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Ride the winners, sell the losers

| July 31, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Right after the Fed promised again that it would deploy all its tools for as long as necessary to right the economy, it seems inopportune to think about an eventual Fed exit. It is still time to get into the Fed trade rather than out of it. The Fed, as it acknowledges itself, has a long way to go. But any good investor knows that getting into a trade requires knowing at the beginning the way out. And the outlines of the way out of the Fed trade already are starting to take shape.

Early second quarter earnings are showing the depth of the initial damage to parts of the corporate balance sheet already suspected of bearing the brunt of Covid-19 and the lockdowns and changes in economic activity that came with it. With half of S&P 500 companies reporting so far, earnings compared to a year earlier have dropped 34%. Companies in aviation and travel have shown the most damage while big tech shines. Investment grade debt markets have figured that out, with technology trading tighter than any other sector and consumer discretionary trading toward the wide end of the range.

It is the occasional investment grade company that takes a view of the way forward from here. Most suspended forward guidance in reporting first quarter results, and only a fifth so far have offered an opinion in reporting second quarter results. Uncertainty about growth has rarely been higher (Exhibit 1). Investment grade companies as a group have taken out record amounts of debt this year as a cash buffer against the uncertainty of their own markets. For now, the investment grade corporate and structured credit markets can count on continued Fed support, both implicit and explicit.

Exhibit 1: Dispersion in economists’ GDP forecasts has rarely been higher

Note: data shows difference between the 25 percentile and 75 percentile in projections of real GDP four quarters ahead. Source: Philadelphia Fed Survey of Professional Forecasters, Amherst Pierpont Securities

Delinquencies have shown the weak points in the consumer balance sheet. Delinquencies in mortgages, auto loans and student loans have jumped and largely plateaued. The news on the consumer balance sheet generally has been encouraging, with unemployment expected to glide down to 10.5% for July. Consumers have received critical direct support from 1-time federal checks and expanded unemployment benefits, and indirect support from the Paycheck Protection Program loans made to small businesses. Moratoriums on eviction and foreclosure have also papered over potential consumer weaknesses. To the extent some or all of these programs lapse, the damage to the consumer balance sheet will become clearer. The chances are good that most of this support or at least substantially similar substitutes will stay in place. That stabilizes the consumer balance sheet and the mortgage- and asset-backed securities and other forms of debt that rely on it. Large parts of the investment grade securitized market have traded back to pre-Covid levels.

The challenge with the Fed trade is highlighted by the Taper Tantrum of 2013 that followed Fed Chair Bernanke’s suggestion the Fed might slow QE. The market volatility that followed reflected the uncertainty created by the Fed itself. The Fed’s presence makes it difficult to know which parts of the corporate and consumer balance sheets can survive without the Fed. Except for the exceedingly remote scenario where companies and consumers return to an economy identical to January 2020, an economy without full Fed support will be one where many companies and consumers are unproven. Fed support is almost undoubtedly essential to protecting the economy and getting it back on track, but it comes with its own risk.

The companies and consumers that did well under the Fed in the second quarter are likely to continue doing well under the Fed and are likely to be in the strongest position when the Fed one day begins its faraway exit. The companies and consumers that did poorly are at risk under the same logic. Even if the pandemic effectively disappears after a vaccine, it is likely to leave behind an economy with memory of pandemic and at least some residual of the caution that came with it.

Investment grade corporate and structured credit did well in the second quarter with significant help from Fed QE and other programs. QE drained the supply of safe assets and forced investors to take risk. But these parts of the market also attracted new capital on their own. The process should continue as long as QE continues, and it is tempting to stretch into the speculative parts of the corporate and consumer markets with clear and continuing fundamental risk. These should have long beta to the Fed trade and could tighten substantially. However, when the time comes for the Fed to exit, these speculative parts of the market should still be fundamentally unproven and the most vulnerable. Keep the winners from the second quarter and sell the losers. It’s a way to stay in with an eye on getting out.

* * *

The view in rates

Real rates continue their steady decline, and implied inflation continues its steady rise. The current 0.53% rate on 10-year Treasury debt implies an average real rate of -102 bp and inflation of 155 bp. Although Fed Chair Powell noted concern about disinflation after the July FOMC, the market thinks the Fed will nevertheless do its job and push inflation back towards its 2% target, possibly even letting it run above 2%. Treasury debt may have value for safety and liquidity, but it is likely to produce limited if any real returns.

The view in spreads

As the Fed continues to absorb high quality assets and spreads tighten, investors will have to move to the next tier of higher risk to get sufficient spread. Spread compression across rating categories or credit quality should continue as long as QE is in place and as long as US deficit spending keep driving up the net supply of Treasury debt. There is fundamental risk in the most leveraged corporate balance sheets, and only there might spreads continue lagging the rest of the market.

The view in credit

The downside in leveraged credit outweighs the upside for now. Many investment grade companies have stockpiled enough cash to survive protracted slow growth, but highly leveraged companies and consumers are at risk. Prices on some sectors of leveraged loans, rating agency downgrades in leveraged loans and high yield and rising bank loan loss reserves signal a wave of distressed credit. Elevated unemployment and delinquency rates in assets from MBS to auto loans show pressure on the consumer balance sheet. However, monetary and fiscal policies are both shoring up these fundamentals for now. The course of leveraged corporate and consumer credit also depends on renewal of fiscal support and other programs.

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