Asset Allocation
Highlights Q1/2020 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark by -40bps during the first quarter of the year – a number that would have been far worse if not for the changes in exposures for duration (increased) and spread product (decreased) made in early March. Winners & Losers: Underperformance was concentrated in sovereign debt, US Treasuries in particular (-94bps), as yields plummeted. This detracted from the outperformance in spread product (+51bps) led by US investment grade corporates (+34bps) and emerging markets (+20bps). Scenario Analysis For The Next Six Months: Given the ongoing uncertainty over when the COVID-19 pandemic and economy-crushing global lockdown will end, we are sticking close to benchmark on overall duration and spread product exposure. Instead, we recommend focusing more on country allocation and spread product relative value to generate outperformance, favoring markets where there is direct involvement from central banks. Feature Global bond markets were roiled in the first quarter of 2020 by the economic fallout from the COVID-19 pandemic. Government bond yields crashed to all-time lows while volatility reached extremes across both sovereign debt and credit. The quick, coordinated policy response from global monetary and fiscal authorities – which includes unprecedented levels of direct central bank asset purchases, both in terms of size and the breadth across markets and counties - has helped stabilize global credit spreads and risk assets, more generally. The outlook remains highly uncertain, however, with many governments worldwide looking to reopen their collapsed economies, risking the potential resurgence of a virus still lacking effective treatment or a vaccine. We are focusing more on relative value between counties and sectors. In this report, we review the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the eventful first quarter of 2020. We also present our updated recommended positioning for the portfolio for the next six months. The main takeaway there is that we are focusing more on relative value between counties and sectors while staying close to benchmark on both overall global duration and spread product exposure versus government bonds (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months Chart 1Q1/2020 Performance: Lagging, But It Could Have Been Much Worse As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q1/2020 Model Portfolio Performance Breakdown: A Missed Rally In Sovereigns, Outperformance In Credit The total return for the GFIS model portfolio (hedged into US dollars) in the first quarter was -0.1%, underperforming the custom benchmark index by -40bps (Chart 1).1 That relative underperformance came from the government bond side of the portfolio, while our spread product allocation outperformed the benchmark. US Treasuries underperformed the most (-91bps) with losses concentrated in the +10 year maturity bucket. (Table 2). After US Treasuries, euro area high-yield corporates were the second worst performer, underperforming the benchmark by -10bps. Outperformance in spread product was driven by US investment grade industrials (+22bps) and EM credit (+20bps). Table 2GFIS Model Bond Portfolio Q1/2020 Overall Return Attribution The potential losses to our model portfolio were greatly mitigated by changes in positioning during the quarter. Our decision to raise overall global duration exposure to neutral at the beginning of March helped shield the portfolio as yields plummeted.2 We followed this by upgrading sovereign debt in the US and Canada, both higher-beta countries, to overweight while moving to an underweight stance on US high-yield debt, euro area investment-grade and high-yield debt, and emerging market (EM) USD-denominated sovereign and corporate debt.3 In an environment of rampant uncertainty, these allocation changes helped prevent catastrophic losses in the model portfolio that had previously been positioned for a pickup in global growth. The potential losses to our model portfolio were greatly mitigated by changes in positioning during the quarter. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -91bps of underperformance versus our custom benchmark index while the latter outperformed by +51bps. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. Chart 2GFIS Model Bond Portfolio Q1/2020 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q1/2020 Spread Product Performance Attribution By Sector The most significant movers were: Biggest Outperformers Overweight US investment grade industrials (+22bps) Underweight euro area investment grade corporate bonds (+16bps) Underweight EM USD-denominated corporates (+12bps) Overweight US investment grade financials (+10bps) Underweight Japanese government bonds with maturity greater than 10 years (+8bps) Biggest Underperformers Underweight US government bonds with maturity greater than 10 years (-36bps) Underweight US government bonds with maturity of 3-5 years (-17bps) Underweight US government bonds with maturity of 5-7 years (-16bps) Underweight US government bonds with maturity of 1-3 years (-13bps) Underweight US government bonds with maturity of 7-10 years (-12bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2020. The returns are hedged into US dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q1/2020 (red for underweight, dark green for overweight, gray for neutral).4 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Predictably, government debt performed the best in Q1/2020 as global bond yields fell and monetary authorities raced to support economies and inject liquidity. UK, US, and Canadian government debt delivered the best returns this quarter. While we started the year neutral or underweight those assets, we moved to an overweight allocation in March, which helped salvage some returns. Also worth noting is that Australian government debt, where we have maintained a structural overweight stance, was one of the top performing markets during the first quarter. The deepest losses were sustained in EM USD-denominated sovereign and corporate debt, and euro area high-yield. Although it seems a distant memory at this point, we did start this quarter on an optimistic note and expected spreads on these products to narrow as global growth picked up. However, we were able to shield our portfolio against excessive losses in these products by moving to an underweight stance in March once the severity of the COVID-19 global economic shock become apparent. Bottom Line: Our recommended model bond portfolio underperformed the custom benchmark index during the first quarter of the year. The underperformance was concentrated in government bonds, which rallied on the back of the global pandemic. However, the portfolio outperformed the benchmark in spread products, where the combination of massive fiscal/monetary easing and direct central bank asset purchases have brought credit spreads under control. Future Drivers Of Portfolio Returns Typically, in these quarterly performance reviews of our model bond portfolio, we attempt to make return forecasts for the portfolio based off scenario analysis and quantitative predictions of various fixed income asset classes. In the current unprecedented economic and financial market environment, however, we are reluctant to rely on model coefficients and correlations to estimate expected returns. Instead, in this report, we will focus on discussing the logic behind our current model portfolio positioning and how those allocations should expect to contribute to the overall portfolio performance over the next six months. Looking ahead, the performance of the model bond portfolio will be driven by three main factors: Our recommended overweight stance on US spread product that is backstopped by the Fed—US investment grade corporates, Agency CMBS, and Ba-rated high-yield; Our recommended overweight stance on relatively higher-yielding sovereigns like the US and Italy; Our recommended underweight stance on EM USD-denominated corporates and sovereigns, where the specter of defaults and liquidity crunches looms. In terms of specific weightings in the GFIS model bond portfolio, we have moderated our stance on global spread product since our previous review of the portfolio.5 While the monetary liquidity backdrop is highly bullish, with central banks aggressively buying bonds and keeping policy rates at the zero lower bound, it is still unclear if and when economies will be able to successfully reopen and put an end to the COVID-19 recession. We are now recommending only a small relative overweight of two percentage points for spread product versus the benchmark index (Chart 5), leaving room to add more should the news on the virus and global growth take a turn for the better. Chart 5Overall Portfolio Allocation: Slightly Overweight Credit We also remain neutral on overall portfolio duration exposure. Our Global Duration Indicator, which contains growth data like our global leading economic indicator and the global ZEW expectations index, has plunged and is signaling bond yields will stay depressed over the next six months (Chart 6). Yet at the same time, yields in most countries have been unable to hit new lows after the panic-driven bond rally in late February and early March, even as global oil prices have collapsed and inflation expectations remain depressed, suggesting that yields already discount a lot of bad news. Chart 6Our Duration Indicator Is Signaling Government Bond Yields Will Stay Low We do not see much value in taking a big directional bet on yields through overall duration exposure at the present time. We also think it is far too early to contemplate reducing duration – even with many global equity and credit markets having rallied sharply off the lows – given the persistent uncertainty over the timing of a recovery in global growth. Thus, we are maintaining a neutral overall portfolio exposure (Chart 7). Chart 7Overall Portfolio Duration: At Benchmark Chart 8Country Allocation: Favor Those With Higher Betas To Global Yields Within the government bond side of the model bond portfolio, we recommend focusing more on country allocation to generate outperformance. That means concentrating exposures in relatively higher yielding markets like the US, Canada and peripheral Europe while maintaining underweights in core Europe and Japan, where yields have relatively little room to fall. That allocation also lines up with the sensitivity of each market to changes in the overall level of global bond yields, i.e. the yield beta (Chart 8). By favoring those higher beta markets, the model portfolio would still benefit from a renewed leg down in global bond yields, while still maintaining an overall neutral level of portfolio duration. By favoring those higher beta markets, the model portfolio would still benefit from a renewed leg down in global bond yields. Turning to spread product allocations, we recommend focusing more on policymaker responses to the COVID-19 recession rather than the downturn itself. Yes, the earlier widening of global high-yield spreads is forecasting a sharp plunge in global growth and rising unemployment rates (Chart 9, top panel). At the same time, the now double-digit year-over-year growth in global central bank balance sheets - a measure that has led global high-yield bond excess returns by one year in the years after the Global Financial Crisis (bottom panel) – is pointing to a period of improved global corporate bond market performance over the next 6-12 months. Chart 9Global Corporate Performance Should Benefit From Global QE In other words, we are focusing on global QE rather than global recession, while maintaining a modest recommended overall weighting on global spread product. Chart 10Credit Allocation: Buy What The Central Banks Are Buying That allocation could be larger, but we suggest picking the lowest hanging fruit in the credit universe rather than going for the highest beta credit markets. That means concentrating spread product allocations on the parts of global credit markets where central banks are directly buying (Chart 10). We are focusing on global QE rather than global recession, while maintaining a modest recommended overall weighting on global spread product. In the US, that means overweighting US investment grade corporate bonds (particularly those with maturities of less than five years), US Ba-rated high-yield that the Fed is now allowed to hold in its corporate bond buying program, and euro area investment grade corporate bonds (excluding bank debt) that the ECB is also buying in its increased bond purchase programs. Chart 11Stay Underweight EM Credit One new change we are making this week is upgrading US agency commercial mortgage-backed securities (CMBS) to overweight, funding by a reduction in US agency residential