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Pausing for Breath, or a Turn?

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When markets collapsed mid-week, it made sense to many. Economists and investors, including those at RockCreek, have puzzled since April over a disconnect between the real world and equity markets. Lower interest rates for longer are now baked in, helping to hold up share prices. But with unemployment above Great Recession levels, output down sharply, bankruptcies looming, and Covid-19 still lurking, it was reasonable to wonder as equities climbed back to January 1 levels and beyond: are company prospects really better now than then, even with the liquidity gushing from the Fed? This week is opening on a downbeat note.
Watch RockCreek Founder and CEO Afsaneh Beschloss discuss managing during crisis, investor behavior, the growing rift between the US and China, and more with Former Fed Chair Alan Greenspan, Teacher Retirement System of Texas CIO Jase Auby, and RockCreek Senior Advisor Caroline Atkinson.
This year has had one market constant: the Big Five tech mega caps have outperformed.  It used to not be this way with the top five stocks, as the chart shows. And as tech companies have grown, they have dominated the S&P in a new way. In 2010, the biggest five names accounted for 11% of the index. Today, that has grown to 21%. Interestingly, a similar shift towards concentration has occurred in China over the same period. But what happens to the rest of the market matters as well. Looking ahead, a broader sustained rally will depend on whether the economy pulls out of recession and earnings hold up as the market expects. And that in turn still has much to do with the pandemic.
As the markets take a pause, three key observations and the takeaways for investors
1. A sustainable rally from here may depend more on the government and coronavirus than on the Federal Reserve

We know that the Fed will do all it can – and that is a lot – to keep markets functioning. Its actions and commitment stopped the March freefall and spurred the April-May rally.  The Fed can stop market panic, and provide enormous amounts of liquidity to almost all corners of the financial markets, and the economy.  But as Chairman Jay Powell made clear again last week, the government also needs to act, with more fiscal support to address the inevitable insolvencies and joblessness caused by the pandemic and shutdown. The economy is past its low point. The US and European economies are reopening. But recovery will not be smooth.  Large companies continued to announce new lay-offs this month.  Indicators of travel and mobility are no longer on the floor, but they are far below their levels of a year ago. If this continues, earnings will eventually have to be revised down further, perhaps sharply, disappointing equity markets. 

Markets may be pricing in a “90 percent economy” – with earnings in 2021 down just 10% from what was expected in January – perhaps based on China’s experience. In the US and Europe, that will require continued fiscal support to maintain incomes, and thus spending, and to limit business failures.  Ad hoc schemes to help workers are now in place in 89% of the 37 advanced economy nations in the OECD.  In Europe, such schemes have helped to keep workers on payrolls, while generous unemployment benefits limit the economic cost of losing a job.  In the US, the payroll protection program (PPP) for small businesses may have limited the increase in unemployment, but millions of Americans have still lost their jobs this year.  And without new action from Congress, there is very little money left in this program now. For those out of work, the temporary federal boost to unemployment insurance will run out at the end of July. Other elements that will hit incomes in the summer and fall include the delayed deadline for 2019 taxes, now July 15 in place of April 15, and the ending over time of rent and mortgage payment deferrals.

Leading economists at the Peterson Institute for International Economics (PIE) suggest that in addition to spending to maintain aggregate demand, governments should implement broad incentives in two key areas: employment and debt restructuring. The extraordinary speed and depth of the economic collapse, and the continued impact of the virus on specific sectors, such as hospitality and travel, call for special measures to preserve jobs and support over-indebted small firms that may be viable in the long-term, once the virus is conquered, but cannot borrow to survive in the short-term. Others, such as the Hamilton Project at the Brookings Institution, have set out plans to make fiscal responses to recession and recovery more automatic.  

What about the virus? One factor in the market’s stumble last week is the disquieting new evidence that infections and hospitalizations are rising in US states that eased lock downs earlier.  Health experts have warned for weeks that reopening the economy while infections remained high would likely lead to a renewed spread of disease.  Few expect that this would trigger another widespread economic shutdown: Americans have had enough of that.  As long as hospitals can cope, perhaps a continued climb in deaths will turn out to be politically acceptable. New York Governor Andrew Cuomo’s weekend threat to parts of New York to shut back down again suggests that he is certainly not of that view. And a renewed sense of danger would almost certainly keep consumers and businesses more cautious about venturing to spend and invest. 

2. This is a political year; election uncertainty is yet another unknown in this year of uncertainty and tumult

As November approaches, it will become more difficult to agree on new policies to support the US economy.  Important calls across America for anti-racist measures continue. One hopeful sign of coming together has been the broad base of support across society for actions to address systemic inequities. But partisan divisions remain deep and will complicate steps on Capitol Hill to craft a fourth CARES act.  Democrats want a shift towards large-scale federal support for social programs, often through states and local governments whose budgets are now being squeezed.  Long-term infrastructure programs to “build a better future” are also favored. But – at least until markets wavered last week – Republicans and the Administration were in no hurry to develop their counter-offer. 

3. The rest of the world is hurting too, but are others coping better?

The pandemic and recession have hit everywhere. International economic agencies including the World Bank and OECD, which have just released new forecasts, and the IMF, which will do so on June 24, have called out the global scale of economic distress.  The decline in GDP in 2020 will be both deeper and more widespread than after the global financial crisis.  As Chief Economist Laurence Boone, a recent guest on the RockCreek Finance Forward podcast, predicted the global economy will rebound from its Q2 low, but stop well before completing recovery to its previous level.

After 2010, the US economy recovered more quickly and steadily than other advanced countries.  This, and continued easy money, powered the tremendous stock market rally that Covid-19 ended. Things are different this time around.  Many countries in Asia, especially North Asia, but also countries as diverse as Vietnam and New Zealand, have had marked success in combating the disease. Rekindling trust among consumers and confidence in business will be that much easier.  In Europe – especially Germany, but notably not the UK – there is now clear evidence of a sharp reduction in infections.  And, contrary to the past, Europe – including Germany – is building up its fiscal response to provide support to economic recovery.  The banking system remains an Achilles heel in Europe. But for once, London and New York have less to celebrate.

4. Investment takeaways 

Institutional investors can be forgiven for being slightly relieved at the market moves this past week, which dovetailed with their more risk-off sentiments versus the more optimistic retail investor. This past week saw the worst week in the S&P 500 Index since March 20th – the VIX ended in the high 30’s after a fleeting moment at 44 and fixed income markets continued to signal a more pessimistic economic reality.

Fixed income markets have been interesting to gauge as they continue to signal warnings that equity investors are ignoring. A selloff this past week in US Govt bonds pushed yields to their highest levels since March, ending the week at about .71%, indicating that market participants continue to be pessimistic despite aggressive monetary stimulus from the Fed and assurances that it is status quo on interest rates for the medium term.

Investors looking for opportunity in high yield will have to be even more selective going forward. Pre-Covid-19, high yield spreads reached all-time lows despite increases in borrower leverage and a proliferation of covenant-lite loans – an increased risk and lower return proposition. Post-Covid-19, dispersion has picked up and – ex-energy (an outlier) – the high yield index currently offers a dispersion in spreads across sectors of over 900 bps. A potential case for attractive arbitrage and relative value opportunities in high yield with the right credit selection.

Dynamics of investing in the previously strong CLO Market post-Covid-19 have also changed. As more downgrades occur, CLOs will have to sell weaker paper to upgrade to higher quality paper. Investors should be wary of the magnitude of the CLO market – almost 70% of the leveraged loan market is owned by CLOs and 60% of the total leveraged loan market has a weaker B rating and is at risk for downgrades. This translates to almost $700 billion of potential downgrades.

Distressed investing naturally comes to mind as the shutdown of the global economy and resulting recession has produced a $900 billion + global distressed credit opportunity. Post Covid-19, defaults are likely to reach 10%+ with the biggest distressed opportunity likely to be in non-performing paper – expected to exceed $150 billion in 2020 alone if looking at the average of default estimates in April.

Companies at risk in a prolonged recession have been looking to get ahead and raising unprecedented amounts of debt in case of a potentially disastrous future, especially if there is another wave of the virus. Looking also at buyback holds and dividend cuts year to date, it is clear that most corporations are planning for difficulties even if markets and retail investors are not in sync. Year to date, Bloomberg indicated that S&P 500 consumer and cyclical companies have announced the highest number of buyback suspensions and dividend cuts compared to all other sectors. Actions that signal approaching distress for more companies over the next few quarters. Through May year to date, 28 S&P 500 companies in these sectors have announced buyback suspensions and 21 have announced dividend cuts. The financial sector and then consumer non-cyclicals follow in terms of sectors that have companies suspending otherwise robust buyback programs.

Interesting to watch is the 14 companies that have announced both buyback program suspensions and dividend cuts – almost all directly due to the economic lockdown of the past three months. Not surprisingly these already include companies like Carnival, Southwest Airlines and Hilton Worldwide. Retailers were also hit hard with Gap Inc. being the most recent retailer just last week to temporarily suspend its share buyback program and Ralph Lauren announcing it was discontinuing dividend cuts at the end of May. With interest rates essentially cut to 0%, investors looking for a steady, low risk, attractive yield have limited options in the market these days. Thus, some investors have turned their focus to dividend stocks. But a dividend is only as good as the company paying it and if a company cuts its dividend (a more likely scenario for some companies), or if dividend stocks underperform the market, it may not be the most attractive long term play.

Big questions remain – what to buy in the markets today and when to turn to downtrodden cyclicals? How risk averse should investors remain as the downside continues to loom large? And will a distressed cycle be one of the better opportunities to position portfolios towards as we wait to see the continued aftershocks of Covid-19? 
RockCreek Update
We are looking forward to welcoming the RockCreek Class of 2020 interns on Monday. As a team with over 80% women and diverse students, these interns will bring creativity, innovation and new ideas as they take on their roles in data science, AI, and more.
 
While the RockCreek team continues to work efficiently remotely and remains close through daily video calls, coffee hours and book clubs, we are preparing our re-entry plans. We continue to monitor best practices from health experts, and scientists to update our internal committee guiding our Covid-19-related decision-making processes and office safety measures.

At RockCreek, we frequently consider risk. The pandemic acted as a catalyst for risk – introducing new risks and heightening many factors already built into our risk management strategy. The governance framework developed in the World Economic Forums’ Transformational Investment: Converting Global Systemic Risks into Sustainable Returns report, done in collaboration with Mercer, and with Foreword by RockCreek Founder and CEO Afsaneh Beschloss and Standard Chartered Group Chairman José Viñals, can act as a guide for evaluating Covid-19 related risks and the pandemic’s impact on the economy, society and financial markets. We encourage all of our partners to read the report to learn more about six systemic risks that account for a $6.27 trillion investment gap: water security, climate change, population growth, geopolitical uncertainty, negative interest rates and technology disruption.

Our team and partners continue to contribute to organizations that are assisting communities during this time of need. If you have any questions or know of other ways we can partner with organizations helping throughout this pandemic, please let us know.

Team RockCreek
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