COVID-19 Update #5: The Kitchen Sink
Dominic Nolan | March 30, 2020
Fed backstop rescues market … for now
Dominic Nolan, senior managing director of Pacific Asset Management, provides his analysis below of the markets currently battered by the COVID-19 pandemic. In this fluid economic environment, it’s important to note that these are his views as of March 30, 2020.
Did the Fed save the day? Absolutely. The anchor of last week’s market reversal was the result of support actions from the central bank. Follow-through came from Congress in passing the Coronavirus Aid, Relief, and Economic Security (CARES) Act. Both areas of government have enacted unprecedented measures, throwing the proverbial kitchen sink at the crisis to support the economy and markets.
I view layers of this crisis in the following tiers, top to bottom: Health, economic, and liquidity. Below is a quick summary of my thoughts.
- Health – Negative tilt at this time given the U.S. data on the coronavirus remains on an aggressive trajectory for cases and deaths. Emerging countries will also begin to show a rapid increase in Covid-19 spread. The optimism pertains to China’s suppression of new cases, possibilities Italy could be peaking, and improvement in global testing.
- Economic – Mixed at this time. Fiscal relief (stimulus) was much needed and, given the size, is meaningful to the economy. However, realization that the economic stoppage and restarting may go longer than anticipated, coupled with a record-breaking turn in unemployment claims and negative gross domestic product (GDP) adjustments, may burn through the stimulus quickly.
- Liquidity – Much better than 10 days ago and improving, primarily due to actions from the Federal Reserve (Fed) with an assist from other central banks. While volatility remains elevated, markets are still in price-discovery mode, and funding markets are still strained, it is a more constructive situation than the abyss various markets were facing earlier in the month.
The Fed vs. Market Liquidity (Part II)
The Fed has acted quickly, broadly, and with size. It started on March 15 with the target rate cut and liquidity injections into the Treasury and mortgage-backed-security (MBS) markets. By March 24, the central bank opened operations across the repo, currency, Treasury, MBS, asset-back security (ABS), corporate, and municipal bond (muni) markets. It has used a combination of old and new facilities, swap-line expansions, loosening reserve requirements, and rate reductions.
Last week, the creation of the Primary Market Corporate Credit Facility (PMCCF), Secondary Market Corporate Credit Facility (SMCCF), and reestablishment of the Term Asset-Backed Securities Loan Facility (TALF) were integral in supporting the corporate bond and ABS markets. In addition to these facilities, expanding the Money Market Liquidity Facility (MMLF) and Commercial Paper Funding Facility (CPFF) to include municipal securities assisted the muni market. These actions have surpassed the Fed’s response in 2008, and the cumulative additional liquidity number will be in the trillions. The Fed’s balance sheet has rocketed past $4 trillion to over $5 trillion in just a week, with more coming.
Investment-Grade Bonds and Market History
With risk assets roaring back last week, I think the investment-grade bond market has a better chance (relative to other areas) at follow-through given Fed support. Access to capital is paramount over the next few months, and the central bank has provided a backstop for many investment-grade issuers. This has not only allowed these companies to access capital markets, it should provide an incentive to stay investment grade. Last week, more than $109 billion in new-issue investment grade came to market, a record for one week. The issuance was largely oversubscribed, indicating further demand for high-quality paper.
Additionally, the incentive to remain investment grade is more pronounced as the Fed facilities allow purchases of BBB rated1 and above. This should lead corporations to more debt-friendly decisions relative to equity-based decisions. From a valuation perspective, spreads currently remain elevated, with higher spreads occurring only during the 2008 financial crisis and Great Depression, and upward rate pressure from U.S. Treasuries should be muted. These are supportive of potential investmentgrade bond returns. A key to managing investment grade will be downgrades, as they will have a greater effect on liquidity options for the next few months. The rating agencies are showing themselves to be more aggressive on this front, which should further separate the winners.
Markets now have a glimmer of proper functioning. This is an important element to move forward as investment-grade credit has recovered earlier than equities in the past two recessions. During the great financial crisis, investmentgrade spreads peaked in December 2008, but equities did not bottom until March 2009. During the 2001-2002 recession, corporate spreads peaked in October 2002, with equities bottoming in March 2003. Who is to say if risk markets will retest mid-March levels, but a healthy bond market is critical for a sustained equity rally. Given the speed of this market, my feeling is any historical sequence will be dramatically compressed.
The media continues to call it stimulus, but at its core, this is a relief package. Essentially, it’s mostly spending and part lending.
Just two weeks ago, the stimulus discussion was anchored at $750 billion. This Phase 3 package, with possibilities for additional rounds, is almost three times that. Initial structuring was important, with provisions to assist individuals, small business, municipalities, large business, and numerous other areas of the economy.
As important in this is the implied messaging from Washington D.C., with bipartisan support from both houses of Congress, the executive branch, and U.S. Treasury, that indicates further funding can be done if needed. People will also need to keep in mind that this is massive, emergency legislation. There will be inefficiencies, and attempted abuse will be rampant. In many ways, it is simply the cost of doing business in a $22 trillion economy. Not perfect, but a much-needed step in the right direction.
Tough Data and Alarming Headlines Ahead
The previous record for new jobless claims was 685,000 set in October of 1982. Last week’s claims of 3.3 million shattered this by almost five times. It is no surprise the majority of claims are coming from states with nonessential business closures. It is an alarming figure and only the first regarding unemployment. Along with unemployment numbers, markets will have to digest a myriad of brutal economic data. Corporate earnings and guidance will be critical, and rating-agency downgrades will have more meaning given Fed programs and liquidity options. This doesn’t begin to touch on the health data as the U.S. has surpassed Italy and China in number of Covid-19 cases. For these asset levels to hold, markets will have to be resilient despite frightening headlines over the next 30 days.
April and a Quick Non-Economic Thought
April will be telling. From a health perspective, growth rates of Covid-19 cases, testing capabilities, and possible treatments could help shed light on a path. Economically,guidance for May and June will be watched closely as officials will need to balance potential health risks versus more economic carnage. Observing China’s economic restart and Europe’s health management have provided data and a framework to base decisions. From a liquidity standpoint, the Fed has provided the balance sheet and facilities, which should continue to improve market functioning.
Spring of 2020 may very well be the “When I was your age” moment for our children. Instead of walking uphill in the snow, they were prohibited from going out, confined to the house, with no school, no visits, no playdates, and stuck with family, night in and night out. Who knows if this will be the case, as only time will tell. As always, thank you for your time and please be safe
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This publication is provided by Pacific Funds. Pacific Funds refers to Pacific Funds Series Trust. This commentary reflects the views of the portfolio managers at Pacific Asset Management LLC, the sub-adviser for the Pacific Funds Fixed Income Funds, as of March 30, 2020, are based on current market conditions, and are subject to change without notice. These views represent the opinions of the portfolio managers and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector, or index, the offer or sale of any investment, or to predict performance of any investment. Any forward-looking statements are not guaranteed. All materials are compiled from sources believed to be reliable, but accuracy cannot be guaranteed.
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