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HomeMy WebLinkAboutReports - 2020.04.30 - 33118                AndCo Consulting | 201 N. New York Ave. | Suite 300 | Winter Park, FL 32789 | (844) 44-ANDCO | AndCoConsulting.com  AndCo contacted CS McKee (core fixed income), Lazard (international equity), Loomis Sayles (small cap and fixed income), and T. Rowe Price (large cap equity) to enlist their thoughts on the current state of the markets. We posed five questions to each manager; their responses are provided below. Lazard and T. Rowe Price included charts and graphs with their responses; we have also sent their responses for you to review. We have also sent the manager’s individual responses that include graphs and charts. Please feel free to contact us with any additional questions or comments (248.390.0589). Thanks for your continued support. 1. What are your expectations for the US and global economies? How bad is the recession (2 quarters, 3 quarters, or longer)? What does the rebound look like? CS McKee: The difficulties in forecasting the length or depth of this recession center around the uncertainty of the virus’ path. What is the optimal time for social distancing to remain in effect? Will there be a second wave of the virus? When will a vaccine be available? Is the US and other countries developing herd immunity? How much more stimulus will governments continue to provide? What will be the second-order effects from missed payments, bankruptcies, and high unemployment? While these are the key questions that everyone is asking and no one has any confident answers currently, we expect that the recession and recovery will likely be “U” shaped, i.e. there will be a sharp contraction as the economy is shutdown, followed by a period of stagnation at low activity levels while we learn about the virus, and then finally a fairly strong recovery as economies reopen. Stimulus in the US has been large and swift – but mainly replaces lost income – and regions around the world have responded in varying degrees as well. The actions by governments to prop up their economies while enacting social distancing measures will alleviate some of the downturn’s pain. As of now, we appear to be entering the second stage of the crisis as our leaders debate how and when to reopen the economy. If economies are opened too quickly and too fully, the risk of a second peak of infections runs high; reopening the economy too slowly results in further strains on individuals, businesses, and government budgets. A balanced approach that minimizes the reoccurrence of the virus and allows a phased reopening of the economy appears the most likely and optimal outcome at this time. Ultimately, the strength of the recovery will be dependent on robust testing and the development of a vaccine or other therapeutic drugs. Testing will provide much needed data on antibody presence in individuals and a greater understanding of the virus’ true spread rate and death rate. A vaccine, which is likely a minimum of 12 months away, would prove to be the single largest boost to confidence that would remove a great portion of today’s elevated uncertainty. Now that we’ve exhausted the list of caveats, we are currently operating under the assumption domestic economic activity will fall 20% to 25% in the second quarter, followed by a rebound of 4% to 6% in the third and fourth quarters. Full year growth for 2021 should average 4% to 5%. Global To: Oakland County Employees’ Retirement System From: Peter Brown and Chris Kuhn Date: April 27, 2020 Re: Responses from the Investment Managers to Market Questions Responses from the Investment Managers to Market Questions 2   AndCo Consulting | 201 N. New York Ave. | Suite 300 | Winter Park, FL 32789 | (844) 44-ANDCO | AndCoConsulting.com  growth contracts between 2% and 3.5% this year, returning to 3% growth next year. Domestic consumer discretionary spending will gradually improve as restrictions are lifted, people return to work and savings begin to be replenished. Business confidence will follow the same gradual path. Embedded in these forecasts are the assumptions that improvements in therapeutic treatments and that second and third waves of the virus that do not overwhelm the global healthcare system to a greater degree than currently witnessed. We also assume an orderly processing of the surge in personal and corporate bankruptcy filings that are likely occur over the balance of this year. Lazard: In the short-to-medium-term, the progress and policy reaction to COVID-19 will likely be the main driver of the performance of international equities, just as it is expected to with every other asset class. So far, policymakers have been aggressive with both monetary and fiscal initiatives, which could benefit value cyclicals in the long run. While it is tempting to compare the current crisis to the last one, they are quite different. Central banks were ultimately able to control the global financial crisis by pumping massive amounts of liquidity into