It’s been a humbling quarter. We thought 2020 would be a pretty good year in financial markets considering solid leading economic indicators and lower tail risks from the US-China trade war and Brexit. Then came COVID-19, followed by the collapse in oil prices. Fear is now driving markets: Global equities were down close to 30% and bonds were down 3% as of March 19. In an emergency response, the Federal Reserve (Fed) and other central banks slashed rates to record lows, but markets questioned the efficacy of monetary policy.
In these uncertain times, we think investors should have a game plan. We anchor ours to our investment process, which uses three inputs: fundamentals, policy, and valuations. Even with monetary and fiscal easing, we think COVID-19 and plunging oil prices will result in a sharp but relatively short global recession (Figure 1). While this implies further potential downside for risk assets1 in the near term, our framework looks out over a 12-month horizon, and on that basis, we see reasons to stay invested and consider being liquidity providers by adding quality assets at much cheaper valuations.
China’s Downturn Is a Bad Omen as the Virus Spreads Globally
Caixin China Composite PMI
Past performance does not guarantee future results. | Source: Bloomberg | Chart data: 12/31/2011-2/29/2020 | Purchasing Managers’ Index (PMI) is an indicator of the economic health of the manufacturing sector. A reading above 50 signals economic expansion; below 50 signals contraction.
Over a 12-month time frame, we expect that COVID-19 will be largely behind us (at least the more economically damaging containment measures) and that record-low rates, pent-up demand, and cheaper valuations will help drive markets higher (Figure 2). Admittedly, the ideal game plan for investors would have been to dramatically reduce risk before the sell-off, wait until the bottom, and then add risky assets to capture the rebound. But we are humble about our ability to time an incredibly volatile market and think a recovery will be priced in quickly and unpredictably. For that reason, we think the focus in equities should be on high-quality companies that are less likely to face solvency concerns but can still participate on the upside. True, cyclical and value-oriented sectors may benefit more coming out of a recession, but we think the uncertain outcome, timing, and economic spillover of the virus make a higher-quality strategy prudent.
Lower Rates May Eventually Lift Economies
US ISM Manufacturing Purchasing Managers Index (PMI) and US 10 year Government Yield
Past performance does not guarantee future results. | Sources: Bloomberg, Wellington Management | X-axis scale range is May 1993 to August 2021 due to 10-year yield being forwarded 18 months. Ten-year yield data is from November 1991–February 2020. PMI data is from May 1993–February 2020. | Chart data: November 1991–February 2020
We prefer credit and quality equities over government bonds. Within equities, we prefer the US over the rest of the world given its lower-beta2 profile and the greater relative magnitude of recent Fed cuts. Paltry sovereign interest rates don’t offer much value and could drive investors to stable dividend payers, but we expect government bonds to still play a diversifying role. Other characteristics we think the market will value highly include free cash flow, low debt, and durable business models. We are moderately bearish on emerging markets and commodities. Many emerging markets are commodity exporters, and we are not confident in a commodities recovery given the politicized nature of the oil market and the uncertain economic growth outlook.
We are bullish on credit. Given recessionary-level spreads3 and continued low rates, we think higher-quality areas are attractive, especially intermediate investment-grade corporates, securitized assets, and BB-rated high yield. We also like tax-exempt municipal bonds for taxable investors, as yields have lagged the rally in US Treasuries and may offer attractive tax-adjusted yields—especially since fiscal stimulus may require higher taxes in the long run.
Our Multi-Asset Views
Change is from previous quarter. Views expressed have a 6−12 month horizon and are those of the authors. Views are as of March 2020, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares or other securities.
Recession Coming but Policy Should Cushion the Blow
While we expect a sharp economic slowdown, we think it will be shorter than the average duration of past recessions. Why? We believe the global economy was solid and turning up when the disease hit: Consumers were in good shape, manufacturing was recovering, and leading indicators were positive. We also think recovery will come faster than in the case of the global financial crisis (GFC). At the core of the GFC was the potential collapse of the financial system; today, banks are better capitalized, less leveraged, and no longer dependent on short-term financing. Unless COVID-19 containment efforts last longer than anticipated, we think systemic failures in the financial system are unlikely.
We expect global central banks to cut rates to zero or below and undertake meaningful quantitative easing,4 as many already have. We think policy rates will remain at record lows long after COVID-19 fears subside, helping to accelerate the recovery, and that governments will have little choice but to respond to demands for a large increase in spending.
Equities: Quality First
Regionally, we prefer US equities as the US economy was in the strongest position heading into the virus outbreak, and the equity market has tended to be less volatile and more liquid than others. US housing, in particular, could benefit from sharply lower rates.
Meanwhile, we are cautious on other regions. Europe was on fragile footing prior to the outbreak, and it may take longer for its economies to recover. Japan’s economy contracted sharply following the value-added tax increase in October, and the Bank of Japan has limited tools at its disposal. Emerging markets are the highest beta and tend to struggle when commodities underperform, as we expect they will.
Coping in Credit at 0%
How does one think about fixed income when all developed-market policy rates are close to 0%? We think the starting point is to clarify the desired role for fixed income in a portfolio. Clearly, in the face of 0% yields, government bonds can no longer be a potent diversifier. Some may ask, “With no yield advantage, why own any of them at all?” But government bonds may still generate capital gains if yields fall further, and they can still potentially diversify equity exposure. We also think agency mortgage-backed securities as well as high-quality taxable and tax-exempt muni bonds may offer good value for high-quality assets and potentially help offset equity sell-offs.
If return is the objective, historically wide spreads across credit may offer some opportunities. Figure 3 shows that high-yield bonds purchased at current spreads have historically translated into excess returns of around 8% over the following three years. The spread between BB-rated and BBB-rated corporates is currently at a record wide level. Corporate spread curves are quite flat, leading to potentially good value in short-to-intermediate corporate bonds. Bank loans have been particularly hurt by illiquidity issues, and these technicals have put spreads around 200 bps5 cheaper than high yield when the median is -36 bps since 1992. Securitized assets may offer diversification relative to corporate bonds and offer a way to tap into the housing market once lower interest rates feed into the real economy.
Spreads Suggest Potential for Positive Excess Returns
Average Forward Three-Year US High-Yield Excess Return by Option-Adjusted Spread Quintiles, 1987–March 2020 (%)
Past performance does not guarantee future results. | Sources: Barclays, Wellington Management
One last thought on credit markets: We expect defaults to rise, as is typical in a recession, but think they are likely to be concentrated in the lowest-quality rungs of the market. Energy would appear particularly vulnerable given that many companies are CCC-rated, have less access to the capital markets, and may not have enough cash flow to service their debt. Other companies with high debt and low access to liquidity may also face default, but we think the government’s extraordinary measures could help otherwise healthy companies through a short-term liquidity crisis and potentially keep the default rate below 10% in the high-yield market.
The biggest risk to our views is that the recession is longer than anticipated or is so sharp that it prevents a quick recovery. The current situation is in many ways unprecedented. Recessions are typically defined by a mild contraction in the economy, but COVID-19 containment strategies are resulting in something closer to an economic full-stop.
Liquidity is also something to watch: A liquidity crisis could become a financial crisis. Strains in the equity and credit markets have been evident in wider bid-offers, smaller trade sizes, spikes in overnight lending, currency-basis swaps, and commercial paper rates in the US. The situation is exacerbated by post-GFC rules that constrain dealers from making markets. The Fed has sought to address these issues by restarting quantitative easing, increasing swap lines with other central banks, and expanding credit facilities to support consumers, businesses, and municipalities.
The most important data to monitor is the growth rate of the disease. While it is declining in China, it is still rising in parts of Europe and the US.
We expect the inflection point in the West, where containment measures are less strict, to be an important signal for the economy and markets. High-frequency data, such as jobless claims, will be one indicator of how long-lasting the damage could be. We will also monitor business and consumer sentiment surveys closely. Finally, while monetary policymakers may lack the ammo to fire a “bazooka” at the economy, fiscal policy could underpin confidence that the government will support the economy through these unprecedented times.
- Quality-oriented equities — We prefer US equities as they are relatively low beta. Our focus is on companies with strong free cash flow, manageable debt, and business models that are unlikely to break in a sharp economic slowdown. We see opportunities in technology, aerospace/defense, REITs, housing, and telecommunications. We think technology will fare relatively well considering 5G expansion and already growing demand for data, speed, and enterprise software, which will likely only accelerate as a result of COVID-19.
- Quality credit areas — For investors seeking return in fixed income, spreads are around the 90th percentile as of this writing, meaning they’ve been wider only 10% of the time. We prefer intermediate investment-grade corporates, BB-rated high yield, and bank loans, which have borne the brunt of illiquidity and should offer the potential for higher recovery values than high yield.
- High-quality government bonds — Agency MBS, high-quality government bonds, and municipal bonds look attractive to us for purposes of boosting a portfolio’s diversification and liquidity (less so in municipals) if the recession is deeper or longer than we expect.
- Active management — One silver lining of high volatility is that it is accompanied by higher dispersion within industries and sectors. This gives active portfolio managers the opportunity to identify solid companies that are unfairly discounted relative to their fundamentals.
The views expressed here are those of the authors. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams, and different fund sub-advisers may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.
1 Risk assets (such as equities, commodities, high-yield bonds, real estate, and currencies) have a significant degree of price volatility.
2 Beta is a measure of risk that indicates the price sensitivity of a security or a portfolio relative to a specified market index.
3 Spreads are the difference in yields between two fixed-income securities with the same maturity, but originating from different investment sectors.
4 Quantitative easing is a form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment.
5 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.
Important Risks: Investing involves risk, including the possible loss of principal. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political and economic developments. These risks may be greater for investments in emerging markets. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Investments in high-yield ("junk") bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. • Loans can be difficult to value and less liquid than other types of debt instruments; they are also subject to nonpayment, collateral, bankruptcy, default, extension, prepayment and insolvency risks. • Investments in the commodities market and the natural-resource industry may increase the Fund's liquidity risk, volatility and risk of loss if adverse developments occur. • Municipal securities may be adversely impacted by state/local, political, economic, or market conditions. Investors may be subject to the federal Alternative Minimum Tax as well as state and local income taxes. Capital gains, if any, are taxable. • A concentration in real estate securities, such as REITs, may subject a fund to risks associated with the direct ownership of real estate as well as the risks related to the way real estate companies are organized and operated. Real estate is sensitive to changes in interest rates and general and local economic conditions and developments. Investments in particular sectors may increase volatility and risk of loss if adverse developments occur.