mortgage-backed securities (MBS) to underweight. While the Fed is still buying agency MBS debt in its new QE programs, MBS spreads have already compressed substantially and are now exposed to potential refinancing risk as eligible US homeowners look to take advantage of the recent plunge in US mortgage rates. We prefer to increase the allocation to agency CMBS, which the Fed can now buy within its expanded QE programs and which offer more attractive spreads than agency MBS (middle panel). One part of the spread product universe where we continue to recommend an underweight stance is USD-denominated EM corporate and sovereign debt. The time to buy those markets will be when the US dollar has clearly peaked and global growth has clearly bottomed. Neither of those conditions is in place now, with the price momentum in both the EM currency index and the trade-weighted US dollar still tilted towards a stronger greenback. That backdrop is unlikely to change in the next few months, suggesting a defensive stance on EM credit is still warranted (Chart 11). A defensive stance on EM credit is still warranted. Model bond portfolio yield and tracking error considerations The selective global government bond and credit portfolio we have just outlined does not come without a cost. While we are currently overweight countries with higher-yielding government bonds, our underweight positions on riskier spread product like EM debt and lower-rated US junk bonds bring the yield of our model portfolio down to 1.8%, –15bps below the yield of the model portfolio benchmark index (Chart 12). We feel that is an acceptable level of “negative carry” given the still heightened levels of uncertainty over global growth. This leads us to focus more on relative value between countries and sectors to generate outperformance that we expect to offset the impact of underweighting the highest yielding credit markets. Chart 12Portfolio Yield: Moderately Below Benchmark Chart 13Portfolio Volatility: Currently High, But Expected To Fall Finally, turning to the risk budget of the model portfolio, we are aiming for a “moderate” overall tracking error, or the gap between the portfolio’s volatility and that of the benchmark index. However, given our pro-risk positioning in the first two months of 2020, combined with the extreme volatility in markets during the first quarter, the realized portfolio tracking error blew through our self-imposed ceiling of 100bps (Chart 13). We expect this to settle down in the coming months as the recent changes in our positioning start to be reflected in the trailing volatility of our portfolio. Bottom Line: Given the ongoing uncertainty over when the COVID-19 pandemic and economy-crushing global lockdown will end, we are sticking close to benchmark on overall duration and spread product exposure. Instead, we recommend focusing more on country allocation and spread product relative value to generate outperformance, favoring markets where there is direct involvement from central banks. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate shaktis@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "What Bond Investors Should Do After The 'Great Correction'", dated March 3 2020, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Train Is Empty", dated March 10, 2020, available at gfis.bcaresearch.com. 4 Note that sectors where we made changes to our recommended weightings during Q1/2020 will have multiple colors in the respective bars in Chart 4. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, "2019 GFIS Model Bond Portfolio Performance Review: Praise Credit & Blame Duration", dated January 14, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Duration: While it’s possible that we are close to the US economic trough, we don’t see any immediate upside in Treasury yields. Investors should keep portfolio duration at benchmark and await signs of recovery in our preferred global growth indicators. Spread Product: Investors should buy spread products that offer attractive spreads relative to history and that benefit from Fed support. We favor: Aaa non-agency CMBS, Agency CMBS, Aaa ABS, municipal bonds and investment grade corporate bonds. High-Yield: We recommend an overweight allocation to Ba-rated high-yield corporates and an underweight allocation to high-yield bonds rated B and lower. Ba-rated bonds will benefit from Fed support and value in the B-rated and below credit tiers does not adequately compensate for likely default losses. Feature Chart 1Fed Actions Spur Rally Even though the economy remains closed and most of us are still confined to our homes, the mood in financial markets has shifted during the past few weeks. Risk assets are rallying as investors react to a cresting in the number of new COVID-19 cases and an unprecedented fiscal and monetary response. Since the Fed announced that it would step into the corporate bond market on March 23, equities have outpaced Treasuries by 28% and high-yield bonds have beaten the Treasury benchmark by 15% (Chart 1). Treasury securities initially rallied after the landmark Fed announcement but have only kept pace with cash during the past two weeks (Chart 1, bottom panel). This reversal in markets begs the question: Is the bottom already in? In this week’s report we ask that question about several different US bond sectors. Too Early To Call The Bottom In Treasury Yields At least in the Treasury market, we think it is premature to call the bottom in yields. Chart 2The Depths Of The Downturn In prior reports we outlined a checklist to call the trough in Treasury yields.1 Two of the items on that checklist were: a severe deterioration in the US economic data and signs of economic recovery in the rest of the world, particularly in those places where the pandemic struck first – like China. We are certainly now seeing the bad US economic data. The Economic Surprise Index is just off its all-time low and a composite of 10 high-frequency economic indicators compiled by the New York Federal Reserve is at its lowest point since the series began in 2008 (Chart 2). Similarly, weekly initial jobless claims set a record three weeks ago. Though they remain extremely elevated, new claims have declined in each of the past two weeks (Chart 2, bottom panel). All this at least raises the possibility that we are close to the trough in US economic growth. However, our second criterion of improving demand outside the US, particularly in China, has not been met. This is crucial because bond investors will need to see that there is light at the end of the tunnel before concluding that US economic activity will trend higher. China’s Manufacturing PMI bounced to just above 50 in March, suggesting that only a small majority of firms experienced better economic conditions in March compared to February. China’s credit impulse is advancing, demonstrating that policymakers are pumping a large amount of stimulus into the economy. But high-frequency growth barometers – like the CRB Raw Industrials index, the performance of cyclical versus defensive equity sectors and the trend in Emerging Market currencies – all remain downbeat (Chart 3). Bond investors will need to see improving demand outside the US before concluding that US economic activity will trend higher. For Treasury yields, the broad CRB Raw Industrials commodity benchmark is particularly important. This is because the ratio between the CRB index and the price of gold closely tracks the 10-year Treasury yield (Chart 4). In a typical economic downturn, we first see Treasury yields and the CRB index fall together as global demand weakens. Then, monetary policy responds by turning more accommodative, leading to a rebound in the price of gold as investors start to reckon with the potential long-run inflationary impact of monetary stimulus. Eventually, bond yields will bottom. But this will only occur once the stimulus seeps through to the real economy and gains in the CRB index start to outpace gains in gold. Chart 3No Global Growth Recovery Yet Chart 4Track The CRB/Gold Ratio The dynamic described above means that we should expect Treasury yields to lag risk assets as the market bottoms. In other words, we will see a sustained rebound in equity prices and corporate bond excess returns before Treasury yields move meaningfully higher. This is especially true in this cycle because the Fed has indicated that it will be slow to shift away from its accommodative policy stance. Bottom Line: While it’s possible that we are close to the US economic trough, we don’t see any immediate upside in Treasury yields. Investors should keep portfolio duration at benchmark and await signs of recovery in our preferred global growth indicators. To hedge against the risk of higher Treasury yields without making a large duration bet, investors should implement duration-neutral curve steepeners. We recommend going long the 5-year bullet and short the duration-matched 2/10 barbell.2 Is The Bottom In For Investment Grade Spread Product Excess Returns? We hesitate to call the bottom in overall spread product returns versus Treasuries. However, we do see many buying opportunities in specific US fixed income sectors. In deciding which sectors to own, we advise investors to search for sectors that: (A) Have attractive spreads and (B) Benefit from one or more of the Fed’s recently announced programs We described each of the Fed’s different lending facilities in last week’s Special Report, and will not repeat that exercise this week.3 Instead, we run through a list of sectors where we think spreads have already peaked and that bond investors should own today. Aaa CMBS Aaa-rated CMBS, both non-agency and agency-backed, meet our two criteria of offering attractive spreads and benefiting from Fed support (Chart 5). The Aaa non-agency CMBS index spread is 119 bps wider than at the end of 2019, and the securities can be used as collateral under the Fed’s Term Asset-Backed Loan Facility (TALF). Specifically, bondholders can borrow from TALF against their Aaa non-agency CMBS collateral at a rate of OIS + 125 bps (Chart 5, panel 2). TALF will also impose a haircut of around 15% on CMBS collateral. Chart 5Buy Aaa CMBS Agency-backed CMBS are even more attractive on a risk-adjusted basis. The Agency CMBS index spread is 50 bps above its end-2019 level and the Fed is directly purchasing Agency CMBS as part of its ongoing mortgage-backed securities purchases. As of April 15, the Fed had purchased $5.7 billion of Agency CMBS since it announced CMBS purchases on March 23. The outstanding par value of the Bloomberg Barclays Agency CMBS index is about $204 billion. If the Fed’s current pace of purchases continues for one year, it will own just under half of the index’s par value. Aaa ABS Though the spread is not quite as attractive as for Aaa non-agency CMBS, the spread on Aaa-rated consumer ABS is 115 bps wider since the end of 2019 (Chart 6). As with CMBS, this sector also benefits from TALF with an interest rate of OIS + 125 bps, and an even smaller haircut. Chart 6Buy Aaa Consumer ABS & Munis Municipal Bonds We also like the opportunity in municipal bonds. Spreads between Aaa-rated municipal bond yields and Treasuries have come down off their recent all-time highs but remain attractive compared to historical levels (Chart 6, bottom panel). The Fed’s Municipal Liquidity Facility (MLF) offers direct 2-year loans to state & local governments. This will provide a back-stop for municipal debt with a maturity of 2 years or less but will also help municipalities meet interest payments on longer-maturity bonds when they are due. Aaa-rated CMBS, both non-agency and agency-backed, meet our two criteria of offering attractive spreads and benefiting from Fed support. We would therefore advise investors to buy municipal bonds at both the short and long ends of the curve. We also do not rule out further Fed measures to support the municipal bond market in the coming weeks, possibly even secondary market bond purchases. The amount of Fed support for state & local governments so far is much less than what is being done for the corporate sector. There is also no convincing moral hazard argument against scaling-up support for investment grade rated munis, especially when the Fed is already supporting some parts of the high-yield corporate market. Investment Grade Corporates As mentioned above, the Fed is providing an exceptional amount of policy support to the investment grade corporate bond market, mainly through three facilities: The Secondary Market Corporate Credit Facility (SMCCF) that will purchase corporate bonds and ETFs in the secondary market. The Primary Market Corporate Credit Facility (PMCCF) that will purchase new bond issues in the primary market. The Main Street New and Expanded Lending Facilities (MSNLF & MSELF) that will purchase corporate loans from