MASTERCLASS: Midyear Outlook - July 2020

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  • 01 hr 00 mins 34 secs
Three experts share their 2020 midyear outlooks, looking back on the historic volatility and looking forward to where the economy is headed from here. They examine market trends, monetary policy, and more.

  • Rob Galuzsa, Portfolio Manager, Fidelity Investments
  • Tom Wald, CIO, Transamerica Asset Management, Inc.
  • Francis Gannon, Co-CIO, Royce Investment Partners



Jenna Dagenhart: Welcome to Asset TV. This is your mid-year outlook masterclass. We'll look back on historic volatility in both directions during the coronavirus pandemic and look forward to where the economy is headed from here. We'll examine market trends, monetary policy, the 2020 election and more. Joining us now, our three expert panelists, Tom Wald, CIO at Trans America. Rob Galusza, Portfolio Manager at Fidelity Investments, and Francis Gannon, co-CIO at Royce Investment Partners. Given the pandemic, which is first and foremost, a health crisis, there's a completely different set of criteria that investors are paying attention to. What's different about this midyear outlook compared to prior years?

Rob Galusza: Well, the shock of the virus came on very quickly, created a lot of volatility in the market, sort of a tornado that came through in March and April. The volatility scared a lot of investors, create a lot of volatility and was more of a liquidity issue that we saw in the markets, relative to earlier going back to the financial crisis, which had more issues with the banking system leverage asset quality. This, initially here, has been a real liquidity event and in terms of comparing it to other times, and the fed was very quick to respond to the market disruption and the disintermediation that occurred for a very short period of time. The programs that they put in place have stabilized markets for the time being, and things have recovered since we started this in the March-April timeframe.

Jenna Dagenhart: Tom, anything you'd like to add there?

Tom Wald: Yeah, sure. When you look at what typically we look at it in a mid-year market outlook, a typical year, you'd be looking at things like trends in the economy and interest rates and corporate earnings, all of which, of course, we're doing again this year and attempting to determine what asset classes are the best risk [inaudible 00:02:39] profiles. But, of course, this year, what we're looking at to make those determinations is so much different than any other year. If you had told me back in January 1st that the mid-year mark, I'd be looking at things like medical data trends on previously unknown virus, or at what pace the economy might reopen from a three months shut down, or how the economy might rebound from a 40% GDP decline in the second quarter, how the fed would implement trillions of dollars of bond buying, and how Congress might implement a second round of $2 trillion plus in fiscal stimulus.

Tom Wald: If you had told me last January, these are the sorts of things that I'd spending most of my time on in June, I might've said, "What episode of the Twilight Zone are you watching?" But this is where we are. COVID-19 has been a major tail risk event. It's drawing upon, let's say some newly developed skillsets and determining where the risks, opportunities and market catalysts are out there. One of the analogies I've told people is a bit like, you play baseball your whole life, and then someone suddenly takes away your ball and bat, throws you a tennis racquet, "Let's go play basketball." It's very much a different environment requiring us to look at different types of criteria looking forward.

Jenna Dagenhart: Certainly a different environment to say, the least. In the wake of the record, sell off equity markets have rebounded tremendously, but the economy still has a long way to go with unemployment and the teams and shrinking GDP growth. Francis, how are you making sense of this disconnect between market valuations and economic data?

Francis Gannon: Well, it's been very typical. I think that's one of the things that Tom and Robert are alluding to is the fact that in this uncertain world of 2019, here we are in the mid-year, the one thing that has been very typical has been how markets have reacted to the news and how they have responded given everything that's gone on. The difference has been the speed. The speed of the decline, the speed of the equity market's recovery, and the volatility associated with both of that in such a short period of time. What's normal has been what worked on the way down, what didn't work on the way down, and the factors that are working on the way up.

Francis Gannon: As we sit here in the middle of the year and we look out, we live in a world where, I think everybody has become very short-term focused. Focused on as Tom alluded to, the medical numbers, the hotspots, what might be going on in any given day in any part of the country. I think you have to pick your head up and look beyond the short-term and look a year ahead. Where's the economy going to be a year ahead, a year from now? Where are these companies that you're investing in going to be a year from now? And try to make that leap of faith if you can possibly do it in what is an incredibly uncertain moment.

Jenna Dagenhart: Rob, what key economic indicators will you be watching as we move into the second half of the year?

Rob Galusza: It's a great question. As Francis mentioned, we are looking at sort of high frequency indicators. What is going on with employment? Initial claims, jobless claims, continuing claims, things like gasoline usage, hotel occupancy, travel. In the short-term, and looking through now through the end of the year, are consumers going to re-engage? And what parts of the groups, the cohorts are going to engage the most? We can see with the stay-at-home economy here, for the time being, there's been a shift in how the economy has responded. Those near-term indicators are going to set the trend for the next second half of this year.

Rob Galusza: Is travel going to pick up? Will people re-engage at restaurants and small businesses? Will you check into a hotel, and will employers re-engage with their employees who may have been temporary laid off or furloughed, and will those become permanent or will they pull the employees back into the workforce and start to reengage as things open up? As others have said, it's very uncertain, and the virus is setting the direction for how the economy is opening, and it's different state by state and a region by region in the US.

