Fixed Income Insights: Q3

Rich Consul, Senior Portfolio Manager for INCORE Capital Management, presents fixed income insights for 3Q 2020. The presentation examines the current environment amid the COVID-19 recovery, the impact fiscal and monetary stimulus has had on today’s markets, and what to pay attention to in the days ahead.

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  • 21 mins 25 secs

Rich Consul: Thank you for joining the INCORE Capital Management Fixed Income Insights for the third quarter of 2020. My name is Richard consul, I'm a Senior Portfolio Manager with the INCORE team. Title of our presentation is, stimulus fueled recovery showing signs of slowing. Our perspective on the markets can really be broken down into four areas. The first Macro, the second half GDP is rebounding largely based on $2.6 trillion in fiscal stimulus. We're going to get to actually the impact of what this means in the pages ahead. But what we saw in the second quarter is the largest contraction in GDP growth in US history. What we're likely to see in the third quarter is the largest rebound in GDP growth in US history. But a lot of this rebound is based solely on fiscal stimulus. And we'll talk about that more in the pages ahead.

Rich Consul: Over half the laid off workers have returned to work, but what we're starting to see is that some of that progress is starting to slow and we'll get into the reasons ahead of why that is. But a lot of that has to do with that fiscal stimulus. With the recovery showing more stimulus swelling, more stimulus is likely needed to sustain the recovery. It is our kind of opinion that Congress is likely to need to move sometime around October or November with the stimulus package. If we are going to continue to sustain the trajectory of the growth that we... and the recovery that we've seen. From our corporate credit perspective, corporate fundamentals continue to deteriorate. As COVID lingers companies are issuing a historic amount of debt to increase short-term liquidity and year to date over 2 trillion in corporate debt has been downgraded with more likely and a really, this is just a function of corporations issuing more debt at the same time that we've seen the impacts of COVID impacting companies, EBITDA and fundamentals.

Rich Consul: From a monetary policy perspective, the FLMC continues to expand its balance sheet. It's now expanded its balance sheet by almost $3 trillion since March. And the balance sheet may reach as high as 9 to 10. After this whole thing is said and done, which should be darn near 50% of GDP, a level that has just never been eclipsed here in the United States previously. From a Federal corporate buy... bond buying is really driving corporate spreads as well. And what it's really leading to is, this kind of skewed risk premium market. Another way of saying that is basically the said is decreased yields. So significantly on treasuries they've created what's called a TINA environment, or there is no reasonable alternative all better than take some prudent risks. And it's one of the reasons why our positioning commentary is to maintain an overweight in high credit quality corporations because of this TINA environment. But when we say high quality corporations, we are recommending that. That overweight and corporate credit be skewed to the higher quality side of the balance sheet.

Rich Consul: Well, there may be opportunities in high yields, we don't think stretching into some of the [inaudible 00:03:24] names at this time, really make a ton of sense. Due to the skewed risk premiums that the Fed has created. When we get kind of a little bit deeper into what actually happened in the first and second quarter of this year, we can kind of conceptualize what happened just by this illustration that shows GDP on a quarterly basis, broken out into its five core components going back to 2017. And you'll notice that the first and second quarter we're dramatic as far as the contraction in GDP that we saw, second quarter alone contracted by 31.7%, which is the largest drop in US history. However, the economic resurgence, since May's recessionary bottom has been dramatic. The Atlanta Fed's GDP now forecast expects third quarter real GDP growth of 35.1% that in itself would be a historic GDP, quarterly growth number.

Rich Consul: So [inaudible 00:04:21] second quarter was the largest drop in US history. The third quarter is largely likely to be the largest single quarter increase in GDP. The question is the sustainability. The court, what has really propelled that rebound in the third quarter here is really encompassed on this slide. And this slide kind of breaks down the fiscal policy stabilization measures that Congress passed during the second quarter to really stabilize the economy. The fiscal stimulus bills took on names that you're probably aware of such as the Care or the Act or the Paycheck Protection Program, but jointly, they provided 2.6 trillion in fiscal stimulus, which is equivalent to six full weeks of GDP replacement. Well, we didn't lose a 100% of GDP during the second quarter, as we just offered the previous side, we only lost around 31%. Well, if you were to take the 2.6 trillion and divided by the contraction of 31%, that six weeks of full GDP contraction is actually equivalent to almost 18 weeks.

Rich Consul: Why that 18-week kind of GDP replacement such an important thing? Well, essentially that just starts to run out in September and definitely by the end of October. So, as we're ending the quarter. The backfill impact of the stabilization programs that Congress passed are really starting to win. And you're going to see this in the charts there. So, when we look at the US savings rate, which is, it has peaked up to a high of 33% back at the peak of the COVID crisis in April, and was subsequent to the initial kind of phase of the Cares Act and Payment Protection Program and injected most of this money, you can see that the fiscal stimulus payments really increased consumer savings, and really that increase in consumer savings, bullied consumption. It's why the third quarter was just such is likely to be such a fantastic rebound and GDP it's because we allowed consumers to get this big inflow of cash during a period of time that we were all kind of locked in our houses.

