November 03, 2020Institutional Investment Management

The Rebound Continues

State of the Markets

A recap of the changes that occurred over the 3rd quarter in the bond market and the equity market seems to be appropriate given this year’s unusual pandemic situation.  Treasury interest rates barely changed during the 3rd quarter.  The yield on the 2-year maturity Treasury fell 3 basis points, the 5-year maturity treasury note also fell 3 basis points and the 30- year T-bond yield increased 3 basis points.  The Barclays Aggregate Bond Index returned 0.62% for the quarter which was largely a function of the income generated.   The S&P 500 advanced 8.9% in the 3rd quarter while the NASDAQ increased 0.7%.

Pension discount curve movements over the 3rd quarter, as represented by the FTSE Pension Discount Curve and Liability Index, exhibited a minor steepening with a decrease in rates across the maturity curve. The 1-year rate declined 0.13% over the quarter while the 30-year rate fell 0.04%. Decreasing rates result in both an increased present value of liabilities (for accounting purposes) and an appreciation of fixed income holdings, providing a rough justification for the implementation of a liability matching investment strategy.

As we think about the economy going forward, we must factor in the Federal Reserve and the outcome of the Presidential election.  Chairman Powell has lowered rates to nearly zero and has provided significant liquidity to the system.  In the third quarter he also pledged to keep rates near zero until the economy reaches full employment and inflation has risen to an average above 2.0%.  The Fed estimates this will take until 2023, or later, to achieve.  The Fed will do what it can to help the economy.  The outcome of the election is less important.  Whoever wins will want a strong economy.  Yes, there are differences with respect to taxes, for example, but a radical departure from current levels seems remote.  The outcome of the election may be less important than having a pledge of unwavering support from the Fed.

Interest Rate Outlook

Whether it has been organic, orchestrated, or accidental, 2020 has been a year of chaos.  The Fed’s efforts have been one of the few sources of nearly catatonic calm on the markets.  The Fed has its share of critics, but the simple truth is that the financial markets have run smoothly since they stepped up to provide numerous sources of liquidity to several corners of the economy.  Yields on most fixed-income securities are low, risk spreads are near pre-pandemic low levels and equity valuations are near all-time highs.  Chairman Powell indicated that “the recovery has progressed more quickly than generally expected” but has also said that “the path ahead remains highly uncertain.”  The Fed’s forecasts indicate that GDP will contract by 3.7% in 2020 and we could see growth of 4% in 2021, but that interest rates will stay low through 2023 (when 4 of the 8 FOMC members expect we will see the next rate hike). 

The combination of the Fed’s outlook and the new 2% long-term average inflation target will likely result in “anchored” short-term interest rates (the short end of the yield curve) and more drama as it relates to the yield on longer-term bonds (the long end of the yield curve).  If we see 4% growth next year some market participants who see the 2% average as a Fed slogan, rather than a change in philosophy, will inevitably conclude that the Fed is “behind the curve” and that inflation will get out of control.  Such sentiment could result in greater price/yield movements in the long end of the yield curve.  Given how low yields and risk spreads are currently, along with the fact that low current market coupons on bonds have resulted in longer bond durations increasing by nearly 50% over the past couple of decades, portfolio and liability values could exhibit abnormal movements which would make a liability-hedging strategy even more relevant if our expectaitons materialize.

Trumping the short-term periods of mania, we think the longer-term trend will be for yields to be pinned at low levels for an extended period.  An investment theme we have held for a long time is that debt is often disinflationary.  Increasing debt in the U.S. appears that it will be continuing for as far as the eye can see.  If we succeed in creating an economy of rapid growth, we will be a victim of our own success in the form of increased costs of servicing our $20 trillion in debt.  The truth is that central banks have plenty of firepower to tamp down unhealthy levels of inflation but as we have seen for more than a decade, the tools in the toolbox to fight economic pessimism are more limited.  Add the potentially disinflationary influence that imminent technologies that 5G networks, quantum computing and artificial intelligence represent, and we expect the long run will involve low yields. 

"The truth is that central banks have plenty of firepower to tamp down unhealthy levels of inflation but as we have seen for more than a decade, the tools in the toolbox to fight economic pessimism are more limited."