Jenna Dagenhart: Yeah, a lot of different questions on a lot of people's minds, as you mentioned, and Tom, you alluded to those, but never before have financial professionals been relying on medical experts for guidance that could impact the direction of the markets. How are you navigating this new normal?

Tom Wald: Yeah, a great question, Jenna. Before I delve into the answer, just quick disclosure, I am not, and have never been a doctor or any other type of a medical expert, nor have I ever worked in the healthcare field. I just want to make that clear, but [crosstalk 00:08:03].

Jenna Dagenhart: That's okay. We don't expect you to be a doctor.

Tom Wald: Okay, thank you. Well, that's good for a lot of people, but that said, I think it breaks down into two main areas. First, you have the medical data on the virus itself, and that of course, is being calculated day-by-day and minute by minute. This of course, has had a direct bearing on how quickly the economy is likely to keep reopening and how soon individuals and companies might revert back to pre-virus consumer behavior. Of course, looking at the COVID-19 data, can often be tough to do because these are tragically, sad statistics to read, let alone interpret, but in attempting to make those important interpretations, I would say that in many countries, including a good part of Europe, the trends have become more encouraging.

Tom Wald: Daily infection rates are down; fatality rates are down, and recovery rates are up. For instance, countries like Germany and Switzerland, about 90% of total reported cases are now completely recovered. Japan is also sort of as a similar ratio. We are seeing some ... We were, I should say we were seeing some fairly encouraging trends here in US up until these past couple of weeks when we got this recent spike, mostly coming from a handful of states like California, Texas, Arizona, and Florida but watching that closely, the fatality rate is yet to follow and our recovery rate is still increasing. The overall medical data here in the US continues to be a mixed bag, but then, separate from all that, you have the scientific side of [inaudible 00:09:53] impact in the markets, as in one, we might see a vaccine or effective therapeutic treatment for COVID-19.

Tom Wald: Having been someone who, way back in my earlier days of my career as a fund manager years ago, I owned a lot of pharma and biotech stocks in the portfolios I managed. One very important thing I learned and always remember remembered was no one ever really knows how scientific data will turn out until that scientific data is actually released, as [inaudible 00:10:25] phase type data based on predetermined clinical trial end points that are necessary for FDA approval. It looks like we could see a few companies with vaccine or drug candidates come out with this type of data between now and year end, and if that looks effective, that could help the market to rally. But investors need to be cautious about this. Drug and biotech clinical data has broken many a heart over the years.

Jenna Dagenhart: Yeah. I know this all feels really other worldly, and to steal a commonly used phrase, very unprecedented, but if you had to compare this crisis to the great financial crisis, what would you say is similar, and what's different, Francis?

Francis Gannon: Well, I think it's a different environment, completely. We're 10 years beyond, or more than 10 years beyond now the great financial crisis. As Rob alluded to earlier, that was driven by leverage and problems within the financial sector, if you will. This was really driven by our own doing, and I guess you could call it the great suppression. We shut down on economy, and the global economy shut down. We've been dealing with the ripple effects of that. That was the pebble that fell into the pond, and as it goes all the way out, that's what's been going on right now, and how has, not only economies reacted, but markets reacted, etc. The difference, one of the major differences, I think, has been the speed at which the federal reserve acted.

Francis Gannon: They acted incredibly quickly, and you saw that in the way the market's bottomed in the middle of March. You really saw this incredible liquidity rally take place as the fed backstopped many businesses. It was not just the monetary policy, but there was fiscal policy as well. All of that was much faster than we saw during the great financial crisis. That is probably the biggest difference at the moment between the two periods of time. What happens now going forward, I think is going to be also more interesting. To me, volatility in this market is going to be quite high. It's going to be driven by the things Tom alluded to, in terms of numbers on a daily basis, it's going to be driven by economic data points, and you're going to see the market be very vulnerable around all of those data points, I think between now and the end of the year.

Jenna Dagenhart: We'll take a closer look at the fed later in this panel, but before we get there, Rob, how would you compare the experience of managing through this environment relative to the 2008 financial crisis?

Rob Galusza: Yeah, I think its similar things that Francis just mentioned, the support of the fed and the fiscal response here was very quick and very significant. You think about where things started in their ability to provide liquidity in the repo market, and the bill's market, and then that moved out to the treasury market, where off the run treasuries were more difficult to trade, and then rolling out programs to support primary and secondary corporate bond market facility. Making sure that that signal, with that kind of firepower, gave people comfort, despite all the volatility and the concerns and some of the long-term effects that will happen. The swift reaction here was very positive.

Rob Galusza: Some of the tools already existed in the feds tool kit, so they were able to work on those with respect to buying treasuries and mortgages, and then to quickly develop new tools to respond. I felt like, versus where there was resistance, if you think back to the previous crisis on some of these programs and tools and the expansion of the fed balance sheet and how they were going to unwind things, there was more acceptance of these programs to stabilize the markets.