banks, removing them from bank balance sheets. All three of these facilities support the investment grade corporate bond market, and investment grade corporate spreads remain elevated compared to history across all credit tiers (Chart 7). Chart 7Buy Investment Grade Corporates Bottom Line: Investors should buy spread products that offer attractive spreads relative to history and that benefit from Fed support. We favor: Aaa non-agency CMBS, Agency CMBS, Aaa ABS, municipal bonds and investment grade corporate bonds. Have High-Yield Spreads Already Peaked? In the high-yield market we follow the same rules we applied in the previous section. We want to buy sectors that have attractive spreads and that benefit from Fed support. Within high-yield, the Ba credit tier meets these criteria as it offers an elevated spread and loans to Ba-rated issuers are eligible under the MSNLF and MSELF. The SMCCF will also purchase some high-yield ETFs and both the SMCCF and PMCCF will purchase securities that were recently downgraded to Ba from Baa. However, for the most part, securities rated B and below will not benefit from the Fed’s new facilities and thus will trade purely on fundamentals.4 This demarcation between securities rated Ba and above and those rated B and below is already showing up in excess returns. Since the Fed first announced corporate bond purchases on March 23, Ba-rated junk bonds have outperformed Treasuries by 16.88%, beating B-rated bonds (13.84%), Caa-rated bonds (9.53%) and the lowest Ca/C-rated credit tier (6.85%) (Table 1). Table 1Corporate Bond Performance Since Announcement Of Fed Purchases Assessing High-Yield Fundamentals Even without Fed support, lower-tier junk bonds are still worth buying if spreads provide adequate compensation for expected defaults. We assessed the likely magnitude of the looming default cycle in a recent Special Report.5 One main conclusion from that report is that, due to elevated corporate sector leverage, the recovery rate on defaulted debt will likely be low during the next 12 months – on the order of 20-25%. Second, based on the expected magnitude and duration of the current economic shock, we expect a significant surge in the speculative grade corporate default rate during the next 12 months, likely hitting a range of 9%-13%. Even without Fed support, lower-tier junk bonds are still worth buying if spreads provide adequate compensation for expected defaults. With these default loss assumptions in hand, we can see what sort of buffer is priced into different high-yield credit tiers. Charts 8-10 show calendar-year excess returns for Ba, B and Caa-C high-yield credit tiers on the vertical axes. On the horizontal axes, the charts show the index spread at the start of the 12-month investment horizon less realized default losses over the course of the year.6 Chart 8Ba Default-Adjusted Spread Chart 9B Default-Adjusted Spread Chart 10Caa-C Default-Adjusted Spread We first observe that a Default-Adjusted Spread below 200 bps usually coincides with negative excess returns for all three credit tiers. In fact, for the Caa-C tier, we’d like to see a Default-Adjusted Spread above 500 bps before going long. Second, the green diamonds in all three charts identify likely outcomes for the next 12 months in three different default loss scenarios. The “Mild Scenario” is defined as a 6% speculative grade default rate and 25% recovery rate. The “Moderate Scenario” is defined as a 9% speculative grade default rate and 25% recovery rate. The “Severe Scenario” is defined as a 12% default rate and 25% recovery rate.7 Based on those choices, we’d place our base case default loss assumptions for the next 12 months somewhere between the Moderate and Severe scenarios. Charts 8-10 clearly show that, while Ba-rated issuers might still perform decently, the B-rated and below credit tiers are not priced at all for our base case default outlook. Note that this analysis does not consider Fed support in any way. Factoring that in, Ba-rated bonds look even better compared to bonds rated B and below. Bottom Line: We recommend an overweight allocation to Ba-rated high-yield corporates and an underweight allocation to high-yield bonds rated B and lower. Ba-rated bonds will benefit from Fed support and value in the B-rated and below credit tiers does not adequately compensate for likely default losses. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “When And Where Will Bond Yields Trough?”, dated March 10, 2020, available at usbs.bcaresearch.com 2 For more details on why we recommend this yield curve positioning please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 3 Please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 4 As we noted in last week’s Special Report, some B-rated issuers will benefit from the MSELF. But this support is minor compared to what is being offered to securities rated Ba and higher. 5 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 6 We use Ba and Caa-C default losses for those credit tiers. For B-rated bonds, we found that overall speculative grade default losses work slightly better than default losses for the B credit tier specifically. 7 We use historical correlations to translate overall speculative grade default rate assumptions into default rate assumptions for the Ba and Caa-C credit tiers. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Portfolio Strategy Our conservative dividend growth assumptions especially for the next three years – largely mimicking the GFC experience – result in an SPX 3,000 fair value target. Relative performance already reflects the jump in demand for packaged foods. A firm US dollar and an ongoing profit margin squeeze at a time when relative valuations have returned to the historical mean compel us to downgrade the S&P packaged foods index to neutral. An upward trending demand profile, a fortress of a balance sheet, exemplary recession resilience, and sustained M&A activity, all warrant an overweight stance in the S&P software index. Recent Changes Trim the S&P packaged foods index to neutral today, which pushes the S&P consumer staples sector to a benchmark allocation. Boost the S&P software index to overweight today, which lifts the S&P tech sector to a benchmark allocation. Table 1 Feature The SPX jumped to a five-week high last week, on the back of news that the economy will gradually reopen next month. In other news, GILD’s remdesivir drug showed some positive early signs in fighting off the coronavirus, sparking an impressive late-week rally in the SPX. From a macro perspective, flush monetary liquidity and extremely easy fiscal policy remain the dominant market forces. While we remain confident that equities will be higher on a 9-12 month cyclical time horizon, we believe that the easy money since the March 23 lows has already been made and a consolidation phase now looms. Thus, monetizing some of these gains would make sense at the current juncture. Keep in mind that the SPX, junk spreads and the CBOE’s put/call ratio have returned to their respective means since 2018 (horizontal lines denote the historical averages, Chart 1). Tack on the stiff resistance that the S&P 500 will face near the 50-day and 100-week moving averages, and a lateral move is likely in the coming weeks. Meanwhile, in our seminal report “SPX 3,000?” on July 10, 2017 we introduced our SPX dividend discount model (DDM) when we first came up with the SPX 3,000 target.1 It is now custom to update our DDM every April when the previous year’s annual S&P 500 dividend payment is finalized from the Standard & Poor’s. Chart 1Consolidation Mode Chart 2Dividends Rule As a reminder, we have been and remain very conservative in our DDM assumptions. Again this year we assume that no buybacks will occur, a long held assumption of ours, i.e. we pencil in a steady divisor in the coming five-year time frame. 2025 is our terminal year when dividend growth settles at 6.6%, 60bps below the long-term average (bottom panel, Chart 2). Our 8.2% discount rate mirrors the corporate junk bond yield historical average. This year we use two different dividend growth approaches: our own estimates and alternatively the S&P 500 dividend futures derived growth. In the spirit of conservatism, we pick the lowest point hit in early April across the different dividend futures expirations. Tables 2 & 3 summarize the results. In the dividend futures derived approach, SPX fair value is close to 2,110. Granted, such dividend contractions for two years running (33% in 2020 and 14% in 2021, Table 2) are extreme and highly unlikely. Moreover, dividend futures have since rebounded violently. However, we stick with them to derive our worst case SPX value. Table 2SPX Dividend Discount Model: Using S&P Dividend Futures Growth Assumptions Our own dividend growth estimates result in an SPX 3,000 fair value target (Table 3). While our assumptions are not as dire as the nadir in dividend futures, they are slightly more conservative than the GFC experience. As a reminder, in the aftermath of the GFC dividends contracted by 20% in 2009 and then recovered rising by 1% and 16% in 2010 and 2011, respectively (please click here if you would like to receive our DDM and insert your own assumptions). Table 3SPX Dividend Discount Model: Using USES Dividend Growth Assumptions Building up on this analysis, we want to identify sectors that are at risk of a dividend cut, and thus pose the greatest threat to our SPX dividend projections. Table 4 shows the 2019 sectorial dividends, profits, and the payout ratio along with indebtedness. While during the Great Recession financials cut their handsome dividends, the current recession is not a financial crisis and we doubt the financials sector will cut their dividends, at least not as aggressively as in the GFC (Table 5). Table 4S&P 500 GICS1 Sector Dividend Analysis Table 5The GFC S&P 500 GICS1 Sector Dividend Experience Energy is a clear standout, but neither XOM nor CVX will forego their dividend aristocrat status (minimum 25 consecutive years of rising dividends) and chop their dividends. In other words, these Oil Majors will do everything in their power including raising debt to ever so modestly increase their dividends and maintain their aristocrat status. Thus, $24bn of energy sector related dividends are safe or 55% of the overall energy sector’s dividend. Keep in mind that the energy sector increased their dividends in the GFC (Tables 4 & 5). Industrials (GE is no longer a big dividend payer), materials, real estate and select consumer discretionary are sore spots, but not large enough to undermine the SPX (Table 4). Tech, health care and consumer staples are in excellent shape and judging by JNJ’s and COST’s recent dividend hikes, these sectors that enjoy mostly pristine balance sheets may even increase their payouts as they did during the GFC (Tables 4 & 5). While utilities and telecom services are debt saddled, their defensive stature and stable cash flow streams along with their history of steady dividend payments also do not pose a real threat to the SPX’s dividend (Tables 4 & 5). This leaves financials as the key sector to monitor for a possible large inflicted wound to the SPX dividend. In the most adverse scenario where the Fed instructs banks to eliminate their dividends, as the BoE and the ECB recently did in Europe, then the SPX dividend will contract, but only by 15%, ceteris paribus. This is because last year the tech sector had the highest dividend weight in the SPX and also because the financials sector’s dividend weight has fallen from 30% in 2007 to 15% in 2019 (Tables 4 & 5). Netting it all out, we are comfortable with our dividend growth assumptions especially for the next three years – largely mimicking the GFC experience – and resulting in an SPX 3,000 fair value target. The path of least resistance for the SPX remains higher on a 9-12 month cyclical time horizon. However, given that the easy SPX gains from the March 23, 2020 lows – when we turned cyclically bullish2 – have been made, opportunistic/nimble investors could monetize at least a part of these massive one-month returns. As aforementioned the SPX may face resistance near the 50-day moving average where it attempts to consolidate its recent gains. This week we are downgrading a defensive group to neutral and boosting a deep cyclical group to an above benchmark allocation. Turning Stale Following up from last week’s report, we heed the message from our research to be wary of staples stocks at the depth of the recession and downgrade the S&P packaged foods index to neutral. This move also pushes the S&P consumer staples sector down to a benchmark allocation from previously overweight. While this defensive index had been severely bruised from the accounting scandal at Kraft/Heinz, it has really flexed its safe haven muscles year-to-date. We use