the system. COVID-19 is not a financial crisis, but rather a profound, sudden demand shock the likes of which the world has never seen, in which millions of people are losing their jobs and millions more are at home, rather than out spending money. While keeping liquidity flowing is necessary, we do not believe it is not enough. Policymakers must also make up for the missing demand in the economy and keep out-of-work people as financially sound as possible to avoid a feedback loop that leads into a prolonged recession when the threat of the novel coronavirus passes. If policymakers successfully bridge the demand gap, it is possible that the global economy can recover relatively quickly once the spread of the virus is under control. Markets are waiting eagerly for a treatment, a vaccine, or simply news that the rate of new infections seems to be slowing in a hard-hit country. Any new developments on this front are likely to continue to drive price movements. Loomis: We believe financial markets are currently in the eye of the hurricane. Global financial markets experienced significant disruptions in March, as the emergence of the coronavirus brought an end to the longest US economic expansion on record. The reaction of policy authorities was unprecedented in both timing and magnitude. The world’s central banks moved immediately to provide liquidity which have calmed volatile markets over the past several weeks. The US Federal Reserve (Fed) cut short-term interest rates to zero, expanded its lending facilities and announced an asset-purchase program that encompassed Treasuries, mortgage-backed securities, municipal bonds and corporate issues. In addition, the US government passed a $2 trillion fiscal stimulus package in late March (the CARES Act). The response was similar overseas, with a combination of accelerated interest rate cuts and a wide range of fiscal measures designed to support growth. While our GDP forecasts are incredibly uncertain given the highly fluid situation, we believe global growth will be deeply impacted in the second quarter of 2020. We anticipate a ‘U’ shaped recovery given the significant impact Covid-19 has had on the services sector, which makes up 70% of global GDP. Normalization of economic activity will be staggered across the US and the world creating a protracted recovery, rather than a quick V-shaped snap back to normal. However, we believe GDP starts to recover by late third quarter. Our 2020 GDP forecasts for major economies is: United States (-5.5%), Euro area (-5%) and China (-1%). The recession, we expect will last at least two quarters and potentially longer if we get a resurgence in virus infections in the summer or fall of this year. That said, we expect a strong recovery in 2021. TRP: We expect the recession to last 2 quarters. Relaxation of social distancing measures are likely to come in 3Q20, which will mean that economic activity increases, and we will see a positive GDP print for the 3rd quarter. However, it is important to note that given the depth of the initial pullback and the expectation that the path back to normal activity will be gradual, we do not expect a recovery to the previous level of GDP in 2020. We may not return to the prior level until 4-8 quarters after the crisis began. Responses from the Investment Managers to Market Questions 3   AndCo Consulting | 201 N. New York Ave. | Suite 300 | Winter Park, FL 32789 | (844) 44-ANDCO | AndCoConsulting.com  We are encouraged by the relative lack of structural imbalances in the U.S. economy going into the crisis (i.e. low levels of consumer debt, modest growth in business capex), as well as the fiscal and monetary stimulus measures that have been quickly put into place. If relaxation of social distancing does not result in a sharp uptick in the spread of the virus, we believe the stimulus measures will allow most businesses to remain solvent (i.e. a “solvency bridge” has been erected) and therefore the much of the spike seen in unemployment will be temporary. As a result, we do expect the shape of the economic recovery to be more V-shaped than U-shaped. 2. What are your expectations for the equity markets? Have the equity markets fully priced in the economic damage? What is your outlook for future earnings? CS McKee: We believe the equity markets (specifically the S&P500) are fairly-to-fully valued in the short-term at current levels. Currently in the 2,850 area, the S&P 500 should hit resistance in the 2,885 to 2,930 range, which should cap the upside for the next month or so. This assumes no breakthroughs with respect to a vaccine or effective therapeutic for COVID-19. The latest revenue and earnings reports, coupled with the frequent removal of forward guidance, led us to revise our outlook for 2020 earnings to a range of $105 - $115, with an expected rebound to $155 - $165 next year. Our mid-year 2021 outlook for the S&P 500 is 3,280-3,360, which assumes earnings levels near the top end of our expected range for next year ($160) and a P/E multiple