For fixed income, it's a tale of two walls
Our fixed-income teams began to turn more constructive on credit almost four months ago, not because the macro outlook was improving but because it was hard to envision it getting much worse. With central banks taking unprecedented steps to backstop the global economy, and governments equally aggressive in providing fiscal relief, fat-tail risks arising from the Covid-19 crisis arguably were off the table. Following our playbook from the 2008-09 crisis, the last week of March and first week of April provided a good window to start taking on spread risk, which we did, moving to overweight in mortgage-backed securities (MBS) investment-grade (IG) credit, asset-backed securities and emerging-market (EM) debt, while moving to neutral in commercial MBS, and near neutral in high-yield (HY). The moves, which summed to 10-20% across our portfolio models, proved beneficial as the spring quarter generated significant alpha.
As we head into the back half of the year, our mix has had only minor shifts from the buying spree. We remain modestly overweight IG and EM, with MBS back at neutral and HY still a modest underweight. It’s a somewhat cautious stance as we find ourselves caught between what my international fixed-income colleague Ihab Salib calls the “tale of two walls.” These are “the wall of worry” surrounding the pandemic as well as the unsustainable speed and magnitude of the initial recovery, and “the wall of liquidity” as central banks and governments all over continue to pump unprecedented stimulus into the global economy. Their actions have all but eliminated the interest-rate volatility that marked the beginning of this crisis. Indeed, after falling 125 basis points in the first quarter, the 10-year Treasury yield closed the second quarter at 0.66%, down a single basis point.
Duration and yield curve aren’t offering a lot
With rates anchored on the short end by the Fed—it’s signaling a target rate near zero through 2022—two areas of alpha, duration and yield-curve positioning, are largely diminished, if not off the table. We are at neutral on duration, with tactical longs or shorts possible if yields move to the high or low end, respectively, of a roughly 20 basis-point range. Not much to play for here. Similarly, with short rates entrenched by the Fed’s low-rate commitment, and the long end potentially subject to Fed purchases, the yield curve doesn’t offer exciting prospects. Here though, we are positioned for a steepener—a widening gap between short and longer-term rates—in case the Fed decides not to exert yield-curve control.
Once again, it comes down to sector and security selection
So the onus, as it often has been in this era of Fed transparency, is on our sector bets and security selection. And the outcome on both fronts will be determined largely on how the economy behaves. By mid-May, it had appeared that, at least in the U.S. and much of the developed world, the Covid crisis had topped out. But recent flare-ups in southern and western states that reopened early have cases hitting new highs, leading several cities to pause and even roll back reopenings, threatening a recovery that had spurted out of the gates. Nonfarm payroll jobs set consecutive records in May and June, rising a combined 7.5 million (albeit after plunging a whopping 21 million the prior two months), while ISM surveys showed manufacturing and services activity expanding again in June.
Of course, the reports came before the final days of June, when Covid cases spiked to new daily highs, raising concerns the recent improvement could stall. We’re expecting a recovery that looks like a square root symbol—almost straight down on the left side, followed initially by a symmetrical V on the way back up, before growth slows and levels off. Until we get a vaccine, rolling shutdowns/pullbacks are likely, with the election introducing potential further volatility, particularly if a “Blue Wave’’ sweeps former Vice President Joe Biden into office and Democrats in the majority in both the House and Senate. Whatever the outcome, we don’t expect GDP to recover to its past peak until the end of 2021/early 2022, with valuations challenged by the Covid/economic recovery/political uncertainty. This tale of two walls is still being told.