Is It Over?
Posted: Jared Jameson
The decline in stock and bond markets related to Coronavirus began about two months ago. After a modest selloff in late February and early March, the decline accelerated and transformed into panic with most stock markets falling about 40% at the bottom. Bonds also suffered with some types declining over 20%. Basically, the riskier the investment the more it was down. Fortunately, stock markets found support in April and are down 15 to 25%. Bond markets have recovered also with most flat to slightly down for the year. It has been a wild ride in a very short time period. In fact, we have never seen such a rapid decline and recovery in market history. The question now is where do we go from here? In this WJNotes, we comment on what the future may hold and current portfolio positioning.
We think it is becoming apparent that the economic impacts of the shutdown are going to be with us a while. The idea of returning to “normal” in rapid fashion does not seem realistic. Until we can have confidence that the person in the office next to us at work, high-fiving us at the football game, or with their arm on top of ours in the middle seat of an airplane does not have Coronavirus, activity will not return to normal. In our opinion, only extensive testing or a vaccine will engender enough confidence to return to normal. Unfortunately, testing so far has been inadequate and a vaccine does not appear to be imminent.
But even without extensive testing or a vaccine, we still must make every effort to reopen the economy as quickly as possible, especially to avoid permanent damage like bankruptcies. We simply cannot continue a complete shutdown for an extended period, as some have called for, because the economic cost is too high. Balancing containment of the virus and limiting further economic damage will be very difficult over the coming months. Mistakes will be made on both sides. The net result, as above, is likely muted economic activity for some time to come.
To address the economic impacts of a shutdown, the Government has done a lot and will need to do more. Since the economic crisis was created by the Government to address the real health risks associated with Coronavirus, they should have the responsibility to protect us from the economic consequences. Even those that do not typically look to Government for solutions seem to agree. The founder of one of the investment management firms that we use, CEO of AQR, Cliff Asness, who is an avowed libertarian, said recently on Twitter, “I am not a libertarian when it comes to Coronavirus.” Government has a role in any crisis, but particularly in this one. To that end, the Government has taken unprecedented steps including passing an over $2 trillion dollar stimulus bill which basically sends checks to most Americans and many other programs to help small businesses retain employees. Large public companies like airlines will also be provided loans and direct grants. In addition, the bill authorized the Federal Reserve in conjunction with the Treasury to purchase many assets. So far, the total proposed is close to $3 trillion. Some assets, like corporate bonds including below investment grade bonds, have never been purchased before. It is likely the Government will need to do even more as the crisis drags on.
The steps taken so far by the Government, particularly by the Federal Reserve, have been unprecedented. Until this crisis, the purchase of high yield bonds by the Federal Reserve was unthinkable by most. A high yield fund manager we listened to last week; said he nearly fell out of his chair when he heard the news. Some argue it is illegal under the Federal Reserve Act. Although it may be, the Fed is doing it anyway. The other unthinkable concept, at least for the US Fed, is the purchase of stocks. Other Federal Reserve Banks, like the Japanese and the European Central Banks, have already crossed the Rubicon and have been purchasing stocks for years. So, is it far fetched that the Fed might purchase stocks if the stock market was to collapse again? We don’t think so.
At the start of 2020, our view was US stocks were overvalued. We expected minimal returns over the next decade. International stock markets were more fairly valued offering mid-single digit returns. Bonds were also expensive, likely not beating inflation over the next decade. What about today? Stocks are only marginally more attractive as a majority of losses have been recovered. Bonds on the other hand look materially worse. The expected return on bonds over the next decade is zero. Therefore, we remain positioned conservatively with respect to stocks with a large allocation to alternatives, albeit slightly smaller than at the beginning of the year. On the bond side we are finding reasonable value in credit markets as we have discussed several times recently. The opportunities do not come without increased risk because credit risk implies potential future defaults. We feel we are being compensated at these levels to take this risk. Over the past three weeks we have purchased two new credit-oriented bond funds. Some details on the funds follow:
Loomis Sayles Bond Fund (LSBDX) is a credit centric bond fund that has been managed by the team since 1991. The primary manager, Dan Fuss, has been at the firm since 1976, and has been managing money for over 60 years. The fund tends to be more aggressive than its peers, with a willingness to invest in high yield credit, convertible bonds, and even non-US dollar denominated debt. It will balance this aggressiveness however, by taking large positions in US treasuries when they want to be cautious. This served the team well in 2020, as they came into the year with 30% in treasury bonds. This is a fund WJ has owned before and is happy to own again. We tend to shy away from risky corporate bonds late into a bull market. This has been the case for the last several years, as we have had no exposure to corporate credit. However, the current environment has created many opportunities that a fund like Loomis is poised to take advantage of. Despite the better environment for credit, there are still risks out there as several companies will likely go bankrupt in the next year or so. For those reasons, it is important to select a credit manager that has a proven record of doing deep analysis of each individual company, rather than buying up the whole market.
Artisan High Income (APDFX) is managed by Bryan Krug, who manages over $3 billion in high yield credit investments for the firm. The fund seeks to generate high returns by investing not only in non-investment grade corporate bonds, but in secured and unsecured loans from US and non-US issuers. Krug’s process centers around 4 pillars: Business Quality, Financial Strength & Flexibility, Value Identification and Downside Analysis. By doing deep fundamental research of a company, Krug hopes to pick out companies who may be temporarily mis-priced by the market, but who otherwise have a strong financial base. The firm also employs a team of industry specific analysts, as one of their core beliefs is that the high yield bond market has cyclical industry dislocations which can be exploited. The process has served the fund well, as it has outperformed its benchmark handedly since the fund’s inception. In addition, prior to being asked to join Artisan, Krug ran a very successful credit fund called the Ivy High Income fund.
So, what happens next? We see a long, slow recovery with markets buoyed by positive health news and hurt by negative economic news. A depression or very severe recession seems to be off the table with the Federal Reserve willing to buy just about any asset at any price, including potentially stocks. We would not be surprised to see another downturn in stocks as the reality of millions of unemployed and an economic malaise with no end in sight wears on market nerves. And, of course, we will continue to see volatility above normal as we work through these unprecedented times. Be safe. We appreciate the trust you have placed in us. Please contact us if you would like to discuss your specific situation.