Happy Days are Here Again
The second quarter of 2020 started with non-stop news and speculation about the devastation the COVID-19 pandemic might cause. At the same time, the markets were trying to digest the efficacy of the massive and unprecedented liquidity programs that the Federal Reserve and the Treasury special purpose vehicles (SPVs) offered, along with the CARES Act that was signed into law on March 27th, which was aimed at supporting economically impacted Americans and institutions. At the time it felt like perhaps both the Fed and the politicians may have crafted just the right solution to carry the economy through the economic shutdown and that the duration of our challenges would mirror that of what was reported by China. On the other side of this mess, there would be a vaccine and a bit more on the country’s credit card.
In truth, the speed with which the Fed/Treasury SPVs and the $2.2 trillion CARES Act were implemented was an achievement. We realized that the pandemic was our problem in March and by the end of April people received stimulus checks and institutions were being approved for Payroll Protection Program forgivable loans. Sure, there are reports of stimulus checks totaling more than $1 billion going to deceased people, along with other stories of waste and unintended errors, but in the grand scheme those instances appear to be a rounding error compared to the magnitude of the challenge we faced. Some people were paid more to stay home rather than to return to work and in the end the benefit of such “flaws” may be that consumer sentiment and hope among business owners was not altogether extinguished. As we saw during the Great Recession and years that followed, once there is a deflationary spiral started, strengthening consumer demand and optimism can require herculean efforts.
"As we saw during the Great Recession and years that followed, once there is a deflationary spiral started, strengthening consumer demand and optimism can require herculean efforts."
The various lifelines seem to have assuaged the market fears. A good measure of the panic and magnitude of the recovery is corporate bond “spreads” (the additional yield that a corporate bond offers as compared to a like-maturity Treasury). In the last half of March, the spread on an investment grade corporate bond was roughly 370 basis points. By the end of March, the spread fell by approximately 100 basis points. Over the second quarter of 2020, the spread has shrunk by nearly 130 basis points to a current spread of 144 basis points. Risk spreads are still higher than where we started the year at 93 basis points. Given the massive amount of economic uncertainty that should remain in the minds of most people, an increase in the risk spread of only 50 basis points seems disconnected with reality. It is also worth pointing out that since the start of the year, yields on 5-year Treasuries have plummeted from 1.69% to 0.30% so corporations who are operating in a much less certain demand environment than was the case in December are able to borrow money at a much lower cost than was the case before the pandemic. Whether you are in the stock market or the bond market, the orchestrated efforts of the monetary and fiscal policy programs have us dutifully singing “Happy Days Are Here Again.”
Observations and Outlook – Enjoy it While it Lasted
Since 2020 is a Presidential election year, nearly everything should be viewed through a political lens, which is unfortunate because it feels like a pandemic should be an episode where collective excellence would serve us best. It does not seem like there is a clear path of how to tackle this situation with “the correct answer.” The more economic hardship we cause, the greater the risk regarding deaths of despair and the trajectory of the working lives of some people may be forever lowered. If we open the economy too soon, we risk more COVID-19 deaths and the possibility of a renewed need to restrict aspects of the economy. The religion of the political tribes seems to be destined to position the U.S. for an ineffective response to this challenge and it could be to blame for what appears as if it will be a “fits and starts” path to the other side of this mess.
The whims of virus mutations, pockets of outbreak, hope for a vaccine and people’s willingness to temporarily change behaviors will be the drivers of optimism and despair for the rest of the year. It brings to light a couple of uncomfortable truths. First, we are not in control of this situation. We certainly should seek and adapt to knowledge as it comes, but we will be living in an environment with imperfect information and missteps. The second truth is that there will be nuanced choices made between destroyed livelihoods and one form of death (for reasons of despair – related to drugs, alcohol and suicide) and another form of death (COVID-19 fatalities).
"We certainly should seek and adapt to knowledge as it comes, but we will be living in an environment with imperfect information and missteps."