Rich Consul: But what we've seen is that after spiking the 33%. The consumer savings rate, as we end August, which is the last date that we have so far has declined by 14%, a normalized level is around eight at the speed that we're losing consumer savings percentages like this, or the buffer kind of disappearing is how we get to the stimulus is likely to run out somewhere between the end of September and the end of October. And that's why some of the commentary that we've seen from Congress about the necessity of getting an additional payer stimulus program passed is really so important. I think everyone who's kind of looking at some of these numbers can clearly see that something is going to need to be done to kind of save consumption either we need a cure, a therapeutic or an additional fiscal stabilization program, or this fantastic rebound that we've seen could hit some type of skid.

Rich Consul: We see a lot of this also, the stimulus, the rebound in retail sales. US retail sales, as we all know, the US economy is really based on what we do on a daily basis, which is consumption. One of the best ways to kind of get... some introspection into exactly what we are buying is through the metric of US retail sales. US retail sales have now fully recovered all COVID losses. And they now stand at all-time highs. The largest sector changes year in year out.

Rich Consul: Our online shopping is as we've obviously during this whole COVID crisis started to purchase more online, whether it be our food, our groceries, or just our sundry items. And as we would expect, the online spending has gone up 27% a year over year, but what can't we do in a lot of States and those are the dining restrictions, and that's why restaurants are not... are still down 14% year over year. So, while overall retail sales are up, there's definitely winners and losers. And there's significant winners and losers. And there's elevated spending has really been supported again by that fiscal relief, which we will remind us, is starting to possibly show signs of running out.

Rich Consul: And its next area. We're going to look at some of the claims activity because while we've seen just a tremendous rebound in net job gains, since the crisis low. One of the things that we're starting to see is some of that improvement may be running out. And we see this so very clearly in the unemployment claims activity. The COVID economic crisis, according to this chart really peaked out in April with the peak and unemployment claims, continuing claims have been improving despite the slowdown and weekly claim activity.

Rich Consul: Initial claims improvement really has stalled since August. I mean, you can see it's still showing some signs on the orange chart of progressing lower, but on the blue chart, which is the actual initial claims activity itself broken down by week. You can see that basically since August, it's been flat lined and while there's improvement in the general kind of continuing claims activity, we would expect at some point in the very near future for this to start moderating out, if initial claims truly has kind of stopped improving at the current 800,000 level. Well, the next stage, we'll also get down into a little bit more on the employment area because I think it gets down to this call.

Rich Consul: Its sectors lagging issue. So, the US economy lost 21.8 million jobs related to COVID in March and April. Since April however, the economy has recovered 11.5 millions of those lost jobs. However, you'll notice in the sectors below, again, just like retail sales numbers earlier, there's individual areas that seem to be more effective than others. The biggest one being leisure and hospitality while they've had a really nice rebounders around four and a half million jobs Since April, you can see that we're still almost losing 2.9. One of the more interesting parts here is the leisure and hospitality area [inaudible 00:11:17] are basically the restaurants and bars. Remember when we were talking in the side of the previous where restaurant spending is down 14% year over year. Well, that really kind of corresponds to a darn near 15% drop in employment activity in leisure and hospitality, the areas that are most directly impacted by the revenue decrease.

Rich Consul: I mean, there are some good aspects of that. The individuals in that area tend to be the lower of the lower economic spectrum. As a result, having a little bit higher unemployment rate there doesn't affect net GDP as much. But it doesn't increase the wealth gap. And that's one of the issues that I think is going to be very critical, kind of in a quarters ahead is to figure out how much of these 2.9 millions leisure and hospitality workers are structurally unemployed. And, while we expect some of these jobs, that 2.9 to kind of continue to work its way off, there are going to be some long-term structural job losses. Its just restaurants closed down through bankruptcy. I mean, we've seen Cheesecake Factory closed down. We've seen a few other national chains closed down during this entire time, and these are big workers.

Rich Consul: And in some of these jobs just probably are not going to come back and rebound as quick. And the question to kind of make the best improvement overall in the employment picture, and as well as the economic fixture for the country is, to determine how can we move some of these structurally unemployed, leisure and hospitality workers into other sectors of the economy and where those jobs coming from. So, that's going to be the kind of the next phase of the economic recovery. As we start to look at it, as we transition from the macro perspective into credit risk. Credit risk can really be broken down into a kind of leverage and interest coverage. So, while companies are really focused on liquidity and flexibility, as they navigate this COVID uncertainty, corporations are really raising massive amounts of debt to just to increase liquidity. Well, when you issue massive lots of debt, what do we expect?

Rich Consul: We expect gross leverage to go up and we can clearly see the spike up in leverage during the beginning of 2020 here. And then more importantly, as you continue to have lower sales ratios and a little bit maybe depressed economic activity in certain sectors while we've seen generally speaking as well, is that interest coverage or the interest divided by EBITDA going down with even done that lower corporate basically clearly shows that corporations are taking leverage up and on underlying corporate fundamentals remain weak. And that's really why we've seen this cascade of debt that we're going to talk about in the patient. Some of the downgrades, when a company gets downgraded from investment grade down into high yield, it's called a fallen angel that the company's called a fallen angel. And typically, what you see is, is just a cascade of them during some type of economic recession or what we just went through right, called the economic pause is the way I like to refer to what we just went through.