this opportunity to trim exposure down to neutral as we deem that this relative advance has run out of steam, despite the once in a lifetime jump in a number of key demand indicators. Chart 3 shows that food & beverage store retail sales now garner 17% of total retail sales a percentage last hit in the early 1990s. Impressively, not only did industry sales rise in absolute terms, but also overall retail sales suffered a severe setback accentuating last month’s spike. Similarly, food output hit a high mark last month, outpacing overall industrial production that came to a standstill. Food products resource utilization also soared, outpacing overall capacity utilization by 10% (bottom panel, Chart 3). As a result, relative share price momentum came close to accelerating by triple digits on a short-term rate of change basis (Chart 4). While such euphoria is warranted, we reckon that most if not all the good news is already reflected in prices, especially given the early signs of a possible reopening of the US economy some time next month. Importantly, sell side analyst optimism has climbed to a similar height observed in late-2015/early-2016 when industry 12-month forward EPS were slated to outshine the broad market by over 10% (bottom panel, Chart 4). Chart 3Demand Boost… Chart 4…Is Already Baked In Worrisomely, despite the rising demand profile, operating margins have been drifting lower over the past decade and a further profit margin squeeze remains a high probability outcome (Chart 5). Finally, on the food export front, the rising US dollar is warning that volumes will remain in check in coming quarters (greenback shown inverted, middle panel, Chart 6). All of this is reflected in valuations that have returned to the 25-year mean with packaged food manufacturers now trading at a 9% forward P/E premium to the broad market (bottom panel, Chart 6). Chart 5Margin Trouble Chart 6Past Expiry Date In sum, relative performance already reflects the jump in demand for packaged foods. A firm US dollar and an ongoing profit margin squeeze at a time when relative valuations have returned to the historical mean compel us to downgrade the S&P packaged foods index to neutral. Bottom Line: Trim the S&P packaged foods index to neutral, today for a loss of 20% since inception. This downgrade also pushes the S&P consumer staples sector to neutral for a loss of 11% since inception. The ticker symbols for the stocks in this index are: BLBG: S5PACK – MDLZ, SJM, KHC, CPB, MKC, CAG, TSN, GIS, HSY, HRL, K, LW. Boost Software To Overweight We recently monetized over 50% relative gains in our overweight in the S&P software index, but today we are compelled to lift this heavyweight tech sub-index back to an overweight stance. One key reason for our renewed bullishness is that for the second time in the past 15 months, software stocks managed to eke out relative gains when the broad market fell peak-to-trough 20% and 35% in late-2018 and in Q1/2020, respectively (Chart 7). This resilience on the way down confirms both the defensive stature of this services tech subgroup and simultaneously our long held belief that when growth is scarce investors will flock to secular growth stocks. Chart 7Recession Proof As a result and following up from our recent data processing upgrade, another defensive services tech group, we are compelled to augment exposure to the S&P software index to overweight. Last week we showed that the tech sector (along with financials and consumer discretionary) best the broad market from the recessionary troughs onward, signaling that the key software sub group will likely lead the recovery.3 Software investment is on a multi decade upward trajectory and is slated to rise further in coming quarters as overall spending takes the back seat, but defensive software capex remains resilient (Chart 8). Not only do corporate executives upgrade software in downturns as these upgrades yield near instantaneous return on investment and are immediately productivity enhancing, but also the push to cloud-based services will only accelerate during the ongoing recession (bottom panel, Chart 8). Tack on that the global coronavirus social distancing measures are also boosting demand for remote working services specifically, and software sales will continue to grind higher (Chart 9). Chart 8Capex Market Share Gains Chart 9Rising Demand Buoys Sales Meanwhile, industry M&A remains robust and both the number of deals are still rising at a brisk rate and the premia paid remain near historically high levels (Chart 10). Contrary to a slew of corporations that have announced dividend cuts and equity buyback suspensions, pristine software balance sheets underscore that shareholder friendly activities will remain in place, if not accelerate, during the current recession (bottom panel, Chart 10). Chart 10What’s Not To Like? Chart 11Model Says Buy Our macro-based software EPS growth model does an excellent job in capturing all these moving forces and it is signaling that industry profits will continue to expand at a healthy pace for the rest of the year, in marked contrast to the broad market’s expected profit contraction (Chart 11). Adding it all up, an upward trending demand profile, a fortress of a balance sheet, exemplary recession resilience, and sustained M&A activity, all bode well for an earnings-led outperformance phase in the S&P software index. Bottom Line: Boost the S&P software index to overweight, today. This upgrade also lifts the S&P tech sector to neutral for a loss of 5% since inception. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA US Equity Strategy Weekly Report, “SPX 3,000?” dated July 10, 2017, available at uses.bcaresearch.com. 2 Please see BCA US Equity Strategy Weekly Report, ““The Darkest Hour Is Just Before The Dawn”” dated March 23, 2020, available at uses.bcaresearch.com. 3 Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert) January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).
Highlights Risk assets have rallied thanks to a healthy dose of economic stimulus and mounting evidence that the number of new COVID-19 cases has peaked. Unfortunately, the odds of a second wave of infections remain high. In the absence of a vaccine or effective treatment, only mass testing can keep the virus at bay. Such testing will become available, but probably not for a few more months. Meanwhile, the global economy remains depressed. As earnings estimates are revised lower, stocks could give up some of their recent gains. Despite the fact that the supply of goods and services has fallen sharply during this recession, the overall effect has been deflationary. Deflationary pressures should subside later this year as demand picks up, commodity prices rise, and the US dollar weakens. Looking several years out, deglobalization and the increasing politicization of central banking could lead to accelerating inflation. Long-term investors should maintain a structurally below-benchmark duration stance in fixed-income portfolios, and position for steeper yield curves. Now What? Imagine being chased through the woods by an angry bear. You manage to climb a tree, getting high enough so that the bear cannot reach you. You breathe a sigh of relief. You are out of harm's way. Or so you think. You look down, and the bear is waiting for you at the base of the tree. You have no weapons. You feel cold and hungry. It is getting dark. This is the state the world finds itself in today. We have climbed up the tree. The number of new infections has peaked in Italy and Spain, the first large European countries hit by the virus. Hospital admissions in New York are falling. This, combined with a generous dose of economic stimulus, has allowed stocks to rally by 28% from their March 23 intraday lows. Yet, we have neither a vaccine nor a cure for the virus (although as we go to press, unconfirmed news reports suggest that Gilead’s drug, remdesivir, has had success in treating patients at a Chicago hospital). Chart 1Widespread Social Distancing Dampened The Spread Of All Flus And Colds COVID-19 is part of the coronavirus family, which includes four members that are responsible for up to 30% of common colds (most other colds are caused by rhino-viruses). Social distancing has driven the number of cold and influenza-like cases in the US to very low levels (Chart 1). But does anyone really think that the common cold or flu will be permanently eradicated because of recent measures? If not, what will prevent COVID-19, which is no less contagious than these other illnesses, from resurfacing? In short, the bear is still there, waiting for us to reopen the economy. A Deep Recession As we wait, the economic damage continues to mount. The IMF’s baseline scenario foresees the global economy contracting by 3% in 2020, with advanced economies shrinking by 6.1%. This is far deeper than during the 2008/09 financial crisis (Chart 2). The IMF’s projections assume that the pandemic subsides in the second half of 2020, allowing containment measures to be relaxed. If the pandemic were to last longer than that, global output would fall by an additional 3% in 2020 relative to the Fund’s already bleak baseline. A second outbreak next year would push global GDP almost 5% below the IMF’s baseline in 2021, while the combination of a longer outbreak this year and a second outbreak next year would cause the level of output to fall 8% below the 2021 baseline (Chart 3). Chart 2Severe Damage To The Global Economy This Year Chart 3Downside Risks To The IMF's Projections The Ties That Bind The sudden stop in economic activity has led to a dramatic surge in unemployment. US initial unemployment claims have risen by a cumulative 22 million over the past four weeks. The true scale of layoffs is probably higher than that, given that some state websites have been unable to handle the flood of insurance applications. Chart 4Only About One-Third Of Those Who Lose Their Jobs Apply For Benefits Historically, only about one-third of those laid off have applied for benefits (Chart 4). While the take-up rate will be higher this time – the CARES Act increases weekly unemployment compensation, while expanding eligibility to self-employed workers – it is still reasonable to assume that the claims data do not capture how much of the workforce has been laid idle. The one piece of good news is that at least so far, temporarily laid-off workers account for the vast majority of the increase in unemployment. This is encouraging because it implies that in most cases, the ties that bind workers to firms have not been permanently severed. In this respect, the recovery in employment following this recession may end up resembling that of another “man-made” recession: the 1982 downturn (Chart 5). Back then, policymakers felt that a recession was a price worth paying to quash inflation. Once inflation fell, central banks were able to cut rates, allowing economic activity to recover. Today, the hope is that by shutting down all nonessential businesses, the virus will be quashed, and life will return to normal. Chart 5Comparing The 1982 Recession Versus Today: Employment Edition Exit Plans It remains to be seen whether vanquishing the virus will be as straightforward as vanquishing inflation was in the early 1980s. As we noted last week, in the absence of a vaccine or an effective treatment, our best hope is that mass testing will allow businesses to reopen.1 The technology for such tests already exists; it just has yet to become available on a large enough scale. Just like during the Second World War, the production of weapons necessary to fight the virus will grow at an exponential pace (Chart 6). Chart 6Now Let's Do The Same For Test Kits Near-Term Pressures On Risk Assets Exponential change is a difficult concept for the human mind to grasp. What seems painfully slow at first can quickly become unfathomably fast later on. The apocryphal story about the origins of the game of chess comes to mind.2 This puts investors in a bit of a quandary. Growth is likely to recover in the latter half of 2020 as COVID-19 testing becomes pervasive and the effects of fiscal and monetary stimulus make their way through the economy. But, the near-term picture could be soured by news stories of continued acute shortages of medical supplies and delays in providing financial assistance to hard-hit households and businesses, not to mention dire corporate earnings performance. The one piece of good news is that at least so far, temporarily laid-off workers account for the vast majority of the increase in unemployment. Indeed, bottom-up analyst earnings estimates still have further to fall. The Wall Street consensus expects S&P 500 companies to earn $142 per share this year and $174 in 2021. Our US equity strategists are projecting only $100 and $140 in EPS, respectively. Stock prices and