Nicholas Zaiko, CIMA
Market Review 3Q 2020
After the severe economic shock from Covid-19, market sentiment rebounded from the March 2020 lows when credit spreads exploded. Many of the extraordinary fiscal and economic rescue spending passed by Congress in March 2020 that helped stabilize the economic impact of shutdowns expired in July and month-end September.
Since May all 50 states have re-opened at varying levels of economic activity. In June civil and social unrest, surges in positive COVID-19 cases, and rollbacks of some of the re-openings have added uncertainty as to the length of the economic recovery.
Economic data was mixed, optimism for additional fiscal stimulus faded, and the surge in COVID-19 cases may cause cautious consumer behavior. Renewed broad-based lockdowns are unlikely. Fortunately, treatments have improved dramatically, and the market continues optimistic about progress on potential therapeutics and vaccines.
The extraordinary amount of global economic slack will take years to absorb even with continued fiscal policy support. Inflation risk is not expected for years.
Geopolitical risks arising from the US-China tensions as China has been emboldened in Hong Kong, the South China Sea, and along the Indian border. China also recently announced retaliatory restrictions against the US on trade and technology.
The US Congress passed a spending bill on September 30 to keep the government funded through December 11,2020.
Fiscal support since the CARES Act passed in March, a $2.3 trillion stimulus package worth approximately 10% of GDP has since waned with no new fiscal support being passed by Congress. Many of the CARES Act expired July 31, 2020. The Federal Reserve Chair and its Governors have been very vocal that additional fiscal spending is critical to sustain the economic recovery.
Congress have been in a stalemate over state and local government support, corporate liability protections, enhanced unemployment benefits and infrastructure projects.
The airline rescue package expired September 30, 2020 and airlines started to furlough 32,000 employees in October. Although the House passed $25 billion funding for airlines to pay salaries through March 31, 2021, the Senate did not budge. Other corporations have announced substantial job cuts globally include Continental AG (auto supplier 30,000), Royal Dutch Shell (9,000), Disney (28,000), Allstate (3,800), that will all hit 4Q2020. Layoffs are no longer hitting hourly workers but administrative and management levels, higher income employees.
President Trump on October 6, 2020 halted the long-running negotiations by House Speaker Pelosi and Treasury Secretary Mnuchin to strike another stimulus deal until after the election. He instructed Senate Majority Leader McConnell to not act on a stimulus bill.
The Federal Reserve continued its QE program by purchasing $80 billion in Treasuries and $40 billion in agency MBS monthly.
On August 27, 2020 the Fed Chairman announced a new policy framework that would allow inflation to run at an “average inflation target” of 2% over time. The Fed stated that a strong job market can be sustained without causing a rise in inflation citing that minority communities benefit the most when there are robust labor markets. The Fed is reluctant to raise interest rates as the US Treasury is financing the high national debt levels. Lower rates for longer will enable to keep the interest debt payments low. The US Treasury yield curve steepened in response to this significant change in Fed policy. The Fed is expected to keep rates low from 2020-2023.
Fed Chair Powell has continued to state that negative interest rate policies (NIRP) are being considered. Experience of other central banks shows that negative interest rates have not helped stimulate growth in Europe and Japan. Negative rates create challenges for banks’ profitability, reduces lending, adversely impacts money market funds and the Fed.
At the September meeting, the Fed re-affirmed that it would keep rates low and its willingness to let inflation increase above 2% for an unspecified period of time.
Fed policy is expected to continue unchanged after the Presidential election results. Fed Chair Powell and other Fed governors have stated their intent to continue an accommodative monetary policy. The lack of additional fiscal stimulus may cause the Fed to provide additional liquidity and support to the markets by the December FOMC meeting.
Fitch announced on July 31, 2020 that it is reviewing the credit outlook on the United States to “Negative” citing a “deterioration in the U.S. public finances and the absence of a credible fiscal consolidation plan.” Tax rates at an all-time low and federal deficit at a 10-year peak. Above average economic growth may enable the US to grow out of its high debt levels but more than likely a debt management program targeted at decreasing spending and/or increasing tax revenues will be more effective.
The US Treasury announced a total of $112 billion in Treasury refunding from August through October, 2020 focusing on 10-, 20- and 30- year maturities which was $4 billion larger than expected.
Labor market data was better than expected. Average hourly earnings growth remains muted, rising an annual rate of 4.7%.
Private-sector payrolls rose 877,000 in September, with a upward revision of 40,000 jobs to the August employment estimate. The net gain of 661,000 jobs in September however reflects a 216,000 drop in public sector jobs. September report was a 66,000 job gain in manufacturing with a substantial increase in factory workweeks.
Department of Labor reported 16.5 million unemployed as of mid- September. The unemployment rate in August fell to 7.9% from 8.4% in July but is attributed to fewer people in the labor force. The underemployment rate (part-time employment) declined to 12.8%.
More layoffs are becoming permanent job losses which poses rising risk to the economy. The unemployment rate expected to range from 7%-9% by year-end 2020 may be higher if job losses continue in 4Q2020.