Francis Gannon: I think that's a great point. The experience of 2008, 2009, and the great financial crisis, for the federal reserve, actually, I think helped them develop everything they need or feel comfortable with doing and acting with the speed in which they did during this particular crisis.

Tom Wald: Jen, I'd also said a market awareness of that, because so much of what the fed did, not just during the financial crisis in 2008 and '09, but how they followed up with continued stimulus all the way up through 2014 played such a role in the market recovery during that period. Market actually moving to new highs at the end of that period. I think investors saw the ... we're able to look back and remember the impact the fed had on the market's non-recovery during that time, so that when they did take action in the market, reaction to that was even more swift.

Jenna Dagenhart: Yeah. On this topic, Rob, can you highlight some of the notable fiscal and monetary policy measures in response to the pandemic and what kind of impact that's had on the fixed income market?

Rob Galusza: Well, sure. I think, right away, when it became apparent that this was going to be a significant event, in two unscheduled meetings, the FOMC moved interest rates down 150 basis points and got us back to that zero to 25 basis point lower bounds. That was an initial move. The $2.2 trillion congressional fiscal package, the Cares Act were able to do that. Then the other facilities, so providing a money market liquidity facility so that those markets could operate normally and providing ... Those were some of the near term events, as we saw institutional prime money market investors leave those funds and move to government money market funds, just a tremendous movement of money into bank deposits, into government money market funds, so programs to provide that liquidity in the repo markets and the short-term funding markets was critical.

Rob Galusza: The programs expanded, as we discussed, expanded from there to the primary corporate market support, all the way down to companies that got downgraded to below investment grade. It was probably unheard of that the fed would buy credit, would take credit risk. Now those markets, they are starting to move in that direction to support those markets. Combination of both monetary and fiscal support played out well in both taxable areas, as well as the municipal market that also needed support in terms of liquidity as the states are going to be significantly impacted by this crisis in the near term, and as their tax revenue deteriorates, will be impacted going forward.

Jenna Dagenhart: Yeah. Tom, do you think that there'll be significant tailwinds beyond 2020 from these economic stimulus measures?

Tom Wald: Yes, I do. I think when you look back at the ... When you think back to what happened during this time, or I should say back during the financial crisis, back in 2008, I think one saying that the markets took very well was that you had a combination of an economy recovery off a very fierce recession combined with monetary stimulus. You look back at where we were, say the second quarter of 2008, when the financial crisis was really at its force point, that was the quarter of that GDP dropped about eight and a half percent on annualized basis. Then, the fed really started gearing up with the quantitative using the fiscal stimulus, and then we started to get the recovery in the economy in 2000, about the second quarter of 2009.

Tom Wald: But it took us until about 2011 to really catch up with pre-financial crisis GDP. During that time, you had a combination of economic recovery and monetary stimulus. I think the fed might be taking a page out of that playbook going forward, and what we could have now is we could start to see a recovery in the third and fourth quarter. If you just run the math a little bit and say we're down this cataclysmically bad 40% in the second quarter fall by maybe positive prints of maybe about 15%, third and fourth quarter and stay around a 5% run rate for 2021, and then we go back closer to trend. We're looking at potentially getting back to 2019 aggregate GDP numbers, somewhere around late 2022 or early 2023.

Tom Wald: I would be really surprised if the fed did not keep short-term rates at zero, and to have some sort of liquidity based monetary stimulus through at least that period of time. Where the opportunity is in the equity and credit markets, in my opinion, is that you get this period of time where the economy does start to recover, although not all the way back to where we were at the end of last year, but you get the fed stimulus occurring during that time. That combination of a recovering economy and fed's stimulus, liquidity-based stimulus and very low, historically low interest rates, can be a powerful combination over that period of time.

Jenna Dagenhart: Francis, has liquidity been better or worse than you anticipated?

Francis Gannon: Well, I think what we saw from the bottom March to really, I'd say the middle of May, was a liquidity driven rally. That changed a little bit after the famous 60 minutes interview with Jay Powell, where I think it became a little bit more around future prospects for many businesses, and so fundamental, it started to matter a little bit more. You saw parts of the economy start to come back. At least from an equity perspective, you saw energy do better, you saw consumer discretionary start to do a little bit better, and that was more around the reopening of the overall economy so then you had this reopening rally, if you will, from the middle of May-ish to the end of the quarter. I think what you're seeing, from a liquidity standpoint, is not that unsurprising. In our space, as an active manager in the small cap space, we monitor liquidity quite closely.

Francis Gannon: There was a lot of liquidity surprisingly, on the way down and even more on the way up. We didn't see the typical liquidity moments that we would have seen. I marveled in talking to our traders as we were doing our regular conversations about how the fact that people were commenting on how wide the spreads were between the bid in the assets of the larger cap stocks as the market was declining. In reality, that's what we deal with in the small cap space all the time. It was easy for us to navigate through this period from a liquidity standpoint.

Jenna Dagenhart: Rob, can you talk a little bit more about bond market liquidity before, during and after the pandemic?