The economic recovery on the other side of the COVID tragedy will offer statistics that will understandably confuse the market.  We are already seeing some outsized numbers.  In August, used car prices rose by 5.4%, the largest gain since 1969.  The core CPI, a broader measure of price movements, increased 0.4% in August, following a 0.6% increase in July, the largest monthly jump in nearly three decades.  For those with students about to enter college, it may be a bit of a relief that college tuition and fees fell by 0.7%, the first decline since 1993 and the largest decline since 1978.  Clearly there is economic pain and stagnation in hospitality and some areas of the service sector that will persist until the worst of the pandemic is behind us.  As the fall election races come to a conclusion, additional stimulus dollars will be spent promoting strong growth numbers for the economy.

As we examine some economic indicators, it seems that a solid recovery is underway.  At some point the pace of the rebound will slow but not necessarily stop.  The gains in the jobs market, as well as the fall in the unemployment rate, have been very consistent.  The housing market is extremely strong.  New home sales are at a 14-year high (1 million units annually).  The ISM data remains at expansionary levels. The Weekly Economic Index published by the N.Y. Federal Reserve shows a very consistent uptrend in economic activity.  Interest rates are extremely low, resulting in record issuance of investment grade corporate debt. 

Now for the uncomfortable subject of the Presidential election, at a time in our history when people seeking racial justice burn down the buildings of innocent business owners, militia groups allegedly target public officials, and first responders are broadly demonized using an indiscriminate brush, the country is left feeling exhausted.  That doesn’t bode well for the incumbent.  Even if the polls didn’t properly capture the true number of voters for President Trump in 2016, the margin of advantage that former Vice President Biden suggests there is a good chance of changing the occupant at the White House.  If Joe Biden wins the presidency the next important influence will be whether Republicans retain the Senate, or if there is a “blue sweep” and Democrats control both houses of congress and the White House.  Divided government should mean that the U.S. experiences muted changes and a sweep likely means higher tax revenues needed to fund the election year promises made by the Biden campaign.  If we are wrong and President Trump retains the job, the divided government scenario (with modest future changes) applies.  The nightmare scenario is that we get into a legally contested election or an election that is subject to voter interference, fraud, or intimidation.  We have had election outcomes that were delayed due to procedural challenges and although it was discomforting, it was livable.  The other worst-case scenario would be a shock to both the markets and the sensibilities of those who feel all eligible voters should have an equal say in their representation.  Our expectation is that rates flounder around the current levels for a short while, move higher as some strong growth numbers grab headlines, and eventually trail lower than current levels when pre-COVID recovery metrics become more commonplace.

"Our expectation is that rates flounder around the current levels for a short while, move higher as some strong growth numbers grab headlines, and eventually trail lower than current levels when pre-COVID recovery metrics become more commonplace."

Municipal Bond Market – Tall Tales and Troubled Truth

Headlines would suggest that municipalities are on the brink of disaster as a result of the COVID lockdowns and added expenses related to addressing the pandemic.  Some areas of the municipal market are certainly facing dire challenges.  Specifically, private student housing issuers, nursing homes, hotels, development deals, and other tourism-centered issuers may be headed for trouble.  Many other issuers that are sounding the alarm bells are either not letting a crisis go to waste or they are reluctant to enact creative or unpleasant solutions.  We will discuss how the vast majority of reasonably run municipalities will have nearly pain-free options available to them, while mismanaged and poorly managed may find that this is the event that causes them to “run out of runway.” 

Through mid-September, of the 32,000 issuers that Moody’s and S&P rates, fewer than 1% received downgrades this year.  As two of the more respected municipal rating agencies, they don’t seem like they are anticipating a muni meltdown anytime soon.  That is with good reason.  As we mentioned last year in an edition of Insights, municipalities had built their reserves to a level that was much stronger than was the case in other recent downturns.  Issuers with some degree of creativity (or capable advisors) have many tools available to them to get them through this cashflow difficulty.  Many issuers in the riskier areas of the municipal market issue bonds with a debt service reserve fund that will often carry the debt service costs for a full year of operation if needed.  Other such issuers, issue bonds that have an annual debt service cost (principal and interest) that is a modest percentage of the “profit” before interest expense and taxes (referred to as interest coverage). Lastly, some revenue bond issuers simply maintain a robust cash position to weather the storm.    

"Municipalities had built their reserves to a level that was much stronger than was the case in other recent downturns."

Good Luck to Us All

Let’s hope that in our year-end edition of Insights we have the luxury of a clearly decided election.  An alternative outcome is the last thing the markets will appreciate and as a Country hopefully seeking out some unity and healing, it is what most Americans seem to need.