After 2Q2020 GDP fell an annualized -31.4%, 3Q2020 GDP to be announced October 29 is expected to grow +25.1%. 4Q2020 expected growth +5% may be endangered as the fiscal stimulus wanes and Congress does not deliver another stimulus package. The Bloomberg composite forecast for 2020 annualized GDP is expected to be -4.4% which is weak but considerably stronger than previously forecast.
Economic data was mixed compared to market expectations, as can be expected in this COVID pandemic. CPI was 1.3% and higher than expectations.
The ISM manufacturing index rose from 52.6 in June to 55.4 in September while ISM non-manufacturing was 57.8 in September. Both Sentiment Indexes are above 50 which indicate an expansion.
Consumer Sentiment Index rose 8.5% to 80.4 in September, the highest level in 6 months according to the University of Michigan. Personal income fell by 2.7% in August, the sharpest fall in three months per the Bureau of Economic Analysis (BEA).
New home sales and University of Michigan sentiment were favorable. The housing market has benefited from limited supply, pent-up demand, low mortgage rates that increased affordability. The Case-Schiller home price appreciation index rose 4.3% YTD as of 7/31/2020. House appreciation is expected to continue to rise through 2020-2021.
The Federal Reserve decided on October 4, 2020 to bar major US banks from share buy backs and cap dividends of US large banks through year-end 2020. Banks impacted are JP Morgan Chase, Citigroup, Wells Fargo and Bank of America. The intent is to ensure that banks with over $100 billion in assets and control a significant
lending market share are sufficiently capitalized to handle any further economic downturn. The banking sector in the US are expected to withstand credit deterioration.
Over 30 banks will be restricted including large foreign banks operating in the US. In June, the Fed limited payouts after completing pandemic scenario stress tests on the banks. Banks cannot pay higher dividends than paid in 2Q2020. Overall, the US banking sector is expected to withstand credit deterioration.
Money Market Funds
Money market yield curves continue to flatten. The lack of a stimulus package combined with no corresponding increase in T- bill supply have resulted in government yields plummeting. Yields in money market securities have continued to compress.
Money fund assets reaching an all-time high of $5.04 trillion on April
30. Since then with the strength of the equity markets and corporate uses of cash, assets under management have led to significant redemptions.
Government and Treasury fund assets peaked in May at $3.9 trillion and have declined to under $3.7 trillion by September. Prime funds also experienced a reduction in assets after peaking in July at $1.1 trillion.
One-month LIBOR rates continue low at 0.15% compared to 2.02% twelve months ago. Three-month LIBOR is 0.23% compared to 2.09% a year earlier. LIBOR will be discontinued by year-end 2021.
Record corporate bond issuance continued through 3Q2020 with
$389 billion in new issuance and reaching a record $1.6 trillion of investment grade bonds YTD 9/30/2020. Issuers continue to retire higher cost debt and term out their debt at record low rates. The global search for yield and number of countries with negative yields are benefiting US corporate issuers. BBB spreads remain moderately wider reflecting ongoing credit risk and potential future downgrades should the economic recovery slowdown.
Under the Primary Market Corporate Credit Facility, the Fed continued to purchase investment grade corporate bonds with maturities less than five years and corporate bond exchange traded funds during the quarter which contributed to a steepening of the yield curve.
The new issuance as profit declines increased corporate debt ratios during 3Q2020. Credit downgrades may have peaked in 2Q2020 and decelerated in 3Q2020. Some corporations reduced their discretionary share repurchase programs and increased cash on balance sheets. Capital expenditures fell 16% to preserve cash. US banks and other companies also reduced dividends to build up cash.
Following the onslaught of the coronavirus pandemic, approximately $151 billion across 27 issuers were downgraded to high yield and became “Fallen Angels”. Downgrades continue to outpace credit upgrades. It is estimated that about 1/3 of the $295 billion worth of investment grade outstanding debt may get downgraded to below investment grade in 2020. Most of the downgrades have been in travel, leisure, cruise, retail and oil- related companies. BBB rated sectors such as telecoms and healthcare are expected to fare well.
During 2Q2020 over one-third of the investment grade corporate index was on negative watch or negative outlook by at least one major rating agency. Almost 30% of these issuers are currently rated BBB-/Baa3. Negative watch indicates a potential downgrade in the near term, while a negative outlook indicates a downgrade could occur over the medium term (approximately 6-24 months).
Credit markets continued to retrace the spread widening from earlier in the year and outperformed Treasuries, which remained muted. All credit sectors added to performance over the quarter. COVID impacted sectors such as energy, lodging, airlines and hospitality services continue under pressure.
All credit sectors added to performance over the quarter and outperformed Treasuries. Investment grade credit spreads tightened by quarter end after having been wider during September.
The extraordinarily low yield environment encouraged corporations to issue new bonds, retiring debt with higher interest rates. Some corporations are tendering outstanding bonds to improve their balance sheets. Corporations are delaying or limiting capital expenditures. Investment grade credit spreads narrowed so that the BBB-rated sector outperformed other credits.