Seizing opportunities in the current market environment

The Fed's response has gone way beyond 2008

COVID-19 vs. Global Financial Crisis – deeper contraction but faster recovery

When the world was heading into the Global Financial Crisis in 2007, households and financial institutions were extremely overlevered. And after the financial crisis, they had an ongoing need to de-lever, which slowed the recovery. The COVID-19 recession has been a much deeper initial shock than in 2008, but overall imbalances heading into the crisis were much lower than prior to the GFC. This time it's more of an income shock than a balance sheet recession and there is less retrenchment to do, which means we should have a healthier recovery as the economy reopens.

There is, however, a lot of uncertainty around when and how we reopen economies, and there are clearly big differences across countries. Other questions are whether and when consumers and businesses will feel psychologically safe enough to return to semi-normal activities, and when they do so can we successfully contain renewed outbreaks of the disease.

Our base case for economic reopening

To genuinely reopen, economies will likely require widely available testing — of the virus and also of the antibodies to see if individuals are immune. Countries may also need contact tracing and surveillance systems so that new waves can be identified quickly. We suspect such capabilities will take at least another month in the US and many other developed economies. We expect to see a gradual, staggered reopening of different areas of the economy over the course of late spring and summer.

A big question is whether we experience second waves of infections, which we've seen happen as some Asian countries, Singapore for example, try to reopen. It seems likely that we will have various waves of the virus which may lead to a start/stop period reopening. Reopening is not a linear process. Antivirals like Remdesivir may help reduce the risk of dying from the disease but they are not preventative. Public health officials expect it will take at least another year for a vaccine to become widely available, which is what is needed for full normalization of economic activity.  We will continue to need aggressive government support to provide a bridge in the meantime.

Asset allocation during the pandemic

As we look at how to think about asset allocation between countries, we've collected data on various countries' relative resilience and vulnerability amid the COVID-19 pandemic.

We have looked at demographics, medical capacity, sensitivity to global trade, governance, fiscal response, and lockdown effectiveness. In developed markets, Germany and Switzerland are near the top of the list. Spain, Italy and Sweden show the greatest vulnerability. In emerging markets (EM), north Asia is most resilient, including South Korea, Taiwan, and China, while South Africa and Türkiye are most vulnerable.

Trades for the current environment

Given this framework, we prefer to overweight Korea, Hong Kong and China equities vs. other EM. We take a similar approach in fixed income, where we find Asian high yield attractive relative to other emerging market debt. In currencies, we are long the safe haven JPY vs. USD given the still shaky global growth environment.  And given extremely accommodative monetary policy and widening budget deficits, we have an overweight to gold.

Delineation of the 'spread widening' effect within global equities

The first cohort could be called 'winners.' These companies are fairly well insulated from the pandemic or are actually strengthened by the current shelter in place, homeworking environment. The second cohort could be called 'demand impaired.' These stocks generally have more economic sensitivity, and are more service-oriented businesses, with slightly more leverage than cohort 1, but meaningful demand impairment has caused these stocks to sell off 40% to 50%. The third cohort could be called 'problem children,' and many had existing issues before COVID-19 with demand, profitability and cash flow (auto-related companies, banks in countries with negative yields and energy companies) and in some cases leverage. Many of these stocks fell 60% to 80% initially and some are still down 40% to 50%.

We're focusing on the downside risk from potentially severe fundamental impairment in the third cohort by analyzing balance sheets and understanding tail risk within this group of stocks. The second cohort offers less tail risk than the 'problem children,' and we see an underlying opportunity in trying to understand these fundamental differences and sizing them appropriately or upgrading the quality of the holdings for similar valuations.

We're combining this valuation analysis with some of the longer term secular trends that will likely continue to provide a tailwind to companies that benefit from themes like factory automation, medical technology, smart mobility, vehicle electrification, and oncology research for example. Another attribute of our portfolio is getting more idiosyncratic about the stock in a portfolio, so that the bulk of the portfolio's risk is derived from stock selection vs. factor exposures (avoiding a large macro — or energy or technology recovery scenario).  We believe that our positioning is more balanced from a sector and regional perspective — with portfolio beta close to 1.0 — given the high level of uncertainty as it relates to economic and behavioral recoveries in a post-COVID-19 world.

We're closely monitoring changes in underlying corporate fundamentals from an intermediate- and longer-term perspective.  We are being especially sensitive to companies operating with high leverage and evaluating direct balance sheet risk and credit quality where supply chains could be negatively impacted through business disruption.

Fully active — increasing exposures where short-term price movements provide opportunities — valuation spreads have widened again to extreme levels, providing enticing opportunities for active global managers.

Buy what central banks are buying

Buy US investment grade credit (IG). The basic principle is to buy what the central bank buys. We had not liked IG corps going into this year; spreads in US and eurozone were both bumping along historic lows with not much upside. But we saw a sudden repricing and even with a subsequent rally US spreads are still attractive. Because the Fed buys primary and secondary issues, including fallen angels, it is underwriting financial stability in the credit markets. It is also clear that the Treasury and the Fed act in perfect harmony – Treasury provides the equity, the Fed runs the program. At face value the Europena Central Bank (ECB) does something similar but with two caveats; they do not buy high yield (HY) debt and ECB and fiscal authorities are not aligned in the same way. We get the same old debt mutualization arguments that have characterized previous crises.

We like quality high yield

Buy short duration US HY, as long as you are buying high quality parts of the high yield market. Think about where the Fed is intervening – it's generally in the better quality part of the high yield universe.  The energy sector is a particular concern for HY as a whole and in our view will account for 50% of defaults over the next year. But we believe there are sectors that should be quite resilient; healthcare, telco, cable TV, tech and gaming. The fact that the Fed will buy down to BB should add some stability.