Rob Galusza: Sure. Coming out of the financial crisis, things over the last 10 years were getting better, and liquidity in the fixed income market was getting much better, but dealer balance sheets were light due to regulations and certain liquidity rules that they needed to have. It was pretty well understood, a lot of, at least within fixed income, a lot of securities were held by large money managers and sovereigns. There was not a real test of that liquidity. Things worked well. The primary market was functioning well until we came right to a real test here. That test put a lot of pressure on all markets for liquidity. There was deterioration in that market. I mentioned before, it was a sort of an intermediation issue where the need for liquidity, the need to sell securities overwhelmed some of the dealer balance sheets.

Rob Galusza: When that became clearly apparent, that's when the fed stepped in. How you were positioned, right going into this, was a determinant of your ability to handle liquidity and impacted performance on the way back up for certain markets. There were difficult spots here, as there were in 2008 and 2009, but again, I go back to the support from the fed in calming the markets is critical to operating and getting things back to a more normal operating market. When things opened up, there was very strong demand for new issue securities, people seeing real opportunity, as certain organizations, companies needed to fund in order to keep their operations going. 

Jenna Dagenhart: Then a lower for longer interest rate environment, Tom, what does that mean for different asset classes?

Tom Wald: Yeah, I think it's good for a lot of asset classes. All things equal, lower interest rates are good for both the equities and the credit markets. You have the inherent comparison that investors will make for stocks and bonds, versus lower yielding or perhaps we should say no yielding cash alternatives. The equity markets, I think it's good because, typically, investors will look at growth premiums, both growth premiums and dividend premiums of stocks, versus lower yielding cash alternatives. One of the metrics that we look at a lot is a very simple calculation called the equity risk premium, where we take earnings yields on stocks and subtract the 10-year bond yield from that.

Tom Wald: It gives us a premium that we then look at historically to see whether or not stocks [inaudible 00:25:52] attractive entry points over the longer term. Even when taking a meaningful haircut to existing earnings yields, because of course, there's a lot of uncertainty about earnings going forward, even when taking a big hair cut to where earnings estimates are right now, that still is showing a pretty attractive entry point for stocks going forward. Also, in the bond markets, lower interest rates enable companies from a fundamental standpoint to have a lower cost of debt. Of course, it improves the overall present value of the fixed income coupon streams going forward. There's a lot of good things, really good things about a lower interest rate environment. Of course, the overriding question is what's creating this lower interest rate environment?

Tom Wald: If it starts to be more the tail [inaudible 00:26:45], where lower interest rates is reflecting pessimism about the future economy, that plays a role as well as the risk of inflation going forward, that the lower interest rates can create over the course of time. But I think when you try and balance all of these out right now, and look at where we are right now, combining the lower interest rate environment with the probability of an economic recovery, and remembering that this was an economic shutdown of our own doing. We had to do it for medical reasons but being that the economy can't possibly come back fairly quickly from where we are right now, amidst that lower interest rate environment, which I think is going to be lower for a long time. I think net, this creates a more favorable environment for investors.

Jenna Dagenhart: Rob, how do you think about managing fixed income portfolios in this low-grade environment? Do you still see opportunities?

Rob Galusza: Well, we have been here before, as Tom talked about. In terms of fixed income providing, real diversification benefits more. Between total return, income, capital preservation, liquidity, it's really, and diversification, it leans more on the diversification side, obviously, as yields come down here. I do agree with what Tom is saying, that we're likely, the increase in the debt loads, both at the sovereign levels and the corporate levels, you can't sustain higher interest rates and service your debt. More of your cash flows and earnings will be dedicated to debt service and lacking reinvestment. Interest rates probably will stay here, as we saw out of the last crisis, relatively low for quite a period of time.

Rob Galusza: However, there are opportunities in terms of movements in the spread market, different parts of capital structures of the slope of the curve, as we saw steepening coming out of the last crisis and a little bit of steepening so far. There are strategies with managing the yield curve with the carry and the roll down that can add total return, the overall returns on fixed income, similar to the last time, would be expected to be lower.

Jenna Dagenhart: To quickly build on that, what would be the implications on the bond market if we saw negative interest rates, not just low interest rates?

Rob Galusza: Well, sure, I can start. The federal reserve has come out a couple of times fairly strong that they do not see the benefits, at least at the front-end, the funds rate having a negative interest rate, that the stimulus benefits are not that great pushing your short-term rates down below zero, as well as disruptions in the banking and money market areas. That's one point at the front end of the yield curve. It's possible, as we've seen in Europe and other parts of the world in Asia, in Europe, where longer rates can go negative. The economies can operate fine. The prices can still go ... rates can go further negative and increase returns, but it's not a favorable position. With the size and how dynamic the US economy is and where we are at the moment with the support, the expectations are not for negative rates, but it just creates more challenges if rates were to be negative, clearly.

Jenna Dagenhart: The investors have certainly flocked to safety. Francis, are they looking for safety in the right places?