At the time of the writing of this piece, the world had seen more than 12 million cases of COVID 19 and nearly 555,000 related deaths. The U.S. has had over 3.2 million cases, with almost 136,000 deaths, resulting in a fatality rate of about 4% (compared to 0.10% for the seasonal flu last year). Almost 40 million tests have been administered in the U.S. which eclipses by a large margin the rest of the globe (except for China who has recorded 90 million tests, fewer than 84,000 cases and roughly 4,600 deaths). A recent study by the Well Being Trust estimates that deaths of despair, depending on the pace of our economic recovery will likely be in the range of 28,000 to 154,000 people. There is not a pleasant path to follow to the other side of this difficult chapter in our history. Institutions will fail, small/family businesses will close, dreams will subside to a new reality, jobs will be lost (some permanently) and families for one reason or another will lose loved ones. How does that translate into record low borrowing costs for corporations and near record high stock prices?
Large amounts of fiscal stimulus are certainly helping but the massive expansion of the Fed’s balance sheet is likely shielding us from the most immediate and largest near-term sources of pain. The likely result of the several trillions of dollars of Fed intervention has given the markets the appearance of being calm, orderly, and seemingly easy to navigate, but it all may be a bit of an illusion. It is a significant positive that the U.S. central bank isn’t trapped in the negative interest rate regime as is the case in Europe, which affords us more flexibility to address the current crisis. The Fed’s actions have distorted the markets such that assessments of risk that are based on policy expectations rather than fundamentals. A few quarters back we suggested that the size and scope of future interventions would need to become exponentially larger to have the same soothing effect on the markets. Well, here we are. The Federal Reserve has grown its balance sheet by roughly $3 trillion since mid-March to the point where the balance sheet is larger than $7 trillion. Given the various plans to buy Treasury and agency mortgage-backed securities each month (totaling $120 billion a month), plans to buy corporate and municipal securities, and a main street lending program to extend credit to medium-sized businesses, it is estimated that the Fed’s balance sheet could hit $10 trillion by the end of the year. Oddly enough, whether the Fed is buying securities, or extending credit to corporations, this money often flows into the banking system (bank reserves have nearly doubled over the past few months), and if loan demand is not robust relative to the rate the Fed pays banks for reserve deposits, the deposit ends up at the Fed (as a liability on their balance sheet). In the end, the Fed holds Treasuries, agency-backed securities, and special purpose vehicles for which the U.S. Treasury is in a first loss position and has bank deposits as the off-setting liability. Many individuals, flush with cash (that earns nothing) buy risky assets, which pushes valuations higher. We have discussed “zombie” consumers and companies in recent editions of Insights. This transfusion of cash seems to be the source of life (or perhaps un-death) of the aforementioned “zombies.”
Excessive central bank actions run the very real risk of creating “zombie” markets. We may be near the point where markets don’t send meaningful price signals and efficiently serve as a nexus for the allocation of capital. Novice day traders are following the financial market betting advice of sports commentators and scoffing at fundamental investors with solid 60-year track records (and in the short run, the “betters” are winning). Long-short hedge funds with 25-year track records are closing because investing based on fundamentals isn’t working in the world of quantitative easing that is being pursued by most of the world’s central banks. Investors pulled $44 billion out of long-short funds in 2019. Perhaps their thinking is that in a world of QE, stocks can only go up (until they don’t).
Unusual central bank actions generally are for the purpose of fixing market disfunction, taming market volatility, improving credit flow, and stabilizing economic activity. Most of those boxes can be checked with the current state of the financial markets and Fed policy. Specifically, domestic stocks are back near record highs (P/E ratios are ridiculous given the state of the world), Treasury yields are low and stable, corporate credit markets are flowing generously ($1.2 trillion of new corporates have been issued this year through May, that’s $400 billion more than the previous record), corporate risk spreads are historically “tight,” and after record job losses we are now starting to see record job gains. Fed Chairman Powell has said that policy is likely on hold through the end of 2022. We hope they have the fortitude to wisely do nothing. The risk of excess action, or overreach, could be game changing.