of 20.5x to 21x. Lazard: Going forward, we expect numerous material negative earnings revisions, particularly in cyclical areas (Exhibit 1). The longer term outlook for earnings is uncertain and will be dependent on the duration of the virus. The performance differential between value and growth stocks has been a headwind to our relative value investment philosophy, in which we invest in companies with an attractive tradeoff between financial productivity and valuation. Yet, despite this headwind, relative performance was broadly in line with the MSCI ACWI ex-USA benchmark. However, we believe the widening gap between the two styles is creating long-term relative value opportunities in both defensive and cyclical value stocks, while reducing opportunities in tech and other expensive cyclicals that have held up relatively well. While central bankers and governments are doing everything they can to ensure liquidity, we still feel that highly levered companies are risky in an environment that has investors seeking safety at all costs. Loomis: (Macro View) Often times you hear the phrase “the stock market is not the economy” and that is proving true. We expect volatility to remain elevated as the downturn runs its course. As of today, April 27th, we believe US equities are priced for a certain level of re-opening that will improve the current operating conditions. At the lows roughly one month ago, the market was pricing a dire economic outlook. We currently believe markets are looking ahead and focusing on a re-opening of the economy and normalized profits in 2021. S&P 500 corporate profits are likely to decline by 33% in 2020, but a 40% rebound is anticipated next year. Similar to the economy, we anticipate 6 or more quarters to pass before S&P 500 earnings reclaim their peak in US dollar terms. (SCG Team) The severe sell off, especially in small cap stocks, and subsequent rebound have all preceded any kind of feedback from companies. This is to be expected, but can also lead to further volatility as investors get more information on how to set expectations around earnings. We would not be surprised to see some of the recent gains off the bottom to be consolidated. We will continue to use the market volatility as an opportunity to buy dynamic secular growth companies that can navigate the macro uncertainty and be capital compounders for many years into the future. TRP: Both the speed of the downturn and subsequent rally have been unprecedented. We think it is wise to question the durability of current market levels, given the uncertainty surrounding the path forward. The peak in daily incremental virus cases combined with improved liquidity were the big catalysts for improvement. For the rally to hold from here, we need the “solvency bridge” to Responses from the Investment Managers to Market Questions 4   AndCo Consulting | 201 N. New York Ave. | Suite 300 | Winter Park, FL 32789 | (844) 44-ANDCO | AndCoConsulting.com  stay intact and successful relaxation of social distancing. Hopefully that is how this plays out, but there will be a lot of potential pitfalls along the way. We expect future earnings to be significantly impaired, given the depth of the downturn. Projections are difficult to make at this point, due to the uncertainty surrounding the re-opening process. How long does it take to get to the “new normal”? Do we have any setbacks along the way? What level of activity does the “new normal” represent? Our best estimate amid this level of uncertainty is that S&P 500 earnings fall by 20-40% for calendar year 2020 relative to calendar year 2019. 3. What are your expectations for the fixed income markets? When do we expect rates to rise? Or will they fall further? How quickly will spreads compress? Is future inflation a concern of yours? CS McKee:  We expect the Fed to be patient with respect to the Funds rate, leaving the current target of 0% to 0.25% in place for the balance of this year. Doing so will lead to a steepening of the yield curve, most notably in the 5-year area. We continue to see value in agency, credit and TIPS holdings, overweighting agencies by 20% or more in intermediate and longer portfolios. Credit and TIPS currently represent overweightings of between 8% to 12%. We expect investment grade corporate spreads, which peaked at 373 basis points in March and currently average 208 basis points, to tighten to the +175 area by year end. The breakeven rates on 5-year and 10-year TIPS are currently 0.7% and 1.10%, respectively, and should widen another 25 basis points over the next 4 to 6 months. We do not believe future inflation is of great concern. Attaining and sustaining an inflation rate above 2% is unlikely in the long run. Lazard: In the past month and a half, some 30 central banks have slashed policy rates, and our experts anticipate that developed market rates will stay anchored near the zero bound for the foreseeable future. Justifiably jittery investors have piled into sovereign bonds even at extraordinarily low rates. As