earnings estimates generally travel together (Chart 7). On balance, we continue to favor global equities over bonds on a 12-month horizon, owing to the fact that the cyclically-adjusted earnings yield is quite a bit higher than the bond yield (Chart 8). However, we have less conviction about the near-term (3-month) direction of stocks, and would recommend that investors maintain above-average cash levels for now which can be deployed on any major selloff. Chart 7Negative Earnings Revisions Will Weigh On Stocks In The Near Term Chart 8Favor Equities Over Bonds Over A 12-Month Horizon Inflation And Supply Shocks: A Keynesian Paradox? One of the distinguishing features of this recession is that it has involved a simultaneous supply shock and a demand shock. Businesses have had to curb supply in order to allow workers to stay at home, while workers have reduced spending out of fear of going to stores or other venues where they could inadvertently contract the virus. Worries about job losses have further dented demand. There is no question about what happens to output when both demand and supply decline: output falls. In contrast, the impact on the price level depends on which shock dominates (Chart 9). Chart 9Inflation And Supply Shocks As Appendix 1 illustrates with a set of simple numerical examples, in theory, a negative supply shock spread evenly across all sectors of the economy should cause the price level to rise. This is because unemployed workers, who are no longer contributing to output, will still end up consuming some goods and services by tapping into their savings, taking on new debt, or by receiving income transfers from the government. In the current situation, however, the supply shock has not been spread evenly throughout the economy. Some businesses have been completely shuttered, while others deemed essential have been allowed to operate. As the appendix shows, in such cases, the drop in aggregate demand is likely to be larger than if all sectors were equally impacted. In fact, it is possible for a supply shock to trigger a demand shock that is larger than the supply shock itself, leading to a perverse situation where a decline in supply results in a surfeit of output. A recent paper by Guerrieri, Lorenzoni, Straub, and Werning argues that the current pandemic represents such a “Keynesian supply shock.”3 Intuitively, such perverse supply shocks can arise if workers are cut off from purchasing many of the goods that they would normally buy. When the menu of available goods shrinks, even workers who are still employed could end up saving much of their income. Deflationary For Now All this implies that the pandemic is likely to be deflationary until more businesses reopen. The data seem to bear this out. The US core consumer price index fell by 0.1% month-over-month in March on a seasonally adjusted basis, led by steep declines in airfares and hotel lodging prices. High-frequency indicators, as well as the prices paid components of various purchasing manager indices, suggest that deflationary pressures have persisted into April (Chart 10). Chart 10Deflation Reigns For NowShelter inflation was reasonably firm in March but should soften over the coming months. A number of major apartment operators have announced rent freezes. In addition, the lagged effects from a stronger dollar and lower energy prices will contribute to lower goods inflation, while higher unemployment will hold back service inflation. Inflation Should Bounce Back In 2021 The discussion of Keynesian supply shocks suggests that aggregate demand will increase faster than supply as more sectors of the economy reopen. This should ease deflationary pressures. In addition, a rebound in global growth starting in the second half of 2020 will prompt a recovery in commodity prices. The forward oil curve is predicting that Brent and WTI crude prices will rise by 42% and 79%, respectively, over the next 12 months (Chart 11). Inflation expectations and oil prices tend to move closely together (Chart 12). Chart 11H2 2020 Rebound In Growth Will Lift Oil Prices Chart 12Inflation Expectations And Oil Prices Tend To Move Closely Together As a countercyclical currency, the US dollar will weaken over the next 12-to-18 months as global growth rebounds, providing an additional reflationary impulse (Chart 13). Falling unemployment will also eat into labor market slack, helping to support wages. Chart 13Stronger Global Growth In The Back Half Of The Year Will Weaken The Dollar, Putting Upward Pressure On US Inflation The Structural Outlook For Inflation… And Bond Yields Looking further out, the outlook for inflation will depend on whether the structural forces that have suppressed the rise in consumer prices over the past few decades intensify or abate. On the one hand, it is possible that the pandemic will cast a pall over consumer and business sentiment for years to come. If households and firms restrain spending, this would exacerbate deflationary pressures. Likewise, if governments tighten fiscal policy in order to pay off the debts incurred during the pandemic, this could weigh on growth. On the other hand, high government debt levels may increase the political pressure on central banks to keep rates low, even once the labor market recovers. This could eventually lead to economic overheating in two-to-three years. Chart 14Global Trade Was Already Stagnating A partial roll back in globalization could also cause consumer prices to rise. Global trade was already stagnant even before the trade war flared up (Chart 14). The pandemic may further inflame nationalist sentiment. Against the backdrop of high unemployment, Donald Trump is likely to campaign as a “war president,” relentlessly chiding Joe Biden for having too cozy a relationship with China. On balance, we suspect that inflation will rise more than expected over the long haul. This is not a particularly high bar to clear. Investors currently expect US inflation to average only 1.2% over the next decade based on TIPS breakevens. Market-based inflation expectations are even more subdued in most other advanced economies. If inflation does surprise to the upside, long-term bond yields are likely to increase by more than expected. Investors should maintain a structurally below-benchmark duration stance in fixed-income portfolios, and position for steeper yield curves. APPENDIX 1: Keynesian Supply Shocks Suppose there are two sectors, A and B. The economy consists of 2,000 workers, with each sector employing 1,000 workers. To keep things simple, assume that workers in each sector evenly split their consumption between the two sectors. Thus, a worker in sector A spends as much on goods from sector A as from sector B, and vice versa. Also assume that each worker, if employed, produces $1,000 of goods and receives a salary of $1,000 for his or her efforts. With this in mind, let us consider three scenarios: Scenario 1: Both Sectors Are Open For Business In this scenario, $1 million of good A and $1 million of good B are produced and supplied to the market. Since each of the 2,000 workers spends $500 on good A and $500 on good B, a total of $1 million of both goods are demanded. Aggregate demand equals aggregate supply. Scenario 2: Partial Closure Of Both Sectors Suppose that half the workers in both sectors are laid off. While the unemployed workers do not earn any income, they still spend half as much as they used to by tapping into their savings ($250 on good A and $250 on good B for each unemployed worker). Each employed worker continues to spend $500 on good A and $500 on good B. Now there is $500,000 in total of each good produced, but $750,000 of each good demanded. Aggregate demand exceeds supply. Scenario 3: Sector A, Deemed The Essential Sector, Remains Completely Open, While B Is Closed In this case, all sector A workers are still employed, earning $1,000 each. Since good B is no longer available for purchase, sector A workers increase spending on good A by 20% (from $500 to $600 per worker). Workers in sector B are all unemployed. However, they continue to tap into their savings. Rather than spending $250 on good A as they did in scenario 2, they increase their expenditures on good A by 20% (from $250 to $300). A total of $900,000 of good A is now demanded ($600*1,000+$300*1,000), which is less than the $1 million of good A supplied. Aggregate supply now exceeds demand for the part of the economy that is still open. The chart and table below summarize the results. The key insight is that a 50% shock to the entire economy curbs aggregate demand less than a 100% shock to half the economy. This implies that demand is likely to grow faster than supply as mass testing allows more of the economy to reopen. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Testing Times,” dated April 9, 2020. 2 In one account, the King of India was so impressed when the game of chess was demonstrated to him that he offered its inventor any reward he desired. After thinking for a while, the inventor said “Your Highness, please give me one grain of rice for the first square on the chessboard, two grains for the next square, four grains for the one after that, doubling the number of grains until the 64th square.” Stunned that the inventor would ask for such a puny reward, the King quickly agreed. A week later, the King’s treasurer informed His Highness that he would need to give the inventor 18 quintillion grains of rice, which is more than enough rice to cover the entire planet’s surface. “Holy Ganges, what have I done?” the King exclaimed, before having the inventor executed. 3 Veronica Guerrieri, Guido Lorenzoni, Ludwig Straub, and Iván Werning, “Macroeconomic Implications of COVID-19: Can Negative Supply Shocks Cause Demand Shortages?” NBER Working Paper No. 26918 (April 2020). Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights Stay tactically neutral to equities. The market may meet some short-term resistance, especially as a slew of poor earnings are released in the coming weeks. The long-term threat to equities comes from the pandemic’s lasting after-effects, such as financial and corporate distress, and/or a political backlash against the private sector. Long-term investors should prefer equities over bonds, with the caveat that the threat does not materialise. Long-term equity investors should avoid oil and gas and European banks at all costs… …but healthcare, European personal products, and European clothes and accessories should all form core long-term holdings. Fractal trade: long nickel / short copper. Feature Chart of the WeekSales Per Share Must 'Catch Down' With GDP, Just Like In 2008 The sharp snapback rally in stock markets has reached an important resistance point – the critical Fibonacci level of a 38.2 percent proportionate retracement of the sell-off.1 Technical analysts define the sell-off in terms of the most recent peak to trough. But we define it differently. We define it in terms of the longest time horizon of investors that capitulated at the sell-off. The market may meet some short-term resistance. The longest time horizon of investors that capitulated at the sell-off’s climax on March 18 was a seven-quarter horizon. Hence, we define the sell-off as the seven-quarter decline to March 18. On that basis, and using the DAX as our benchmark, we would expect the index to meet resistance at around a 21 percent retracement rally from the March 18 low. Which is pretty much where the DAX stands right now (Chart I-2).2 Chart I-22020 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement After A Sharp Snapback Rally What Happens Next? The maximum length of investment horizons that capitulated on March 18 was unusually long at seven quarters. This should comfort long-term investors because of an important investment identity: Financial markets have fully priced a downturn when the longest time horizon of investors that have capitulated = the length of the downturn. So, the good news is that the March 18 bottom should hold if the downturn does not last longer than seven quarters. In this regard, the main risk of a protracted downturn comes not from the pandemic itself. Even if the pandemic returns in second and third waves, any economic shutdowns, full or partial, should last considerably less than seven quarters. Instead, the main risk comes from lasting after-effects, such as financial and corporate distress, and/or a political backlash against the private sector. The long-term threat comes from the pandemic’s after-effects on economic and political systems. But a protracted downturn of what? As we are focussing on the stock market, the downturn is not of GDP per se but its stock market equivalent: sales per share. In the long run, sales per share and GDP advance at the same rate. But the sector compositions of the stock market and GDP are not the