Francis Gannon: I guess that's always the ultimate question, right? I think one of the biggest safety trends that you saw coming out of the bottom of the equity market was in those top five stocks in the Russell 1000, that investors liked going into the decline and the recession, and they're continuing to like at this particular moment. I think you have to think of the world differently between the offensive areas and this more cyclical or economically sensitive in today's world. That to me, is where the opportunity is. If you look at what's happened from an economic perspective over the past 10 years or so, you've had these economic growth scares prior to this recession that created great buying opportunities and more cyclical companies. I think this was another particular moment in time where people flock to the more offensive areas, the more safety areas, or perceived to be safety areas, as the market declined.

Francis Gannon: But as we look out over the next three to five years, and even over the next one year, I would think that some of the more economically sensitive businesses should do better. There are pockets of strength in the midst of all this bad news. There are many businesses, small cap businesses that are doing fine in this particular moment in time. A lot of them are not necessarily defensive names that have the utilities or redirect, things like that. Some of them are just wonderful, innovative businesses that you can find in the middle of the country that are industrial, that are involved in machinery, etc., whatever it might be. But to me, that's the opportunity set right now, is around these more economically sensitive reciprocal areas, as opposed to the defensive areas where people might be looking for those bottom-line proxies.

Jenna Dagenhart: I see you nodding your head over there, Tom. Anything you'd like to add?

Tom Wald: Just that, when looking out where will companies be a year from now, two years from now, three years from now, I think you have to take into account which companies are going to stand the most to benefit from a hyper recovery off a historical decline. You've got this environment, that I mentioned a couple of minutes ago, that potential 40% annualized decline in the second quarter, followed by potentially strong ramp ups of 15%, or better third and fourth quarters and above trend in 2021. I think, to Francis's point, who stands to benefit from that, and that's sort of a little bit of a different mindset that maybe people were thinking about six months ago.

Jenna Dagenhart: Who should be worried right now, Rob, can you discuss the potential risk for downgrades in the corporate bond market as a result of the pandemic?

Rob Galusza: Well, we have seen some already. The agencies, based on their experience last time, they're not going to wait around. They will review, put on credit watch or outlook negative, and move quickly across sectors. Areas like we've seen in autos and aviation and energy, fallen angels where rating agencies have taken companies to blow investment grade. Again, the fed has been supportive of the market here, even for companies that have been downgraded as of a certain date in March relative to COVID impacts. It is an important point because we do see heavy issuance in the corporate bond market. Year to date, we've had gross issuance of about $1.2 trillion, companies are issuing debt to bridge the gap to get over this difficult period, leverage is coming up. They are tendering for the short end of the market and trying to extend their maturities with these lower coupons that they can lock in.

Rob Galusza: But leverage is higher. That makes for a moderately riskier market. You need to look at those companies, are they sustainable and can they service their debt? Do they have free cash flow? Are they going to defend their ratings or are they going to be very aggressive and have ratings go down? Because they have many constituents to feed, so they have dividends, they have share buybacks, they have debt service, they have CapEx expenditures, so how are they going to deploy their cashflow is a real important issue in the uncertainty over, say the next 12 to 24 months, we could see the impact of this higher leverage, on corporates as well as governments.

Jenna Dagenhart: Yeah. I'm so glad you bring up leverage Rob. Francis, can you walk us through operating leverage versus financial leverage, and what kinds of companies have the capacity to withstand all of this volatility?

Francis Gannon: Yeah, sure. It's interesting to listen to Rob because it's some of the things that we've been worried about within the small cap space for a period of time here, even prior to this economic crisis that we've been in, or the recession that we've been in. We were watching the number of zombie companies increase dramatically within the Russell 2000. In fact, zombie companies are companies that we define as those who actually have to borrow money over a three-year period to finance the interest on their current debt load. That number was going up. We know that, at the end of the first quarter, close to 39% of the Russell 2000 was comprised of non-earning companies. That cashflow number is more important today than it was at the beginning of the year, in terms of being able to maintain the debt load of some of these companies, which is going to be very difficult for them to do. So, you are going to see leverage go up, you're going to see financial leverage go up in a lot of these businesses.

Francis Gannon: We have always been a fan of operating leverage. In the small cap space, we're dealing with fragile entities, to begin with. We try to take that financial aspect of it off the table and focus more on the operating leverage of these businesses, because you never know where that out of left field event is going to take place, and it does, as we all know, as we've learned this year, it can and put undue stress on a particular business. The focus, I think, as the market goes forward here, I think the market is going to focus more and more on those type of businesses that don't need access to the capital markets per se, that have their own free cash flow to continue to grow. Because even in an environment like this, which has been very difficult from an economic perspective, better companies can continue to grow, better companies to use the financial missteps of their competitors and take advantage of it to continue to grow their business through product lines or acquisitions.

Francis Gannon: You're going to see a raft of bankruptcies, which have already starting to pick up, and the better positioned companies will be able to take advantage of those missteps.

Jenna Dagenhart: Rob, how do you think about the impact of COVID on other sectors in fixed income like ABS and CMBS?

