The defining characteristic of the Covid-19 crisis is proving to be speed: the rapidity of the virus’ spread, the swift grinding to a halt in economic activity and the extraordinary quick market selloff. But the pace of action by policymakers has been equally speedy. The Fed and other central banks have been able to borrow from and expand the crisis-era playbook of 2008 while the U.S. and other countries have turned on the fiscal taps at record speed. The imminent passage of the $2 trillion bipartisan stimulus package in the U.S. and the positive progress made on Germany’s €750 billion program highlight how lawmakers are rising to the occasion when it comes to Covid-19. As such, maybe it really isn’t so surprising that markets have bounced off the lows as hard as they have this week. The question on the minds of many investors is whether this is a bear market rally or the beginning of a true recovery in asset prices.
For credit markets, the Fed’s Monday announcement that it would buy investment grade corporate bonds and move to unlimited purchases of Treasuries and mortgages was key to improving sentiment this week. While the Fed’s new primary and secondary purchase programs (PMCCP and SMCCP) are not yet up and running, a week ago the notion that the Fed might buy corporate bonds was unimaginable. Moreover, the stimulus bill allocates a further $425 billion to the Treasury’s Exchange Stabilization Fund (ESF), which will allow the Fed to leverage up its lending to $4 trillion. These are funds that will be used to support the Main Street Business Lending program but could also be used to expand the corporate bond buying programs. As is, the PMCCP and SMCCP target the front-end of credit markets, which are the most dislocated. If the Fed deems it necessary, the Fed now has the ammunition necessary to purchase longer-dated bonds or move down the credit spectrum into the high yield and leveraged loan asset classes.
In a very real sense, the Fed’s actions have brought the investment-grade credit markets back from the brink of freezing up. The Bloomberg U.S. Credit Index peaked at a spread of 341 basis points but over the last three days is 60 basis points tighter. Meanwhile, there has been more than $100 billion in investment-grade issuance this week, which sets the all-time weekly record and means that March 2020 becomes the heaviest month for issuance ever with more than $200 billion issued. Against a backdrop of outflows from fixed income mutual funds, the performance of the markets in the face of so much supply is a testament to the improvement in sentiment among investors who now seem willing to put to work any dry-powder they have kept in reserve. The Fed’s actions to improve dollar funding conditions are also beginning to translate into more foreign buying of U.S. investment grade with large overnight buying throughout the week.
In contrast, the news on the spread of the virus continues to be mixed. There are some nascent signs that the number of new daily cases in Italy, France and Germany is slowing thanks to efforts to quarantine, but it’s still unclear how the U.K., U.S., and many EM countries will fair. Economically, we think there’s a high likelihood that 2Q GDP (annualized) declines by 25-40% in the U.S. and the unemployment rate spikes to 8-12%. Indeed, Thursday’s history-defying surge in initial jobless claims to 3.28 million suggests there is significant risk to the downside relative to expectations for next weeks’ nonfarm payrolls report.
Yet even if the economic data continues to deteriorate and the virus numbers worsen as we expect they will, the selloff in credit got so bad at the end of last week that we still believe there is room for spreads to continue tightening. After this week’s rally the near-term upside may be diminished somewhat, but the 6-12 month case for owning U.S. investment-grade credit remains compelling. Utilizing a global relative value perspective is particularly helpful. The fact is that U.S. IG underperformed Euro IG by more than 100 basis points last week. Looking at the long-term relationship between the two markets suggests that U.S. IG could tighten another 50 basis points before it would come back into line. With both the ECB and now the Fed buying corporates, it would make sense for the two markets to trade closer to each other.
In the credit portfolios, we continue to add risk in-line with our recently-upgraded short- and long-term outlook scores, taking our view to +1 for both horizons (out of a scale of -3 to +3). The purchases being made are almost exclusively via A-rated primary market issuance. As previously discussed, the highly-rated companies that have been in the market have been issuing with concessions of 20-40 basis points into a market where credit spreads are gapping tighter and Asian-based investors continue to buy in the overnight session. As such, many of the deals we have purchased in the last 72 hours now trade at spreads that are 50-75 basis points lower than where we purchased the bonds. All of this is good for performance. That said, it is still difficult to have a high degree of certainty around performance given how choppy markets remain. Nevertheless, the credit portfolios continue to fair well through the volatility and we continue to find sufficient liquidity to maneuver and reposition into more defensive credits.
Views and opinions expressed herein are as of March 2020 and may change based on market and other conditions. The material contained here is confidential and intended for the person to whom it has been delivered and may not be reproduced or distributed. The material is for informational purposes only and is not intended as a solicitation to buy or sell any securities or other financial instrument or to provide any investment advice or service. Legal & General Investment Management America, Inc. does not guarantee the timeliness, sequence, accuracy or completeness of information included. Past performance should not be taken as an indication or guarantee of future performance and no representation, express or implied, is made regarding future performance.