As suggested last quarter, the current coziness between the U.S. Treasury and the Federal Reserve blurs some lines that may have serious consequences. Our primary concerns are in the areas of political autonomy, credibility, and irreconcilable conflicts. The fact that wealthy Americans hold a large percentage of the risky assets that are seeing price appreciation may open the Fed up to charges of worsening the wealth inequality gap. Similarly, the degree of coordination between the Fed and the Treasury to create the special purpose vehicles, where the Treasury has an equity position and the Fed is the financier and manager, gets dangerously close to ending the concept of an independent Fed. If the Treasury is in an equity position and the Treasury Secretary is a member of the U.S. President’s cabinet, does that enter the Twilight Zone where the President’s subordinate is a co-head of a large percent of the Fed’s balance sheet? Hopefully not, but will future Presidents see this and not care about any nuances (of which we are unaware) that keep this from being the case? The politicization or weaponization of the central bank is a risk with almost unthinkable consequences. The credibility issue comes from the fact that since the Great Recession, the bond market has generally led the Fed’s actions and when the stock market gives a confirming signal, the Fed has been willing to give the market what it wants, with haste. A final concern for the current state of the Fed has to do with the very real concept of fiscal dominance. In the extreme, it involves the central bank giving the government all the money it needs and in turn the Fed policy could be influenced by the need to manage the cost of the debt. Since U.S. government debt now exceeds $17 trillion, a modest increase in the interest cost on the debt could have a crushing impact on government finances. Getting our debt and deficits under control is in the interest of a sustainable economy over the long term. An independent Fed is also in the best interest of those who don’t want to see this house of cards topple over.
"An independent Fed is also in the best interest of those who don’t want to see this house of cards topple over."
We expect Q3 will feel like a head fake (and heartache). Just as strong consumer sentiment and job growth numbers start to hit, the various lifelines that have allowed many Americans to suspend their pessimism and lost hope will be severed. Consumer sentiment in June rose to 78.9 from 72.3 in May and expectations of future conditions increased to 73.1 from 65.9. Payrolls rose in June by 4.8 million and the gains in May were upwardly revised to 2.7 million. The surprise strength reduced the unemployment rate to 11.1%. Not surprisingly, enhanced unemployment benefits have increased continuing claims for benefits. The last full week of June saw an increase of 1.43 million people seeking continued unemployment benefits. Some projections for the job environment in July suggest that net job losses on the order of 1 million will reflect the fear of a second wave of COVID-19 cases. Severely impacted entities in the restaurant, hospitality, sports entertainment, tourism, and a multitude of other businesses and institutions that were barely surviving pre-COVID-19 will have spent their PPP funds and begin to fail in Q3. The roughly 2/3 of unemployment recipients who earned more staying at home rather than working will start to lose their enhanced unemployment around July 25th. The current talk of the extension of the program would involve receiving less than 100% of their compensation when working (to get people incented to go back to work). Since it is a Presidential election year, we can expect some desire to make the employment numbers look as good as possible while delaying the institutional failures into Q4. Following the July congressional recess, we expect another round of stimulus checks, a more targeted version of the Payroll Protection Plan (restricted to failing businesses), and some assistance for hospitals and municipalities.
Even if a vaccine or successful treatment is released sooner than expected, we don’t see a sustainable scenario where interest rates materially climb. Fed Chairman Powell has said that the pandemic could inflict long-lasting damage on the economy and a full recovery will take years. The fact that consumer savings rates have climbed during this episode after more than a decade of the Fed unsuccessfully trying to truthfully get inflation at or above the 2% target, suggests that perhaps a generation of people have learned the lessons that haven’t been hardwired into the population since the Great Depression. An alternative to learning Depression Era lessons would be moving away from a capitalist system and interest in experimenting with adding elements of socialism to our economy. The economic tone of the Millennials and Generation Z may be one of either disinflationary tendencies or a more uniform standard of living. Q3 should offer short-lived optimism and somewhat higher interest rates, perhaps on the order of what we experienced in March. We continue to expect that yields at the end of the year will come back down to current levels, or possibly revisit the lows of the year based on the results of the November elections. Risk spreads should enjoy stability and support from the Fed’s corporate buying program. Since they can only lend to solvent entities, junk bond spreads could see some volatility if junk issuers become insolvent and start failing (unless the Fed and Treasury get into the forced corporate marriage business).
Municipal Bond Market – A Tale of Two Markets
The “headline risk” we mentioned last quarter has generally made munis a great value compared to many areas of the bond market. People are correct to expect defaults in areas of the municipal bond market, but they will very likely be a rarity in “essential service” sectors of the municipal bond market. Municipalities will have to make difficult decisions, and some may need to resort to cashflow borrowing to bridge the gap in revenues. Delayed expenditures, budget cuts, and increased debt burdens will gain headline space, but they are far from fatal to the perpetual nature of most municipal entities. Those that fail will be largely municipal entities that are exposed to the competitive nature of a market (substitution is a risk we would include as a market risk). Some early warning signs in this area of the muni market suggest broader institutional challenges lie ahead.