Rob Galusza: Sure. Initially, I think, as the volatility hit right away, all markets were hit substantially. Whether it was securitized, even government mortgages widened out substantially. We saw initial spread widening here. In these other sectors, it is a little bit different because some are consumer related. In the consumer related markets like credit cards and autos and other types of asset backed securities, it will really be driven by the consumer health here. With a high degree of unemployment and furloughs and job losses, you would expect delinquencies and charge offs in some of those consumer sectors to go up. Now, they've been supported by the fiscal stimulus and the programs that have provided support and increased in unemployment benefits, but if those should start to unwind and there'll be less of those, then you're going to see delinquencies, potentially head up higher.

Rob Galusza: Borrowers have been able to defer mortgages, so that's been positive for the time being, but eventually, loans will have to be paid back. Then on the commercial mortgage side, that's also very interesting. We've seen obviously, significant impacts to certain segments of that, hotels, retail, markets that are in those securitizations that will experience potential higher defaults. Staying higher in the capital structure in these securitized sectors is very important and having the credit enhancement to withstand increased charge offs and losses. We do expect those two to head up, and the economy is changing. There will be changes to things like commercial real estate and the use of commercial real estate going forward, but it may take some time to work itself out.

Jenna Dagenhart: To quickly shift gears here, it wouldn't be a 2020 mid-year outlook panel. If we didn't talk about the 2020 election. That being said, Tom, what kind of risks and opportunities do you see on the horizon, if there's a change of power, and how will the 2020 presidential election factor into your outlook?

Tom Wald: Yeah. Great question. Like everything else under the sun, the presidential and congressional elections have been turned absolutely upside down by COVID-19, I think. When you look back a couple of months, I think the prevailing thought was, back in January, February, that most of the odds makers were giving president Trump a better than 50% probability of being reelected and the Republicans holding the Senate. I think that has now been turned upside down. Former vice president Biden has double digit lead in the polls right now, and that can change, but I think you have to look at a distinct probability now that the Democrats could have a clean sleep in November, the Senate House and White House, and what that could mean from a risk perspective, and please bear in mind, this is a market comment, not a political comment, so I don't want to alienate friends and relatives out there.

Tom Wald: But in that case, you could see the market reacting adversely to what could be, in 2021, higher taxes and stricter government regulation, kind of the reverse of the rally that we saw in late 2016, early 2017. But I think the key point here is, you have to take these ... Elections happen every four years. You have to take them into account with your outlook, but the markets really have historically been through Republican and Democrat administrations, Republican and Democrat converses, in basically every possible combination there are. In the end, the markets will follow a business and an economic cycle and not a political one. I think that's really what you have to take into account between now and November.

Jenna Dagenhart: Francis, how are you monitoring the 2020 election as it relates to equity markets, and specifically, small cap stocks?

Francis Gannon: Well, I guess the best way to describe it, I think right now the front pages of most of the papers in the country are quite busy. There's a lot to talk about, and it doesn't seem as if the election has actually permeated front page news as of yet. You're hearing just the beginning of what I think is going to be more and more conversation about that. Therefore, you're going to have much more volatility around that. I think the election is just another unknown that can cause increased volatility in the third quarter of this year, going into November. Our objective always has been, to take advantage of that volatility. As you see increased volatility, which we have this year, active managers tend to be better.

Francis Gannon: To me, maybe I'm being too simplistic about it, while I don't know who's going to win or what's going to happen, I know it's going to cause volatility as markets trying to assess and assume who might win or take overpower. Our job as an active manager in the small cap space is really to take advantage of that volatility.

Jenna Dagenhart: Volatility can be a good thing for active managers.

Francis Gannon: Volatility tends to be a very good thing for active managers. When you live in a market, like we had for a period of time, where people are basically lulled to sleep by the lack of volatility, performance seems to concentrate in a certain area of the market. Within our market, it might've been biotechnology, in a larger cap market it might've been technology related names in the upper end of the S&P 500. But as you see increased volatility, you tend to see things spread out. You tend to see intraday stock volatility being really helpful. Therefore, as a long-term manager, we're thinking three to five years down the road, our job is really to buy these great businesses when we can during some type of dislocation from their stock standpoint. That's our objective. As you see increased volatility here, you're going to see that that gyration of the market that active managers should be able to take advantage of and really front load their performance or invest in their performance three to five years down the road.

Jenna Dagenhart: Yeah, the list of unknowns is perhaps the longest it's ever been, but you would say that can be a positive for active managers?

Francis Gannon: I would. We are in an uncertain environment, without question. There is an enormous number of unknowns out there, from COVID to politics at this particular moment in time, but I know that's going to cause volatility in the market. I think the objective of investors today is to think longer term. The short-term ness, if you will, of the market right now is pretty pervasive. You can see it in how the market reacts to the newest hotspots or the spikes in COVIT of late, but what you're going to see, I think going forward is, people have to start picking up their head and looking across the valley here to the other side, to what should be a better economic environment, as Rob and Tom had alluded to, since the economic numbers get better, which will also have very easy comparisons year over year as you look into 2021. Earnings will have easy comparisons as you go into 2021.