Safe haven assets for investors in recent market turmoil

China's bonds are a safe haven for investors

Trade 3: Own China government bonds. It's a trade we liked before and still like. A number of factors support it. Most essentially it is still a good hedge to other markets. Most other developed markets see higher volatility, lower yields and increased correlation. In March, China bonds were one of the few sectors that generated a positive return (US nominal treasuries being the other). Even after recent moves Chinese real and nominal yields are still higher than many other markets and have further upside because of more monetary and fiscal policy flexibility in China. Final point, there is a technical factor supporting Chinese bonds because they have been added to several global indices when most are underinvested.

Final point; whatever trade one puts on in this market one should acknowledge that the path of the recovery is highly uncertain. It is most likely to follow a game of snakes and ladders in my view; some advances followed by quick setbacks and then start again. And different parts of the world will recover at different rates. So when investing today be sure to pick the trade that has the features and is right-sized to fit that world.

We see a potential opportunity to originate mezzanine loans or preferred equity for properties that aren't excessively leveraged. Targeted IRRs for these deals would be 15%+ with a minimum 2-year duration and an attractive position in the capital stack ahead of the equity and attractive yield to maturity. Our platform is well-positioned to take over the properties if the borrowers default.

At this stage, real estate investors are still waiting on pricing discovery. Transactions have come to a halt. The 1Q20 appraisals reflect valuations largely completed prior to the impact of COVID-19 on the US. Bigger value declines are expected in 2Q20 and potentially beyond. This may create interesting buying opportunities, but it is too early to tell.

We still think low capex property types (apartments & industrial) will outperform higher capex property types (office & retail). While the issues with retail assets are obvious the office market also has a lot of challenges. Over 60 cents per USD1 of NOI is being reinvested into office assets and this capex is unlikely to pay off. Data centers and self-storage also seem to be safe bets, but are unlikely to see much of a correction in pricing.

Medical office was seen as a stable property type in distressed situations, but the shelter-in-place order has changed that dynamic. Non-essential surgeries and treatments have been canceled creating issues for dermatology, dental and mental health practices.

A wild card is the life science/lab space. It was the hottest property type pre-COVID 19, but had a limited tenant base. We need to continue to follow this sector to see if there is increased investment in biotech firms creating increased demand for space in this sector.

Rules-based investors can become forced sellers of paper when downgrades impact their ratings buckets and collateral tests. We believe that we're just at the beginning of that trend which may create a significant amount of dislocations and opportunity in the levered loan market to step into stressed areas. And then you may have corporate defaults and distressed opportunities really coming into the end of the year and forward. We think the time is now to put money to work in these deeper credits and take advantage of it.

We saw the dislocation in agency MBS. We expect downgrades to continue to accelerate into Q2 and Q3. That will lead to heavy selling from CLOs and dislocations in levered markets. We had redemptions coming into the June cycle from structured credit hedge funds which are going to create an overhang in the mortgage market.

Specific to credit, the Fed announced the Primary Market Corporate Credit Facility which will allow investment grade companies to borrow up to four -year debt directly from this facility. In addition, they announced the creation of the Secondary Market Corporate Credit Facility which will be charged with buying 5-year and in bonds issued by investment grade companies or newly fallen angels, along with ETFs focused on investment grade and some capacity for ETFs focused on High yield. 

These programs, USD 750bn in size to start, have established a floor into spreads, driven capital into the credit market, helped define a market to allow the transfer of risk between buyer and seller, increased demand for the asset class, and enabled companies to access the public capital markets. Since the first announcement and subsequent expansion, we have seen investment grade and leveraged finance spreads retrace about 40%-50% of their widening before the Fed has even bought a bond. From here we expect the front end of the curves to further normalize, steepen, and tighten — given the presence or threatened presence of the Fed's purchases

Of vital importance is the ability to purchase fallen angels. Since March there has been USD 120bn of debt downgraded from investment grade to HY and we expect downgrades on another USD 350-400bn.  While we don’t expect the PMCCF to get utilized, we expect a full take up of SMCCF (subject to final terms).

More important to note here is what the Fed is not directly including in its programs.  The Fed is not buying HY bonds or leveraged loans directly, they are not buying private label MBS, CMBS single conduits. Specific to HY and leverage loans we think direct purchases are too much of a third rail. We all have heard regulators for the past few years warn about the risk in leveraged finance markets. The Fed is attempting some back-door support via the HY ETF purchases, CLO AAA inclusions in TALF, and the Main Street lending program, but we believe this is the extent of the support they can give and is not the equivalent of buying bonds directly. Because of this we believe we will see a continued decompression trade between leveraged finance and investment grade spreads. Post the Fed announcement curves have begun to normalize and record outflows have now turned into inflows.

The Fed, to their credit, and in an extraordinarily aggressive way addressed liquidity.  However, for lower quality companies they have not addressed solvency.  And we believe the market has overshot in leveraged finance.  We expect 12-month defaults in the range of 11%-13%. As of early April, HY spreads are 713bps after hitting a wide of 1200bps.  In 2008/2009 we hit wides of 2100bps with a peak 12-month default rate of 13%.  Recession spreads ex-GFC average 1100bps. Given the tail risk and lack of direct Fed support we think leveraged finance spreads should be wider.

The new programs highlight the Fed’s flexibility and willingness to respond — they’ve already upsized them once in the course of two weeks and we believe they will exercise that option again if necessary.  The bazooka cured liquidity and we believe provides a floor on high quality fixed income assets.   However, the duration of this episode is still unknown, and solvency is an ongoing issue.  We prefer owning assets the Fed is buying and staying up in quality and defensive sectors.