary Theory’* do to the world’s reserve currency?
- Will the euro survive?
- Will China emerge from the crisis stronger relative to the US?
New Crisis, New Rules
We do know that the world has changed this quarter, in ways no one could have imagined. Applying old rules now can be very dangerous. Two of the great promises made by policymakers after the 2008 crisis were “we will improve income inequality and reduce the levels of debt in the system as a proportion of GDP”. They failed on both counts and many societies will not now accept the same solutions to this crisis.
In most jurisdictions, the worker, shareholder, and governance relationships will change dramatically. Societies will demand a different set of priorities, starting with public health, against a backdrop of deglobalization and more volatile geopolitics.
A different Churchill line would now seem to apply to investment decision making: “Thought arising from a factual experience may be a bridle or a spur”.
* Modern Monetary Theory is a heterodox macroeconomic framework that says monetarily sovereign countries like the US, UK, Japan, and Canada are not operationally constrained by revenues when it comes to federal government spending.
Past performance does not guarantee future results.
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