Rich Consul: And what we've seen is that investment grade and high yield downgrades basically are occurring at the highest levels since 2008. And specifically, a lot of the concern of triple B issuance that we were talking about prior to COVID some of those triple B they get downgraded. Down near 2 trillion of them specifically got downgraded with another half a billion, excuse me, half a trillion in debt remained on downgrade watch with a potential to have sliding into high yield as well. So, despite elevated downgrade risk though, short-term corporate liquidity remains strong as we talked about a lot of these corporations have taken the leverage up, but it's really to mainly maintain liquidity. So well, we've seen this cascade of fallen angels. We don't think that we're going to have a much larger spike up in default rates than we've already seen from here, unless this economic pause lasts longer than it already has, or stimulus runs out.

Rich Consul: And finally, we'll leave you with a monetary policy. There was a lot of big changes in monetary policy during the second quarter and third quarter, the Federal Reserve continues to articulate that fed funds rate is likely to remain near zero for the foreseeable future. Well, one of the biggest changes it's like we... the change has likely not been felt today or yesterday as much as it will likely be felt in the years to come. If the Federal Reserve has changed its inflation management policy during the quarter, the Fed has and will begin using inflation averaging instead of inflation targeting. Typically, the prior to this change if the federal reserve saw inflation as measured by PCE or CPI, one of their... for two preferred measures, if prices increase to 2%, that was kind of their target zone to start raising interest rates.

Rich Consul: And they believe that basically one of their core mandates and specifically in their charter, that they have to maintain employment combined with price stability. Well, if in flee, their thought was if inflation was above 2%, that was inconsistent with price stability and required that the Fed to start raising rates. Well, what has since happened is a lot of research has taken place actually by the old Fed Chair, Ben Bernanke over at the Brookings Institute. [inaudible 00:17:08] did determined that interest rates and interest rate targeting specifically by the federal reserve is likely to need more of an interest rate or inflation averaging, philosophy. And as a result, we're likely to see many quarters or a few quarters, at least the inflation run above 2% before you would see the Fed start to actually move interest rates in any tangible way. And as a result, that's why we're likely to see the fed funds rate remain zero for at least, I would say 18 to 24 months, or unless inflation were to materialize significantly from a place that we have yet to see.

Rich Consul: And the last thing is the Federal Reserve continues to expand its balance sheets. It's... well, the balance sheet is now expanded by 75% since March, which is just driven yields across all fixed income sectors to all-time lows. And that kind of brings us to our next year portion here, which is the kind of the risk factors. When, we look at the Fed. The Fed is really driving a lot of the kind of the long-term risk factors that we need to be aware of. And two of those are right here. The Fed is skewing market risk premiums, creating a TINA environment of there is no alternative environment for risk assets. So, one of the reasons that we've seen equity markets just to stream higher since the COVID low, despite a 31.7% negative contraction in GDP in the second quarter.

Rich Consul: And it's going to be very interesting to see exactly how high these risk premiums can go in. And what will it mean when the fed actually decides to step away or pause their QE program? What does that taper tantrum look like? The other part is, can the Fed continue pushing aggressive, monetary stimulus with equity markets abroad, pre COVID highs? I mean, you've heard the Fed talk about the necessity for continued fiscal stimulus that the Congress needs to do more and pass more from a fiscal stimulus perspective and that they will continue to help, but that the Fed is starting to kind of push on the string here as far as what their ability to accomplish things with just continue to QE without a corresponding monetary increase or fiscal increase in activity. The next page kind of, it gives you an illustration of what the Federal Reserve's balance sheet expansion has looked like in the fourth in QE four, you'll see that we've broken down each individual QE segment of time, QE one, two, three, all the way through kind of where we are today with a B.

Rich Consul: But the key thing is the Fed's balance sheet will be nearly 50% of US GDP once it's completed at the end of this year. And, and we'll, you'll notice that the orange line is corporate OES levels or corporate spread yields for the compensating for defaults risk. And you'll notice that every time the Fed has come in for some round of quantitative easing, that they've driven the corporate yields down, this is a clear illustration of the Fed skewing risk premiums, especially at a time like today where default rates and corporate fundamentals continue to deteriorate.

Rich Consul: Overall, we still remain positive on economic expansion, but we do believe that some of that economic expansion continuing is likely to be a forced Congress to do a little bit more on the fiscal stimulus side or a cure therapeutic needs to kind of materialize before year end, either one would [inaudible 00:20:48] it would bother dynamics of the economy is still strong enough that either one of them would work at this stage, but whatever it is, it needs to be resolved sooner rather than later, as its fiscal stimulus and its positive effects are showing some signs of running out.

Rich Consul: Again. My name is Richard Consul. I'm a Senior Portfolio Manager here with the INCORE Fixed Income team, and we appreciate you attending our third quarter of fixed income insights.