a consequence of this flight to safety and the need or desire to raise cash, spreads on high quality short-duration and floating rate debt, sheltered to some extent against macro volatility, have risen significantly. As sentiment recovers, our professionals expect these and other high quality corporate spreads to tighten again. Some of Lazard’s fixed income strategists took advantage of similar circumstances in the wake of the global financial crisis, abandoning Treasuries entirely in favor of high-quality corporate issuance, and portfolios benefited from credit- spread tightening over several years as the economy regained its footing. Overall inflation as measured by PCE and CPI should remain muted. Although the pandemic-related fiscal and monetary programs have increased debt levels, this debt is unproductive debt from a growth perspective. This is also true of the debt that had been accumulated before the pandemic. Also, the output gap should remain wide, with economies running below potential, which should also be disinflationary, if not deflationary. Our analysts cautioned, however, that the strategy calls for active management on an issue-by-issue basis to determine whether obligors have strong balance sheets, access to the capital markets, and whether the issue itself has long-only institutional market sponsorship and standard lending terms and conditions in its indenture1. Loomis: For the remainder of 2020, US Treasury rates are expected to be range bound with the Fed on hold at zero and aggressively engaged in providing liquidity via multiple purchasing facilities across market sectors. We expect intermediate and longer duration Treasury rates to begin to move moderately higher in 2021. Heightened uncertainty and extreme market volatility caused investment Grade (IG) and high yield (HY) corporate spreads to widen significantly. IG corporate spreads widened over 200 basis points (bps) from ~100 to 370 bps in the month of March. HY spreads widened over 750 bps. However, valuations have come back sharply in both markets. Spreads are currently at levels that our team considers fair, given where we are in the market cycle and our risk premium models. The investment team believes that some caution is warranted here given the sharp rally in risk markets especially since we may not have seen the full extent of economic damage. Responses from the Investment Managers to Market Questions 5   AndCo Consulting | 201 N. New York Ave. | Suite 300 | Winter Park, FL 32789 | (844) 44-ANDCO | AndCoConsulting.com  COVID-19 will have a negative effect on prices in the near-term given lower demand. We could see price pressure rebound later in the year into 2021, especially if demand comes back more quickly than supply. Despite a deal to cut production, oil prices have collapsed due to COVID-19 related demand issues, we expect prices to begin to normalize around $40 later in 2020 into early 2021. TRP: We think it’s very unlikely that rates will rise over the near term. Given the depth of the economic slowdown, the Fed is unlikely to raise interest rates soon. With the Fed “out of bullets” from a rate-cutting standpoint, the Fed is now focused on providing alternative means to support the economy and market liquidity. The rise in debt issuance by the U.S. government in response to the crisis may eventually put upward pressure on rates—but this factor is likely to be overwhelmed by deflationary forces, economic weakness, and a demand for “safe” assets over the near term. Inflation could become a concern if it turns out that we have “over-stimulated”, which would occur if the virus is contained much more quickly than expected. We view this as very unlikely. Over the longer-term, we think most of the factors that have contributed to low inflation will remain in place. Automation and disruption are likely to accelerate. Commodity prices will rebound from current levels (which are extremely low), but we expect the longer downward trend to continue after this initial bounce. Globalization, however, is the one factor that we could see reverse – but we do not expect this reversal to be strong enough to offset the other factors. The timing of credit spread normalization is difficult to predict. Like earnings, this is likely to hinge on the timing and success of the re-opening process. A long process with multiple setbacks would mean more bankruptcies and further bouts of spread widening. However, we do believe spreads have moved to levels that will prove to be attractive for investors with a long-term horizon. 