same, so over shorter periods sales per share can underperform or outperform GDP. In which case, sales per share must catch up or catch down (Chart of the Week). In 2008, sales per share had to catch down. As a result, world sales per share declined for seven quarters through 2008-10, considerably longer than the decline in GDP (Chart I-3). Hence, the stock market found its bottom in early March 2009 when the longest time horizon of investors that had capitulated had reached seven quarters (Chart I-4). Chart I-32008-10: Sales Per Share Fell For Seven Quarters Chart I-42009 Low: A Seven-Quarter Capitulation Followed By A Fibonacci Retracement From this March 2009 bottom, the Fibonacci retracement equated to a 35 percent advance, which the market achieved by early June 2009. Thereafter, stocks met short-term resistance and gave back some of the snapback rally. Fast forward to 2020. Having likewise reached the Fibonacci retracement, the market may meet some short-term resistance, especially as a slew of poor earnings are released in the coming weeks. Assuming no lasting after-effects from financial distress or political backlash, the next sustained advance will happen later this year. Valuations Flatter Equities, But They Still Beat Bonds Turning to long-term investors the three most important things are: valuation, valuation, and valuation. Our favourite valuation measure is price to sales, which has been a good predictor of 10-year prospective returns going back to at least the 1980s (Chart I-5). Chart I-5Price To Sales Might Over-Estimate Prospective Returns In 2020, Just Like In 2008 But the predictive power depends on a crucial underlying assumption – that the past is a good guide to the future. Specifically, today we must assume that the pandemic causes just a brief blip in the multi-decade uptrend in stock market sales and profits. To repeat, the main long-term threat to stock markets comes not from the pandemic itself. The long-term threat comes from the pandemic’s after-effects on economic and political systems – such as crippled banking systems or large-scale nationalisations of the private sector. Furthermore, price to sales will err in its prediction if sales per share have deviated from GDP – implying either a future catch up or catch down. In the 1990s sales per share had underperformed GDP, so future returns outperformed the valuation prediction. However, in 2008 sales per share had outperformed GDP, so future returns underperformed the prediction. Today, just as in 2008, sales per share have become overstretched relative to GDP, so there will be a catch down. Which will weigh down prospective returns relative to what valuations appear to imply. Still, even adjusting for this, equities are likely to produce annualised nominal returns in the mid-single digits, comfortably higher than the yields on long-term government bonds. Hence, with the caveat that the pandemic does not generate lasting after-effects for economic and political systems, long-term investors should prefer equities over bonds. What Not To Buy, And What To Buy If a stock, sector, or stock market maintains a structural uptrend in sales and profits, then a big drop in the share price provides an excellent buying opportunity for long-term investors. In this case, the lower share price is stretching the elastic between the price and the up-trending profits, resulting in an eventual snap upwards. However, if sales and profits are in terminal decline, then the sell-off is not a buying opportunity other than on a tactical basis. This is because the elastic will lose its tension as profits drift down towards the lower price. In fact, despite the sell-off, if the profit downtrend continues, the elastic may be forced to snap downwards! Do not buy sectors whose profits are in major downtrends. This leads to a somewhat counterintuitive conclusion for long-term investors. After a big drop in the stock market, do not buy everything that has dropped. And do not buy the stocks and sectors that have dropped the most if their profits are in major downtrends. Specifically, the profits of oil and gas and European banks are in major structural downtrends (Chart I-6 and Chart I-7). Long-term equity investors should avoid these sectors at all costs. Chart I-6Oil And Gas Profits In A Major ##br##Downtrend Chart I-7European Banks Profits In A Major Downtrend Conversely, the profits of healthcare, European personal products, and European clothes and accessories are all in major structural uptrends (Chart I-8 - Chart I-10). As such, all three sectors should be core holdings for all long-term equity investors. Chart I-8Healthcare Profits In A ##br##Major Uptrend Chart I-9European Personal Products Profits In A Major Uptrend Chart I-10European Clothing Profits In A Major Uptrend Fractal Trading System* Given the outsized moves in markets over the past month, all assets have become highly correlated making it more difficult to find candidates for trend reversals. Chart I-11Nickel Vs. Copper However, we find that some relative moves within the commodity complex have not correlated with risk on/off. Specifically, the underperformance of nickel versus copper is technically stretched, so this week’s recommended trade is long nickel / short copper, setting a profit target of 11 percent with a symmetrical stop-loss. The rolling 1-year win ratio now stands at 67 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 0.382 = 1- phi. Where phi is the Golden Ratio, defined as the ratio of successive Fibonacci numbers in the limit. Alternatively, phi =1 / (1 + phi). 2 The seven-quarter sell-off in the DAX (capital only) to March 18 2020 was 39.4 percent, so a full retracement rally equals 65.1 percent, and a 0.382 geometric retracement equals 21.1 percent. 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Highlights Portfolio Strategy The Fed’s QE and ZIRP, the collapse in gasoline prices and extremely depressed breadth readings that are contrarily positive, all signal that it no longer pays to be bearish consumer discretionary stocks. A boost in demand for e-commerce, the high-growth profile of internet retailers along with neutral valuations and technicals, all compel us to trigger our upgrade alert and lift the S&P internet retail index to overweight. The rising gap between house price inflation and mortgage rates, the looming increase in residential investment’s contribution to GDP growth and firming industry operating metrics, all argue for an above benchmark allocation in the S&P home improvement retail index. Recent Changes Boost the S&P consumer discretionary sector to overweight today. Execute the upgrade alert and lift the S&P internet retail index to overweight today. Augment exposure to the S&P home improvement retail index to above benchmark today. Table 1 Feature The SPX oscillated violently last week, and a glimmer of good news on the coronavirus fight front, the Fed’s newly announced bazooka and a tick down in unemployment insurance claims all signaled that the bulls have the upper hand. We first showed the Google Trends’ worldwide searches for “coronavirus” series in our early-March Weekly Report,1 when stocks were unhinged and we were still bearish. Now, the most recent update of this indicator suggests that the recessionary lows are likely in for the SPX – this search term peaked a week prior to the overall stock market’s bottom (Google Trends shown inverted, Chart 1) – and we therefore reiterate our cyclically sanguine equity market view.2 Moreover, two weeks ago we highlighted that market internals were confirming the SPX recessionary lows.3 Not only did the SOX versus NDX and small caps versus large caps bottom in advance of the S&P 500, but also transports along with the Value Line Geometric and Arithmetic Indexes relative ratios all led the broad market’s trough.4 Chart 1Joined At The Hip Chart 2Dr. Copper... Importantly, Dr. Copper is also sending a bullish signal for the broad equity market. Economically sensitive copper tends to trough prior to the SPX especially in recessions. Copper collapsed below $2/lb recently leading the SPX by a few days (Chart 2). Similarly, in the recent late-2015/early-2016 manufacturing recession, the 2007/09 and 2001 recessions, copper sniffed out the bottom before the overall equity market troughed (Chart 3). Turning over to the macro backdrop, keep in mind that the Fed first cut rates this year on March 3, 2020, a mere nine trading days following the SPX peak when it fell just below the 10% correction mark. Then, on Sunday March 15, 2020 the Fed cut rates to zero, as the SPX had fallen another 10% into a bear market. Chart 3...Tends To Lead Just to put these moves into perspective, the last time the SPX fell roughly 20% from its peak was on Christmas Eve 2018, and it took the Fed seven months to cut interest rates. While a retest of the 2174 ES futures lows is possible, we would rather not fight the Fed. Instead, we continue to recommend investors deploy cyclically oriented capital in the broad equity market with a 9-12 month time horizon. Chart 4 shows that the Fed is on track to balloon its balance sheet over $11tn in the coming year, i.e. almost trebling it, and soaring to over 50% of GDP. Chart 4Follow The… Beyond the Fed’s QE5 liquidity injection and skyrocketing bank credit, in response to firms tapping existing credit lines, money seems to be growing on trees. M2 money supply growth spiked to 14.8% of late, the highest rate since WWII! This breakneck pace of M2 growth translates into $2tn created versus last year. In the past two weeks alone, M2 grew by $805bn. Deposits and money market funds’ assets are surging, driving the money supply to unprecedented levels. While we have sympathy to some investors’ view that very little of this money and credit will flow to the real economy, such flush liquidity is likely to spillover from the banking system. Asset prices will be the primary beneficiaries of that flood, albeit with a slight lag (Chart 5). Chart 5…Money Trail Meanwhile, we have heeded our research of how to prepare a portfolio from the SPX peak to the recessionary trough highlighted in the Special Report penned in May 2018, and we have been overweight health care and consumer staples (please refer to Table 5 in that Special Report).5 We are now building on the research from that report. Table 2 shows the (unweighted) average relative sector performance six, twelve and eighteen months out from the SPX recessionary troughs, using market cycles since the 1960s. Table 2Sector Winners From Recessionary Recoveries Early cyclicals financials and consumer discretionary along with tech are clear winners in all three periods we analyzed. This empirical evidence confirms the theoretical backdrop that early cyclicals are the first to sniff out a recovery during a recession. At the opposite end of the spectrum, defensive utilities, consumer staples and telecom services fare poorly in the three time frames we examined. Impressively, health care (we are overweight), which is the defensive sector with the largest market cap weight, manages to eke out modest relative gains. Charts 6 & 7 depict these time series profiles for the ten GICS1 sectors (we use telecom services instead of communication services due to lack of historical data). Chart 6Early Cyclicals Rise To The Occasion... Chart 7...But Defensives Lag We are already overweight financials, hence, this week we heed this empirical evidence and are upgrading the S&P consumer discretionary sector to overweight via executing the upgrade alert on the S&P internet retail index and also via augmenting the S&P home improvement retail (HIR) index to an above benchmark allocation. Boost Consumer Discretionary To Overweight… While we may be a bit early, we recommend investors augment exposure to the S&P consumer discretionary index to overweight, today. The Fed really cares about household net worth (HNW). It is a key pillar of consumer spending, which powers over 70% of the US economy. Greenspan in the late 1990s eloquently described this relationship between HNW and the economy. In Q1/2020 HNW will take a beating, but the Fed is making sure it recovers in Q2, and is doing everything in its power to keep the stock and residential real estate markets afloat (roughly 50% of HNW). Granted employment and income are also currently of paramount importance, and the Main Street Fed programs along with the massive fiscal easing package should partially cushion the blow from the looming surge in the unemployment rate. We are therefore comfortable with lifting consumer discretionary to an above benchmark allocation. Chart 8 highlights the inverse correlation between consumer discretionary relative performance and the fed funds rate dating back to the 1980s. Now that the Fed has returned to ZIRP and is on track to expand its balance sheet to over $11tn, the risk/reward tradeoff favors consumer discretionary stocks. Keep in mind household balance sheets have been repaired since the Great Recession with both debt/income and debt/GDP ratios plumbing multi-year lows as the GFC hit the consumer (and financial sector) hardest (bottom panel, Chart 8). Chart 8Buy Consumer Discretionary Stocks Our consumer drag indicator comprising interest rates and oil prices also signals that the path of least resistance for this early cyclical sector is higher (Chart 9). Not only will consumers eventually take advantage of ultra-low interest rates to buy big ticket items on credit, but also a wave of mortgage refinancing at lower rates translates into more cash in consumers’ wallets. Keep in mind that $20/bbl oil also saves US consumers money as retail gas at the pump has now plunged to $1.8/gallon from a recent high of $2.8/gallon. If we are correct and the US economy avoids a Great Depression/Recession, then the swift economic collapse will likely prove transitory as the authorities will have to slowly reopen the economy in early May, and the US consumer will come roaring back in the back half of the year. Finally, sentiment is bombed out toward consumer discretionary equities. Earnings breadth is as bad as it gets, technicals are washed out and a lot of damage has already been done to these interest rate-hypersensitive stocks (Chart 10). True, valuations are a bit extended, but were our thesis to pan out, these early cyclical stocks will grow into their expensive valuations. Chart 9Tailwinds Netting it all out, the Fed’s QE and ZIRP, the collapse in gasoline prices and extremely depressed breadth readings that are contrarily positive, all signal that it no longer pays to be bearish consumer discretionary stocks. Chart 10As Bad As It Gets Bottom Line: Boost the S&P consumer discretionary sector to overweight today from previously underweight, for a modest loss of 1.4% since inception. …Via Executing The Upgrade Alert On Internet Retail To Overweight… E-commerce has been garnering a rising market share of total retail sales uninterruptedly for over two decades. In fact, this juggernaut accelerates during recessions not only because overall retail sales level off, but also internet sales prove resilient during downturns. We are thus compelled to boost the bellwether S&P internet retail index to overweight by executing our upgrade alert to take advantage of the ongoing explosion of internet sales in the face of the coronavirus pandemic (Chart 11). AMZN dominates the internet retail space and by extension the broad consumer discretionary index, especially ever since the media complex migrated to the newly formed S&P communications services index in October 2018. Therefore, as AMZN goes so goes the rest of the consumer discretionary sector. Chart 11Market Share Gains As Far As The Eye Can See AMZN is a retail category killer and the “amazonification” of the economy is not something new as evidenced by the shopping mall evisceration and the dampening of retail sales price inflation. Nearly every segment AMZN has entered it has dominated. The Whole Foods acquisition has also positioned this internet retail behemoth to benefit from an online push for groceries. All of these forces were ongoing prior to the current recession. Now we deem they will accelerate and disproportionately benefit internet retailers at the expense of bricks and mortar retailers: the howling out of the latter is best evidenced by the recent double demotion of Macy’s from the big leagues to the S&P 600 small cap index. Related to the inevitable rise in demand for e-commerce owing to social distancing, growth is a highly sought after attribute that this index enjoys. Time and again we have stressed that when growth is scarce investors flock to industries that exemplify growth (Chart 12). AMZN’s cloud business, AWS, represents another aspect of significant growth, that will remain on an exponential trajectory as more and more businesses move to the SaaS model catalyzed by the current recession. While at first sight this index appears expensive, versus its own history it has worked off previously extreme valuation readings. In more detail, our relative Valuation Indicator has fallen from three standard deviations above the mean back to the historical average. Similarly, despite the recent run-up in prices, relative technicals are only back up to the neutral zone (Chart 13). Chart 12Seek Out Growth… Chart 13...At A Reasonable Price Adding it all up, a boost in demand for e-commerce, the high-growth profile of internet retailers along with neutral valuations and technicals, all compel us to trigger our upgrade alert and lift the S&P internet retail index to overweight. Bottom Line: Execute the upgrade alert and boost the S&P internet retail index to overweight, today. The ticker symbols for the stocks in this index are: BLBG: S5INRE - AMZN, BKNG, EBAY, EXPE. …And Upgrading Home Improvement Retailers To Overweight Home improvement retailers (HIR) were the first consumer discretionary stocks to sniff out the end of the Great Recession, troughing even prior to the China-sensitive materials and industrials equities (Chart 14). As such we believe these economically hyper-sensitive stocks will once again showcase their early cyclical status, and we recommend augmenting exposure to above benchmark. ZIRP along with the rising gap between house price inflation and mortgage refinancing rates are a tonic for home improvement retailers (fed funds rate shown inverted, Chart 14). While the residential real estate market will remain in the doldrums for a few months (we recently monetized impressive gains in our underweight stance in the S&P homebuilding index and lifted to neutral), mortgage holders that retain their jobs will be quick to benefit from lower refinancing rates, and boost their savings. Some of these savings will likely flow into home improvement activities courtesy of the recent quarantine rules. One big assumption is that these retailers remain open during the coronavirus induced lockdown. Chart 14Overweight Home Improvement Retailers… If our thesis pans out, then given the looming drubbing in Q2 GDP, residential investment/GDP should jump and provide a relative boost to the S&P HIR index (second panel, Chart 15). None of this positive news is priced in relative forward sales or profits that are flirting with the zero line (third panel, Chart 15). Importantly, relative valuations have dropped below par and are 30% below the historical mean, offering a compelling entry point for fresh capital with a 12-18 month time horizon (bottom panel, Chart 15). Turning over to industry operating metrics, there is a budding recovery in a number of the indicators we track. Chart 15...As A Play On A Relative Rise In Fixed Residential Investment Chart 16Firming Operating Metrics While it is not very visible in Chart 16, lumber prices have bounced from $275/tbf to over $338/tbf of late, signaling gains for industry relative profits. As a reminder, HIR make a set margin on lumber sales, thus earnings tend to move with the ebb and flow of lumber prices. Moreover, the Fed is resolute to keep the residential real estate market afloat, as we aforementioned, owing to the HNW effect and all these new and old Fed QE policies should underpin the US residential market and by extension lumber prices (Chart 16). Meanwhile, the HIR price deflator has made an effort to exit deflation recently and should also contribute to the sector’s profitability in the coming quarters (Chart 16). Tack on the V-shaped recovery in the HIR sales-to-inventories ratio, albeit from depressed levels, and factors are falling into place for an earnings-led rebound in relative share prices (Chart 16). In sum, the Fed’s ZIRP and QE5, the rising gap between house price inflation and mortgage rates, the looming increase in residential investment’s contribution to GDP growth and firming industry operating metrics, all argue for an above benchmark allocation in the S&P home improvement retail index. Bottom Line: Lift the S&P HIR index to overweight, today. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA US Equity Strategy Weekly Report, “From "Stairway To Heaven" To "Highway To Hell"?” dated March 2, 2020, available at uses.bcaresearch.com. 2 Please see BCA US Equity Strategy Weekly Report, ““The Darkest Hour Is Just Before The Dawn”” dated March 23, 2020, available at uses.bcaresearch.com. 3 Please see BCA US Equity Strategy Weekly Report, “What Is Priced In?” dated March 30, 2020, available at uses.bcaresearch.com. 4 Please see BCA US Equity Strategy Daily Report, “Watch The Value Line Geometric Index” dated April 1, 2020, available at uses.bcaresearch.com. 5 Please see BCA US Equity Strategy Special Report, “Portfolio Positioning For A Late Cycle Surge” dated May 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert) January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).
Highlights US Corporates: The Fed continues to expand the reach of its extraordinary monetary policies designed to combat the COVID-19 recession, now giving itself the ability to hold BB-rated US high-yield bonds within its corporate bond buying programs. Raise allocations to US BB-rated corporates to overweight, within a neutral overall strategic (6-12 months) allocation to US high-yield. Euro Area Corporates: European investment grade corporate debt has seen significant spread widening over the past month, but spreads have stabilized with the ECB introducing a new asset purchase program with fewer restrictions. Upgrade euro area investment grade corporates to neutral from underweight on both a tactical (0-6 months) and strategic (6-12 months) basis. Favor debt from beaten-up sectors that are already priced for severe economic weakness like Energy, Transportation and non-bank Financials. Central Banks Are A Corporate Bond Investor’s Best Friend Right Now Chart of the WeekThe Fed & ECB Are Supporting Bond Markets The actions of policymakers worldwide to help mitigate the severe economic shock from the COVID-19 recession have helped boost global risk assets over the past couple of weeks. This is particularly notable in US corporate bond markets, where credit spreads have tightened for both shorter-maturity investment grade bonds and Ba-rated high-yield (Chart of the Week). It is not a coincidence that those are the parts of the US corporate bond market that the Fed is now explicitly backstopping through its off-balance-sheet investment programs. Last week, the Fed unveiled yet another “bazooka” to help ease US financial conditions, broadening the scope of its previously investment grade-only corporate bond purchase programs to include Ba-rated high-yield corporate bonds and high-yield ETFs. In Europe, meanwhile, the European Central Bank (ECB) is also providing additional monetary support through increased asset purchases of both government and corporate debt. Those purchases are focused more on the weakest links in the euro area financial and economic chain like Italian sovereign bonds. This has helped to stabilize credit spreads for both Italian government bonds and euro area investment grade corporate debt. This support from policymakers is critical to prevent a further tightening of financial conditions during a severe global recession (Chart 2). The excess return (over government bonds) for the Bloomberg Barclays global high-yield bond index is now down 15% on a year-over-year basis. High-yield corporate bond spreads are well above the lows seen earlier this year on both sides of the Atlantic, across all credit quality tiers. In the US, spreads between credit quality tiers had widened to levels not seen in several years. Within the US investment grade universe, the gap between Baa-rated and Aa-rated spreads had widened from 20bps to 60bps (Chart 3), a level last seen in September 2011, but now sits at 39bps. Chart 2Junk Bonds Already Discount A Big Recession Chart 3The Fed Wants These Spreads To Tighten Looking in the other direction of the credit quality spectrum, the spread between Baa-rated and Ba-rated corporates – the line of demarcation between investment grade and high-yield bonds – had blown out from 132bps in February to 556bps, but is now at 360bps. This is the market pricing in the growing risk of fallen angels being downgraded from investment grade to junk. In our view, the Ba-Baa spread is the best indicator to follow to see if the Fed’s extension of its bond purchase program to high-yield is working to reduce borrowing costs for lower-rated US companies. Both in the US and Europe, we continue to recommend a credit investment strategy that favors the parts of the markets that the Fed and ECB are most directly involved in now. That means staying overweight US investment grade corporate bonds with maturities of less than five years (the Fed’s maturity limit for its bond buying program). It also means staying overweight Italian government debt versus core European equivalents. The Fed’s new extension into high-yield corporates within its buying programs means we need to upgrade our recommendation on US BB-rated high-yield to overweight within our recommended neutral strategic (6-12 months) allocation to US junk bonds. We are making that change on a tactical basis in our model bond portfolio, as well, as can be seen on pages 14-15. As the title of this Weekly Report suggests, buy what the central banks are buying. The Fed’s new extension into high-yield corporates within its buying programs means we need to upgrade our recommendation on US BB-rated high-yield to overweight within our recommended neutral strategic (6-12 months) allocation to US junk bonds. In Europe, there is now scope to also raise allocations to euro area corporate bonds, as well, as we discuss over the remainder of this report. Bottom Line: The Fed continues to expand the reach of its extraordinary monetary policies designed to combat the COVID-19 recession, now giving itself the ability to hold BB-rated US high-yield bonds within its corporate bond buying programs. Raise allocations to US BB-rated corporates to overweight within a neutral overall strategic (6-12 months) allocation to US high-yield. Looking For Value In Euro Area Investment Grade Bonds The outlook for euro area spread product does not have as clean-cut a story as is the case for US credit. The ECB is not explicitly supporting European corporate credit markets to the same degree as the Fed is with its open-ended off-balance sheet investment vehicles. While the ECB has introduced a new large €750bn asset purchase program, the Pandemic Emergency Purchase Program (PEPP), to help ease financial conditions in the euro area, no specific details have yet been provided specifying how much of the PEPP will go towards corporate debt versus sovereign bonds. The ECB has already loosened the country and issuer limit restrictions it has imposed on its existing Asset Purchase Program (APP), however, which means that the central bank will be very flexible with the PEPP purchases. That means helping reduce sovereign risk premiums in Peripheral Europe by buying greater amounts of Italian, Spanish and even Greek government debt. That also likely means buying more corporate debt in the most stressed sectors of the euro area economy, as needed. Greater ECB bond purchases would make euro area investment grade credit – which has seen some value restored after the recent bout of spread widening - more attractive over both tactical and strategic investment horizons. This is true even with much of the euro area now in a deep recession because of COVID-19 lockdowns, which has already been discounted in the poor investment performance of euro area corporates. Greater ECB bond purchases would make euro area investment grade credit – which has seen some value restored after the recent bout of spread widening - more attractive over both tactical and strategic investment horizons. Year-to-date, euro area corporate credit markets have been hit hard by the global credit selloff (Table 1). In total return terms denominated in euros, the Bloomberg Barclays euro area investment grade corporate bond index is down -5.0% so far in 2020. The numbers are slightly better relative to duration-matched euro area government bonds (the pure credit component), with the index excess return down -5.5% year-to-date. At the broad sector level, the laggards so far in 2020 have been the sectors most exposed to the sharp downturn in European (and global) economic growth. In excess return terms, the worst performing sectors year-to-date within the eleven major groupings shown in Table 1 have been Consumer Cyclicals (-8.5%), Transportation (-8.1%), Energy (-7.2%). The best performing sectors are those that would be categorized as less cyclical and more “defensive”, like Utilities (-4.3%), Technology (-4.3%) and Financials (-4.7%). In many ways, this is a mirror image of 2019, when Consumer Cyclicals and Transportation were among the top performers while Technology was the worst performer. Table 1Euro Area Investment Grade Corporate Bond Returns Chart 4Euro Area Corporate Spreads Are Relatively Subdued Vs. Past Credit Cycles When looking at the differences in spreads between credit tiers in the euro area, the gaps are not as wide as in the US (Chart 4). The index spread on Baa-rated euro area corporates is only 44bps above that of Aa-rated credit, far below the 100bps gap seen at the peak of the 2001 and 2011 spread widening episodes and well below the 200bps witnessed in 2008. Looking at the difference between Ba-rated and Baa-rated euro area spreads paints a similar picture, with the gap between the highest high-yield credit tier and lowest investment grade credit tier now sitting at 297bps after getting as wide as 431bps in late March – close to the 500bps peak seen in 2011 but far below the 1000bps levels seen in 2001 and 2007 The broad conclusion looking strictly at credit tiers is that euro area corporates have cheapened up a bit during the COVID-19 selloff, but on a more modest scale compared to previous euro area credit cycles. A similar conclusion is reached when looking at industry-level credit spreads. The broad conclusion looking strictly at credit tiers is that euro area corporates have cheapened up a bit during the COVID-19 selloff, but on a more modest scale compared to previous euro area credit cycles. A similar conclusion is reached when looking at industry-level credit spreads. In Charts 5 & 6, we show the history of option-adjusted spreads (OAS) for the major industrial sub-groupings of the Bloomberg Barclays euro area investment grade corporate indices. Unsurprisingly, spreads look relatively wide for the biggest underperforming sectors like Energy, Consumer Cyclicals and Transportation. The spread widening has been more contained in the better performing sectors like Technology. Chart 5A Mixed Performance For Euro Area Investment Grade Spreads By Industry … Chart 6…. With Spreads Well Below 2001 And 2008 Credit Cycle Peaks When looking at the individual country corporate bond indices within the euro area, the current levels of spreads do not look particularly wide in an historical context. In Chart 7, we show a bar chart of the range of index OAS for the six largest euro area countries (Germany, France, Italy, Spain, the Netherlands, Belgium and Austria). The current OAS is shown within that historical range. The chart shows that current spreads are in the middle of that range for most countries, suggesting some better value has been restored by the COVID-19 selloff but with spreads remaining relatively subdued compared to past euro area credit cycles.1 Chart 7Euro Area Investment Grade Corporate Spreads By Country On a relative basis, investment grade spreads are tightest in France (203bps), the Netherlands (202bps) and Belgium (226bps), and widest in Germany (255bps), Italy (255bps), Austria (251bps) and Spain (234bps). With the ECB already promising greater flexibility in the country allocations of its sovereign bond purchases within the PEPP, Italian corporates may offer the best value within the major euro area countries. With the ECB already promising greater flexibility in the country allocations of its sovereign bond purchases within the PEPP, Italian corporates may offer the best value within the major euro area countries. We can get a better sense of relative corporate bond spread valuation at the country level by looking at the 12-month breakeven spread percentile rankings of those spreads. This is one of the tools we use to assess value in global credit spreads, as measured by historical “spread cushions”. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. In Charts 8 & 9, we show the 12-month breakeven spread percentile rankings for Germany, France, Italy, Spain, Belgium and Austria. On this basis, the current level of spreads looks most historically attractive in Germany, Italy and France, with the breakeven spread in the upper quartile versus its history dating back to the year 2000. Spreads in Spain, Belgium and Austria also look relatively wide versus their own history, but to a lesser extent than in Germany, France and Italy. Chart 8German, Italian & French Investment Grade Corporates Offer Better Value On A Breakeven Spread Basis …. Chart 9… Than Spanish, Belgian & Austrian Investment Grade Corporates Chart 10Euro Area Investment Grade Corporate Spreads Are Relatively Wide Across All Credit Tiers So while there are some modest differences in value to exploit within the euro area investment grade corporate bond universe at the country level, there is less to choose from across credit tiers. The 12-month breakeven spreads for Aaa-rated, Aa-rated, A-rated and Baa-rated euro area corporates are all within the upper quartiles of their own history (Chart 10). One other tool we can use to assess value across euro area investment grade corporates is our sector relative value framework. Borrowing from the methodology used by our colleagues at BCA Research US Bond Strategy to assess US investment grade corporates, the sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall euro area investment grade universe. The methodology takes each sector's individual OAS and regresses it in a cross-sectional regression with all other sectors. The independent variables in the model are each sector's duration, trailing 12-month spread volatility, and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS is our valuation metric used to inform our sector allocation ranking. The latest output from the euro area relative value spread model can be found in Table 2. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot in Chart 11 shows the tradeoff between the valuation residual from our model and each sector's DTS. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation We can then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. The strongest overweight candidates (a DTS score equal to or greater than that of the overall index with the highest positive valuation residual) are the following euro area investment grade sectors: Packaging, Tobacco, Other Industrials, Media Entertainment, Supermarkets, Integrated Energy, Consumer Cyclical Services and all non-bank Financials (Insurance, REITs, Brokerages and Finance Companies). Against the current backdrop of euro area corporate spreads offering relatively wide spreads on a breakeven spread basis, and with the ECB providing a highly accommodative monetary backdrop that includes more purchases of both government and corporate debt, we think targeting an overall portfolio DTS greater than that of the euro area investment grade corporate bond index is reasonable. On that basis, we are looking to go overweight sectors with relatively higher DTS and positive risk-adjusted spread residuals from our relative value model (and vice versa). Those overweight candidates would ideally be located in the upper right quadrant of Chart 11. Chart 11Euro Area Investment Grade Corporate Sectors: Valuation Versus Risk Based on the latest output from the relative value model, the strongest overweight candidates (a DTS score equal to or greater than that of the overall index with the highest positive valuation residual) are the following euro area investment grade sectors: Packaging, Tobacco, Other Industrials, Media Entertainment, Supermarkets, Integrated Energy, Consumer Cyclical Services and all non-bank Financials (Insurance, REITs, Brokerages and Finance Companies). The least attractive sectors within this framework (negative risk-adjusted valuations) are: Senior Bank Debt, Natural Gas, Other Utilities, Metals and Mining, Chemicals, Construction Machinery, Lodging, Cable and Satellite, Restaurants, Food/Beverage, Health Care, Oil Field Services, Building Materials and Aerospace/Defense. Bottom Line: European investment grade corporate debt has seen significant spread widening over the past month, but spreads should stabilize with the ECB introducing a new asset purchase program with fewer restrictions. Upgrade euro area investment grade corporates to neutral from underweight on both a tactical (0-6 months) and strategic (6-12 months) basis. Favor debt from beaten-up sectors that are already priced for severe economic weakness like Energy, Transportation and non-bank Financials. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 For the Netherlands, there is a much shorter history of corporate bond index data available from Bloomberg Barclays than the other euro area countries shown in Chart 7. The OAS range only encompasses about seven years of data, while the other countries go back as far as the early 2000s. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns