July 13th, 2020-Weekly Insights
Whistling Past the Graveyard – Gregory J. Hahn, CFA
The phrase “Whistling Past the Graveyard” describes the tenuous uncertainty that accompanies ignoring growing negative circumstances which could ultimately culminate in terribly bad outcomes. As we measure the euphoric response from the stock market to monetary stimulus and hope for a vaccine, we contrast the elevated valuations in the stock market against the backdrop of a virus that continues to spread, an economic environment still largely shutdown, the carnage of growing problems in the economy and capital markets, and the lack of cohesive plans to address the array of issues we are facing.
The first six months of the year was one of the most tumultuous periods in economic history as global economies struggled to combat a growing pandemic forcing business shutdowns in a manner never before experienced. In a period of 60 days, our domestic economy moved from one of the longest periods of economic expansion, to a deep recession with a 14% rate of unemployment and 23 million people out of work.
We are now transitioning to the second phase of the pandemic which involves managing through re-opening the economy without a way to control the spread of the virus or a cohesive plan to address the economic re-opening.
We want to be careful not to confuse monetary stimulus with an economic recovery. The Federal Reserve has initiated several programs to help provide stimulus and liquidity to the markets. However, in the second phase of dealing with the pandemic, we must now address the growing problems which include:
1. The growing problems in the municipal bond market where projects that rely on proceeds from sales taxes from hotels and restaurants to service the debt are insufficient
2. The $4.5 trillion gap in unfunded pension liabilities which will be difficult to narrow due to inadequately low investment assumptions
3. A chronically high rate of unemployment as lay-offs and furloughs continue
4. The deterioration in the economics of higher education and its impact on state and local economies
5. An airline industry that has too many planes and too few people to travel on them
6. The growing problem in commercial real estate where declining rent payments will no longer cover the interest expense
7. The uncertainty around the November elections
8. Unresolved trade agreements with China and Europe.
Unfortunately, this list is not comprehensive. However, the fundamental premise for investors is that there is no coordinated plan to address how to safely re-open the economy and drive economic growth. While earnings expectations are adjusted lower, we are expecting an increase in volatility and lack of patience for earnings misses.
Equity– Freddy Lavaric
The S&P traded higher 1.5% last week to finish at 3185. Year to date, the index is only down 1.42% and 7% off all-time highs. We saw the Nasdaq continue its rally, bringing its month to date gain to 11%. Stocks including Amazon, Apple, Netflix, and Google continue their new highs.
The upcoming week will provide us with significant insight into the actual damage sustained by companies from COVID-19 as 42 companies in the S&P are reporting earnings. This quarter of earnings will show the largest drop since 2008, as estimates range from 20-40% decline in earnings. Sectors such as Energy, Consumer discretionary, and Financials are expected to see well over a 50% drop in profits, while Tech is expected to see closer to a 10% drop in profits.
The calendar for the week ahead is as follows:
Tuesday: JPMorgan, Wells Fargo, Citigroup, Delta
Wednesday: Goldman Sachs, United Healthcare, US Bancorp, PNC
Thursday: Bank of America, Morgan Stanley, Netflix, Truist Financial, Johnson & Johnson, Abbott Laboratories, PPG, Domino’s Pizza
Our desire is to build defense into the Portfolio Models to help weather the potential for increase market volatility. We are constantly monitoring our exposure to large cap and large cap growth as it continues to outperform within our Core Series and Tactical Models. We remain cautious on value strategies, as many of these industries, including airlines, hotel and entertainment, continue to be impacted by COVID-19.
Fixed Income– Adam Coons, CFA
Interest rates moved lower during the week, led by a strongly bid 30-year auction and a general “risk off” tone across markets. The 10-year U.S. Treasury declined by 7bps to end the week at 0.62%. We believe rates are likely to remain low over the near term as continued market volatility and expectations for slower economic growth have created a ceiling to how high rates can go.
Similar to equity markets, corporate spread tightening stalled over the past couple of weeks. The lack of continued performance is even more striking given the continued purchases of corporate bonds totaling nearly $200 million per day by the Fed. In addition, the enormous issuance in corporate debt in 2020 has resulted in an increase in leverage on corporate balance sheets. It is becoming clearer that the Fed bond-buying backstop has supported a market that fundamentally should be weakening. Increased debt burdens may help some companies limp through this ongoing pandemic, but ultimately high debt loads will suffocate future growth and will stress the system.
Similar to corporates, municipal bonds have recovered sharply from their March sell off and performance is positive for the year. This performance comes despite heavy headwinds from a historical decrease in tax-payer income and uncertainty on how to make debt service payments on many projects that are siting dormant as a result of the virus. Much like corporate debt, municipalities have issued a large amount of debt. So far this year, $194 billion has been issued versus $163 billion for the entire 2019 year.
The fact remains that many municipalities are under significant stress and cannot survive without a federal assistance. Transportation revenue bonds such as Metropolitan Transit Authority, and revenue sources such as convention centers and parking garages have experienced obvious declines in revenue. The Fed has established a Municipal Liquidity Facility to support municipalities by purchasing their debt; however, the current rules appear unworkable to municipalities that are approaching the edge of default.
High Yield– Charles Kovarik
High yield spreads hardly changed over the week as the Friday market rally offset spread weakness earlier in the week. The beginning of July has been quiet for the high yield market as the total return for the Bloomberg Barclays High Yield index is up about 1% in price change. This performance is still driven by the higher quality credit. BB rated category remain the only rating tier that is positive year-to-date in total return.
The primary market was surprisingly active last week compared to investment grade, as over $8 billion worth of high yield issuance priced last week. The credits were primarily focused in higher-quality and were met with decent amount of demand. Taylor Morrison, Alcoa, and Charter (unsecured) all came to market to further bolster their balance sheets and liquidity. We still expect primary issuance to be light this week as much of the market enters their earnings blackout. This should be a slight technical to help support credit spreads.
In keeping with the theme of “Whistling Past the Graveyard,” Winthrop Capital Management continues to underweight high yield in its Portfolio Models. If second quarter earnings are poor, it will likely be a drag on high yield spreads as they are moderately correlated with equities. Default risk has increased in high yield, especially in oft maligned industries such as energy and airlines. In the investment strategies that include high yield, Winthrop Capital Management remains defensive and has moved up in quality to the BB area.
After taking a short breather, demand for high yield mutual funds picked back up. There were just over $2 billion in inflows into high yield ETFs and mutual funds, offsetting about a third of the outflows two weeks prior.