Unprecedented Precedent

On March 23, we wrote about the impact of the COVID-19 virus on society, the global economy and financial markets, and how it was unprecedented in every facet: the speed at which the virus shut down entire countries and economies; the speed at which financial markets were repricing every asset class, and the extent to which central banks and governments were likely to respond.

We went on further to say, “…from a longer-term perspective, these episodes of pronounced volatility tend to lead to attractive buying opportunities. This time should be no different although the timing is difficult. After all, the financial market fallout is a symptom of the broader COVID-19 health care crisis that has overwhelmed the entire global healthcare system and economy. Our view remains that there will be tremendous buying opportunities. We are not there yet, but we are getting close”.

A lot has happened in the last month. The pandemic itself has not ebbed whatsoever and even today, opinions as to when cities, states, provinces, countries will “reopen” vary widely. It is certainly not going to be a one-size-fits-all solution. The same can be said for central banks and governments, in terms of the global pandemic response. Certainly not one-size-fits-all, but in the aggregate, the response will not be simply unprecedented, it will be nothing short of spectacular.

Programs from the U.S. Federal Reserve (the Fed) keep coming: at this point, they total around $6 trillion or 28% of U.S. Gross Domestic Product (GDP). The programs target various sectors of the economy, with $2 trillion of direct stimulus (10% of annual GDP) to help households and small businesses and $4 trillion of quantitative easing (QE4) asset purchase programs targeting asset classes that include corporate bonds, corporate bond ETFs, certain high yield bonds and municipal bonds. That is in addition to the existing treasury and mortgage-backed securities (MBS) purchases and, as such, will drive the Fed’s balance sheet to 30% of GDP. As amazing as this is, it is not farfetched to think that more is to come. In fact, just this morning (April 22) Congress added another $480 billion to the Payroll Protection Plan (PPP) for small businesses and promised substantial extra funding for hospitals and testing.

In Canada, the overall response is perhaps less dramatic than in the U.S., but it is unprecedented nonetheless. Ottawa is spending nearly C$300 billion on direct stimulus like wage subsidies and unemployment benefits as well as other stimulus aimed at business lending and tax deferrals. Regarding asset purchases, the Bank of Canada (BoC) will be buying approximately C$73 billion of Canadian government bonds, C$50 billion of Provincial bonds, and $10 billion of investment grade corporate bonds. This will push direct stimulus spending to nearly 17.5% of GDP and the BoC’s balance sheet will balloon to 25% of GDP from around 5%.

The market response to these programs has been fairly strong, and most risk assets are well off their low valuations for the year—that is, aside from crude oil, which is another crisis and a story for another commentary. Equity markets have bounced back 22-24% from their lows on March 23 and are now down for the year by 15-17%. Investment grade corporate bonds (using the larger U.S. market as a guide) are 12% above their March lows as spreads have narrowed from 373 bps to 214 bps. Year to date (YTD), credit is up about 1%. In high yield, returns are 13% above their March lows and down 9% YTD. High Yield index spreads, which reached 1,100 bps in late March, stand at 768 bps in late April.

The performance of our funds has improved nicely over this period. We estimate that our average strategy has trimmed the YTD underperformance by one third to one half. We expect that there is more recovery to come, but do not and would not expect it to come in a straight line extrapolated from what we have seen over the last four weeks. There is continued uncertainty around the pandemic and what it means for “opening things up”, so any forecast around economic activity or the ultimate path forward should be taken with a large grain of salt.

We continue to expect rates will stay low for the foreseeable future. The slowdown in economic activity, together with the oil price shock, will weigh on inflation metrics for some time. Longer term, with the rampant government deficit spending, we do worry about both inflation and higher rates. But that is not today’s story. We also still want to be net long the U.S. dollar. It acts as a hedge to risk assets when markets sell off and volatility rises. We also believe that the Canadian economy is likely to fare worse than the U.S. going forward.

Regarding credit, we have monetized or rolled off all our Credit Default Swap Index (CDX) investment-grade and high-yield credit put option positions. While they were helpful in terms of providing protection, the magnitude of the move overwhelmed our strategies’ expected volatility ranges. In other words, we did not position the hedges as protection from a 10 standard-deviation event; they were targeting more normal risk-off market environments.

We have been buying credit opportunistically in both the new issue and secondary markets. Many new issues have been priced extremely attractively and have performed well. Security selection is going to be doubly important in this environment as we enter a period of potential downgrades by rating agencies; the onset of a new default cycle in the high yield and loan markets; a record- breaking increase in “fallen angels”; and the possibility of a rapid revaluation of assets and business models in response to changing consumer and business behaviour in the post-COVID world. In this uncertain context—one in which a rising tide most certainly does NOT lift all boats—we believe that prudently managed active portfolios like ours, with access to the broadest possible universe of diversifiers, and where decision-making processes are rigorous and based on the best fundamental and quantitative research available, are the ones that are most likely to shine.