So far this year, at least 104 municipal borrowers have missed debt service payments, violated clauses of their indentures (the bond “contract”), or have made unscheduled draws on debt service reserve funds. It is the largest number since 2012 and impacts roughly $4 billion in bonds. The canary in the coalmine we are watching is the unscheduled draws of debt service reserve funds. Unscheduled draws, in the face of a delayed return to normalcy, suggests to us that many multi-notch credit downgrades and defaults may start to hit the riskiest corners of the muni bond market. We highlighted these types of issuers last quarter but some of the issuer types in this segment of the market include; small private colleges, hospitals, airports (with direct exposure to a particular airline), stadiums, museums, college dorm operators, hospitals, toll roads, transportation systems, convention centers, nursing homes, and Industrial Development Revenue bonds (IDRs involve a corporate entity accessing the muni market through a conduit municipal entity). They are generally not widely held by ACG but are commonplace in many municipal bond funds. We have seen multiple convention centers, nursing homes, senior living facilities, and IDRs needing to make unscheduled draws on their reserve funds. Some issuers are starting to default. Most recently a California Goodwill store operator and a management company that runs a sports and equestrian center in California have announced that they were unable to make debt payments on July 1st. Hospital systems are reporting that revenues are down as much as 50% and some senior living facilities indicate that leads for new residents are 75% lower. There should be pain coming in the high yield sector of the municipal market. Our expectation is that ACG’s Essential Purpose Philosophy will once again shield our clients from portfolio price swings and defaults.
"Unscheduled draws, in the face of a delayed return to normalcy, suggests to us that many multi-notch credit downgrades and defaults may start to hit the riskiest corners of the muni bond market."
Strategy and Summary
Given our broader interest rate forecast, episodes of panic that may cause investment to flee the muni market should present a buying opportunity. At current levels we feel “AA” rated munis in the 13-year to 15-year area represent a good value, with yields of roughly 2.0% as compared to a 10-year U.S. Treasury yield below 0.70%. There will be headlines of municipal employee lay-offs, rainy day funds being raided and a combination of a multitude of lost revenues and COVID-related costs but this is not the end of your state’s ability to function or your local water and sewer district’s ability to provide continued service. For context regarding the scope of the problem, currently the municipal bond market has nearly $4 trillion of outstanding debt. The underfunded liability for municipal pensions is estimated to be between $4.5 trillion and $6 trillion. The Federal Reserve Bank of Cleveland estimates that the lost revenue over the coming year will be between $25 billion and $137 billion. A professor at the University of Pennsylvania estimates the lost revenue and added costs could approach $500 billion. Even at the extreme, if the municipalities were to shoulder the entire burden, it would increase their debt load by roughly 12%. The broader muni market will be fine, and it is very likely that some type of municipal government assistance will be a part of the next COVID-19 bailout package. If investors respond to the headlines by throwing the baby out with the bathwater, give an increased allocation to high quality and essential purpose munis some serious consideration.
In addition to headline risk that may face the muni market, recovery-based economic optimism may offer another opportunity to buy bonds at what we believe will be attractive yields over the next year or two. We continue to think that recovery expectations could drive the 10-year Treasury yield to the vicinity of 1.0%. Municipal yields relative to Treasuries are quite appealing and we are a buyer since “AA” rated bond yields have reached a level that is nearly 250% of the comparable Treasury in the 13-year to 15-year segment previously mentioned. Fear of widespread muni defaults could drive that ratio higher but most of the misplaced concern seems to be baked into the current pricing. Temporary improved economic enthusiasm is most likely the force that would drive muni yields somewhat higher.
The fact that the world is awash in liquidity leads us to believe short rates will remain low for the foreseeable future. Ignoring the potential influences of fiscal dominance addressed earlier, longer-term rates should be held down by the magnitude and number of economic challenges and failures that lie ahead. There is also a strong possibility that future economic expectations will be anchored by the past decade of subdued inflation and growth experience. In the event we are wrong about those levers, the Fed has more than enough tools to address runaway inflation expectations (a problem they have been dreaming of addressing since the Great Recession). Don’t try to perfectly time the market. The peak is very often short-lived, and the supply of bonds of the type that you would care to buy may be insufficient to fill your needs during the handful of “perfect” days.
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