4. What are the biggest risks for investors? What are the best opportunities in the markets? CS McKee: The largest risks we see for investors begins with a resurgence or mutation in COVID- 19. Should the economy resume growth, only to be interrupted by more than just flare-ups of the virus, would strain global governments’ ability to sustain growth and income and impart greater damage to business and consumer confidence. Fundamental valuations on risk securities would suffer, exacerbated by declining market liquidity and spiking volatility. On a brighter note, we believe the domestic credit market to be attractive at current valuations. Despite the rapid improvement in yield spreads, hedged U.S. dollar securities trade at a discount to European and Asian market securities, inviting increased sponsorship from overseas investors. Looking several years forward, emerging market equity performance should outpace that of domestic entities, though with greater volatility. Lazard: Specifically, as it relates to the Lazard International Strategic Equity (ACW ex-US) that we manage for Oakland County Employees’ Retirement System, the portfolio team has concentrated first on adjusting exposure to aviation and to weaker balance sheets, and then on taking advantage of what they view as significant opportunities thrown up by the market falls. Broadly, the team sees three types of idea emerging. a. The first is in resilient businesses, including some utilities, caught up in the general market downdraft. b. The second is in high-quality companies with strong returns and market positions, but which are seeing a sharp short-term impact from this crisis. These may be related to aviation, but also to consumer spending more broadly, and to commercial services. c. The final category is in more traditional ‘value’ categories such as autos, energy and financials, whose valuation dispersion from growth companies has become even more stretched in the sell-off. These stocks will be more dependent on the shape and strength of the economic rebound. Responses from the Investment Managers to Market Questions 6   AndCo Consulting | 201 N. New York Ave. | Suite 300 | Winter Park, FL 32789 | (844) 44-ANDCO | AndCoConsulting.com  Loomis: We believe a deepening or resurgence of the Covid-19 crisis is one of the largest risks which would lead to further economic contraction, higher unemployment and significant downward pressure on asset prices. Both IG and HY corporates have moved further along in the credit cycle from the expansion phase into downturn. Outlooks for margins and corporate leverage have worsened as prospects for growth have declined and we are expecting losses from credit migration to rise with increases to downgrades and defaults. Aggressive fiscal and monetary stimulus have helped limit the damage but the future credit trajectory will depend on the timing and speed of the economic recovery after the virus is deemed sufficiently under control. We believe the current spread widening presents a very attractive long-term investment opportunity. We have been taking advantage of price volatility and providing capital to an illiquid market. We are focusing on issuers with strong balance sheets, adequate liquidity, and leaning on our invaluable credit research analysts to pick the right bonds, right issuers, and sticking with our foundational investment tenets during this volatile time. The new issue market has been very robust as companies are issuing debt to raise their cash balances due to the uncertainty surrounding the length and magnitude of the economic shut down. The majority of companies issuing debt have been “blue chip” high quality names from very diverse industries. We have been able to participate in dozens of new issues at very attractive levels. As we enter the recession, we will see additional stress on investment grade corporates and may see many more names downgraded to below IG. We have already witnessed numerous downgrades from IG to HY and we are expecting more in the coming months. Although we may see names currently held in the portfolio downgraded, we also see fallen angels as a potential buying opportunity. Historically, fallen angels have represented great value opportunities. The downgraded bond spread tends to widen significantly due to forced sellers once a name falls out of the index, and they usually don’t stay at those levels for long. ABS markets are also looking more attractive and new issues have just started to come back to market. Announcement of the TALF 2.0 program has provided support to this sector. Similarly, CMBS markets look more attractive here as well. The first CMBS conduit deal will be coming to market this week. TRP: We think the biggest risk for investors from an asset allocation standpoint is a lack of diversification. We believe a recovery is coming, but the timing remains very uncertain. When markets become convinced that there is a clear path to recovery, we believe the hardest hit areas of market will rebound the strongest—likely led by small cap equities, value equities, and high yield debt. However, these are also the areas that will be most at risk if we experience setbacks to normalization. As a result, we think it is wise to have exposure to these areas but not hold significant overweights. 