Francis Gannon: I think you're starting to see the earnings cuts for many businesses stop going down. The possibility of further surprises from an earnings perspective are going to be, I think, quite powerful. As we look forward here in the next six months, you really have to look almost another six months out. You have to look out to the next year to really understand the fundamentals of your business and the opportunity sets, just given the large number of unknowns.

Tom Wald: Yeah. I just want to say, those were great points that Francis is making. I think, in association with that, you have this kind of stuff scratch and claw in the economy with corporate earnings to get back to where we were about a year ago, but when we get there, and you get to those economic numbers and you get to those earnings numbers that we saw about a year ago, we're going to be there with lower interest rates. That should improve equations. You actually should get a bit of a linear tailwind in the valuation schematics, just by getting back to where we were six months ago. I think that provides sort of a natural sense of optimism for active managers to be able identify the opportunities.

Francis Gannon: I think the other thing to stress is we've been through moments like this before. It might not be the same, given the fact that this was us shutting down an economy, but we've been through moments of dislocation, we've been through recessions before, and the markets are acting the way they should. They responded to the news and they're responding to the support that it's getting from both a monetary and fiscal standpoint. I think you just have to use history as your guide here to help you out over the next year. What we're seeing, especially in the small cap space, is exactly that. The markets are reacting the way they should in what is an environment full of a lot of unknowns.

Tom Wald: Yeah. Jenna, just to touch on that also. One thing, we classified COVID-19 is an extreme tail risk event that is very, very rare by history. We went back and looked at a number of the other ones, everything from the 1929, stock market crash in the early days of World War II, to stagflation in the early 1980s. All the sort of really, what we believe to the extreme tail risk events, and history infers, once that event is reconciled, typically the market, over the next several years, 10 years or so, tends to perform pretty well, once that tail risk has been taken care of. When you're looking out several years, that's something investors might want to take into account as well.

Jenna Dagenhart: Especially after an event that is so deep into the left tail, like this one.

Tom Wald: Exactly.

Jenna Dagenhart: Looking ahead, there are still so many unknowns as we've been discussing for the broader economy. That being said, Rob, how are you keeping a close eye on all these uncertainties as it pertains to fixed income?

Rob Galusza: Sure. Well, as is Tom and Francis have been discussing, we have two things going on right now, with COVID and dealing with the economic impact of that, and the election coming up, are two very impactful events that can move the markets. How the outcome, as we head towards the fall, of the election could have impacts on tax policy, could have impacts on regulation, could have impacts on the deficits. As we approach that event, coming through ... As I mentioned earlier, we've been very focused on these high frequency, short-term data points, but then you reach these milestones of an election or a vaccine or getting to the other side. That can determine who sits in certain agencies, who's at the SEC, who is at the Department of Labor, what are we doing to get people back to work?

Rob Galusza: These are all issues. It's going to be an intense second half of the year because of the consequences of these events coming together at the same time. But I do agree with what Francis and Tom are saying that, we have been here before, the US, particularly, is very resilient, and we have many options with which to respond to these challenges. That gives me optimism as we get past this and things 

Jenna Dagenhart: What would you say is the ultimate wild card with COVID, Tom? Is it a vaccine here?

Tom Wald: Yes. It's a vaccine. We've had this economic shock, capital S-H-O-C-K, shock. I think that the wild card would have to be a medical outcome or medical solution that would help to get us out of the shock much quicker than what we would expect. We have the prospect of a vaccine. Other ones could be, perhaps the virus mutates into a less dangerous form that's ultimately how historians believe the Spanish Flu of the early 1920s went away, or perhaps just better ways for the medical community to be able to treat the virus overall. But I think a wild card is just that, a wildcard. I don't think it's anything that investors should really count on or expect.

Tom Wald: As we look out, I think we have to be prepared to gut this one out, so to speak, over the next year or so until we get to the other side of the virus and get to an economic recovery. Wildcards are good, to know that they are potentially out there, but I think investors need to be very careful, especially what they hear on the news. Until you've got a proven medical outcome to COVID-19, I don't think that too much stock should be put in wildcards.

Jenna Dagenhart: Building off of that, do you think that there could be another economic shock, of course, a negative one, if there is a second wave? We've already seen infections ticking higher.

Tom Wald: Yeah. Certainly, a second wave would not be good, but I think that if we do get a second wave, we're not going to see an economic shutdown, anything close to what we saw this time around. We've sort of seen the impacts of that. Looking forward, if we do get a second wave, I don't think we're going to have a business and economic shutdown, the likes of what we've experienced over these last three months. You also have to take into account, with an economic shutdown ... I'm sorry, with a second wave, what will be different this time around? You could see a spike in cases, but fatality rates could be different recovery rates could be different. How consumers behave could be different. I think there's a lot to be taken into account as to what could happen in a second wave. I don't believe that we will see the economic impact like we did this time around.

Jenna Dagenhart: When things do eventually return to normal, Francis, do you think that we'll see an uptick in IPOs and M&A, and if so, how will that impact small caps?

