After the most incredible first quarter of 2020, we have seen an almost equally incredible second quarter. It is clear to us that the market overreacted in March, but it has also overreacted in its interpretation of the recovery.
For weeks, high profile commentators and investors have been talking about the dislocation between fundamentals and the markets. They are not wrong, but is the dislocation justified?
Fundamentals are just one of the inputs to market prices, so let’s have a look at our fixed income market. I don’t need to say much about rates that I have not said before. Policymakers have taken their base rates as low as they feel comfortable with, and investors have taken the rest of the yield curve in risk-off government bonds to incredibly low levels from which there is not much room for further yield compression, perhaps with the exception of the very long end.
From our perspective, while these government bonds are termed ‘risk-free’, the majority of them are now probably return-free as well. Ownership of government bonds is going to change quite significantly in the quarters ahead as central banks pick up the baton and government bonds move from private to public hands. Private investors will likely be looking to book profits and find better opportunities in various parts of the credit world.
In credit, just like equities, we have seen a strong recovery, perhaps stronger than we would have expected back in April. However, things have changed since then and the initial rebound from oversold markets has morphed into a full-on rally. Just for context, US high yield rallied from over 1080bp over the risk-free rate on March 24 to 552bp over on June 4, making it the most powerful rally since the initial bounce following the global financial crisis. All other credit markets have to varying degrees followed suit.
Before we try to predict the path ahead over the quieter summer months, we should try to justify the rally we have witnessed. I will say it up front, we think it is fully justified. The initial bounce-back was a heavy bounce from oversold markets reacting to the extraordinary global policy interventions. However, back then there were still huge uncertainties. The world was still in lockdown, the economic data was going to be appalling, the default rate was expected to be equally appalling, and people were quite rightly questioning whether the aid packages would work and find their way into the real economy, to name a few.
Since then we have gradually found answers to many of these uncertainties. From our perspective, one of the single biggest drivers as we considered when to embrace risk was to be the path of the recession, which in this case we saw as quite predictable. It was clear to us that April 2020 would be the worst month, Q2 2020 would be the worst quarter, the recession would be extraordinarily deep and the global economy would probably take at least two years to recover. However, we also knew that from April 2020 onwards the data would begin to get incrementally better, albeit from a very low level. We knew it was the direction of the fundamentals that would be important in helping to sustain a rally even if markets raced ahead.
Even more significant though in our view has been an extraordinary technical picture, driven ultimately by three powerful but independent forces.
The first was from the authorities and central banks, whose liquidity always finds its way into the markets, partly by design and partly by unintentional consequence. The Fed’s support umbrella now includes corporate bonds for the first time, for example. This confidence and liquidity boost would play a crucial role in the sustained recovery. The second source was, and still is, the outflow from government bonds into credit securities, just as we mentioned above. Government bonds had run their course and investors held huge volumes. New issue credit markets saw almost insatiable demand during Q2, virtually on a daily basis. Then finally, once the recovery sets in and fund returns across the market start to turn positive again, investors tend to to flock back in droves as they realise yields are now attractive and the trend is toward higher markets once again.
This powerful technical backdrop has been more subdued in June as the investment banks were rushing borrowers to the primary market ahead of an anticipated big summer lull, since professional investors will finally be able to take a break after a gruelling few months. July and August, in contrast, should see very little new issuance after the flurry seen in Q2. (As an aside, we should remember this when projecting Q2 vs Q3 earnings figures for banks with investment banking capabilities.)
For those that declared the Q2 rally unjustified and missed out, they perhaps had not appreciated the absolute strength of the technical picture. However, it is likely that as the fundamentals do begin to catch up month by month, this wave of frustrated investors will become buyers on dips, therefore making pull-backs shallower and shorter than prior volatility might suggest.
So where do we go from here?
It is finally summer and investors will be taking a break. Supply will die down significantly. However, the QE programmes are still buying, aid programmes are still prolonging solvency, investors are still moving out of governments and into credit, and mutual fund inflows are still very positive. On top of this, default rate expectations are being marked lower as the authorities have indeed saved the day for many firms, and yields are still a lot more attractive than at the start of the year. Going back to our US high yield example, the yield spread over risk-free today is 630bp, versus a low of 351bp in January. The technical picture still looks solid, perhaps even better than in June. Fundamentals are improving slowly each month.
What about earnings season? It kicks off shortly and we will have results from the big banks near the front of the queue. We think investors will be positively surprised by the bank numbers, and from a capital standpoint we expect buffers to once again increase over Q2 as dividends are not paid. We don’t expect many to be like JP Morgan, which looks set to announce no increase in its credit provisions (and will have had a monster quarter at its investment bank), but in general we think bond investors will be happy.
However, there are other sectors which are of more obvious concern where we will have the chance to see just how severe the whole quarter was. For the travel, leisure, retail, automotive, metals, mining and energy sectors, to name a few, it will be a very interesting time to review how companies have been able to weather the storm, if in fact they have. But there are plenty of other sectors that will have the chance to show their resilience from a bondholders perspective. For this reason, and those above, we remain constructive. The rally is intact, spreads are still attractive, technicals look extremely favourable and the fundamentals are very gradually catching up.
We are not likely to see the powerful ripping rally of Q2, but a slow grind towards lower spreads over the summer is what we are expecting and hoping for.