5. Would the government have been better off temporarily enhancing unemployment benefits than creating business loan programs? Explain. CS McKee: In our view, the creation of business loan programs and the enhancement unemployment benefits were two complementary actions that are necessary to support the economy through virus containment measures. By providing loans to businesses – primarily through the SBA’s $670bn Paycheck Protection Program – the Federal government strives to ensure that the small businesses who employ roughly 47% of the US population will still be around once the economy reopens. Assisting businesses to maintain their payrolls and help meet monthly expenses (loans are forgivable if used to retain workforce at current compensation and pay mortgage, rent, and utilities, but 75% of loan must be for payroll) will also keep many workers off of state run unemployment insurance programs. Many states are constrained by balanced budget legislation and a growing population of unemployed would severely strain the state’s finances. Responses from the Investment Managers to Market Questions 7   AndCo Consulting | 201 N. New York Ave. | Suite 300 | Winter Park, FL 32789 | (844) 44-ANDCO | AndCoConsulting.com  While many small businesses will still fail during this time and workers will be let go, the enhanced unemployment compensation plus additional stimulus checks to certain households will help individuals bridge the gap while the economy remains shut. Together, both programs look to support businesses so that there are jobs still available once the economy reopens and that individuals can meet their liquidity needs if they are out of work. Maintaining liquidity for businesses and individuals will help to prevent further knock-on effects of missed payments and bankruptcy. Lazard: The current situation is unprecedented. The US and global economies have entered a very sharp, very deep recession that is the result of deliberate policy to shut down the economy. The Congressional Budget Office (CBO) projects that US real GDP will contract by an annualized 39.6% in 2Q 2020 and that the unemployment rate will average 16% in 3Q 2020. Much is uncertain about these and other forecasts: How will COVID-19 behave? Will policymakers be able to relax physical distancing policies without a resurgence? How much will they be able to relax, and for what activities? What will be the lasting impacts on public psychology and different parts of the economy? The shape of the recovery from the current recession will depend on the answers to these questions, as well as economic policy support: first, to provide relief while policymakers shut down the economy; and then to stimulate activity when it is safe to do so. We believe policymakers were right to both enhance unemployment benefits and create business loan programs in the Coronavirus Aid, Relief, and Economic Security (CARES) Act enacted on 27 March 2020. There are valid concerns that two may work at cross purposes in some instances: extending forgivable loans to small businesses to incentivize their keeping employees on payroll while also making unemployment more attractive. We believe these concerns are overwhelmed by the need to rapidly ease financial distress and to ensure that businesses make it through this very difficult period and are able to contribute to the eventual recovery – particularly small businesses that can be financially vulnerable and account for ~50% of total employment. Looking ahead, we believe it is positive that the Small Business Administration’s Paycheck Protection Program was replenished after being exhausted, with another $321 billion in the Paycheck Protection Program and Health Care Enhancement Act enacted on 24 April 2020. There have been concerns with the program’s execution and oversight. We hope that measures like those included in the new Act help ensure that more of the forgivable loans reach businesses with less access to the banking system. We also believe that more funding for states and local governments and for enhanced unemployment benefits will be necessary.2 Loomis: Ultimately we believe US fiscal transfers to consumers and businesses will prove effective. The fiscal policies created by this administration were aimed at re-opening the economy as fast as possible once it is safe to do so. Ideally the loan programs will allow businesses to bring employees back to work with little time wasted once the economy re-opens. The broad lockdown and shelter in place order are two factors specific to this downturn that are unlike anything seen in modern history. The US government made efforts to ensure that Americans could make ends meet without encouraging excessive consumption outside the home. TRP: We think the small business loan program (i.e. the Payroll Protection Program) is a good policy because it essentially combines both concepts. In order to keep the “solvency bridge” intact we need to support both small businesses and their employees. The PPP provides loans to small businesses that are fully forgiven if the business uses 75% of the proceeds to pay employees. It allows businesses to stay solvent while paying their employees. We think this is a wise approach.