Francis Gannon: That's a great question. I think the M&A story is one that's always with us. You always see an enormous amount of M&A. My guess is you're going to see an increase in M&A. Over the past couple of years, you've seen it more large cap focusing on the mid cap space, looking for growth. I think you're going to see, now the small cap area come into play a little bit more here, from an M&A perspective. Not only is your enormous amount of capital on the sidelines, we know that the private equity world is flush with cash right now. You're going to see that start to be deployed, and that usually takes place in the form of just pure acquisitions. That happens to affect a lot of companies in the small cap space. The thing, I think is, building upon what Tom was talking about in terms of some of these unknowns, at the end of the day, we're not going to know what the unknown is.

Francis Gannon: If we're talking about it now, it's something we're actually already thinking about. Much like COVID-19, most people [inaudible 00:54:40] at the beginning of the year, they wouldn't have said that that was going to be a major thing in terms of the market this year. It's turned out to be an incredibly important part of what's happened from an economic perspective and a market perspective. But to me, it's the out of left field event that's going to be the one thing we're not thinking about, either positively or negatively, that is going to affect the market here. I look at it, as I think, in our world, we're still vastly below the all-time high within the Russell 2000, probably 15% to 20%.

Francis Gannon: You've got different indices within the market hitting new highs. We think we have a long runway here in terms of recovery, but it's the unknown part of it that we just don't know how it's going to affect.

Jenna Dagenhart: Rob, what have you observed regarding issuance in the investment grade bond market? Do you anticipate any trends continuing?

Rob Galusza: Well, we do. We've seen a significant issue in a pattern after the short period of dislocation in March and in April. We've had, as I said earlier, about $1.2 trillion of issuance here, and companies are trying to build up liquidity to get themselves to bridge this period so that they can even handle funding through 2021. If they're able to do that, they can take investors' concerns off of their liquidity profile. You have seen companies who maybe are just coming off the back of an acquisition at the end of 2019, or closing in the beginning this year, that had too much debt and felt well, the markets are fine. We'll be able to pay this down and ran into problems.

Rob Galusza: We have treasury issuance, and this is not counting T-bills, but gross issuance of 3.5 trillion. You're going to have treasury issuance, net treasury issuance, bonds, treasury bond issuance of close to a trillion, excluding all the T-bills that they roll. There will be a tremendous amount of debt outstanding. It continues to grow. Thank goodness, the fed is there. The fed is buying a lot of this paper as well, and foreign investors. How foreign investors approach the US market, is it advantageous for them? Their searching for yield, as many investors are, will determine how a lot of this issuance is absorbed.

Rob Galusza: Then there are other markets like the mortgage market and other securitized markets that may slow down a bit, depending on demand for loans. The system has plenty of liquidity. The bank system is very liquid. I think one of the issues going forward is going to be demand. Are we going to get the demand of the business demand, the capital investment, and the consumer demand that will allow companies to repair their balance sheets? That's something we're very focused on. Expanding the balance sheet's one thing. It's how do you repair the balance sheet over time as things calm down.

Jenna Dagenhart: Tom, any other market trends that you'd like to highlight that you think might continue into the second half of the year?

Tom Wald: Yeah, I think the unprecedented historic fiscal and monetary stimulus that's been applied over these last couple of months will continue to filter through the economy and the markets throughout the second half of the year. I think the real opportunity looking forward, for both the stock and the credit markets, is going to be the forthcoming economic recovery that we should start to see in the third and fourth quarter. Looking beyond that, how that dovetails with that fiscal and monetary policy that I think is going to be around for a couple of years. Lastly, within the context of those opportunities, investors are just going to have to brace for more volatility in the markets. The rollercoaster is not over just yet, nor will likely be over in the near future, even if the overall paths to the market is linear.

Jenna Dagenhart: Yeah. Francis, any final thoughts on your ends as we head into the second half of the year?

Francis Gannon: Well, like Tom said, I'm a big believer. You're going to see increased volatility that is going to be very dependent from an economic perspective, as well as what might be happening from the COVID disease and where it is. That being said, I wouldn't be surprised if you had a little bit of a pause in the market. In the midst of that volatility, you might see some consolidation as really fundamentals catching up to where the market is. There's two types of corrections, price and time, and you might be in a time correction where it looks like you're doing a lot, given day-to-day volatility, but in reality, you're not moving that fast or going that far.

Francis Gannon: Therefore, I think it would give the market a chance to rest and have the economic and fundamental really ... the fundamentals catch up to the valuations that you're seeing in the market right now, which wouldn't be the worst thing. Then to see a pickup in economic data in the latter part of the year, you could see it take off again. But I think you're going to see a period of consolidation given all the volatility that we've seen so far this year.

Jenna Dagenhart: Well, certainly a roller coaster indeed. Everyone, thank you so much for joining us. Great to have you.

Francis Gannon: Thank you.

Rob Galusza: Thank you.

Tom Wald: Thank you, Jenna. It was to be here.

Jenna Dagenhart: Thank you for watching this mid-year outlook masterclass. I was joined by Tom Wald, CIO at Trans America, Rob Galusza, Portfolio Manager at Fidelity Investments, and Francis Gannon, co-CIO at Royce Investment Partners. I'm Jenny Dagenhart with Asset TV.