Five Key Observations for the Economy, Equities, and Fixed Income in Q2 | Lord Abbett
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Market View

A lasting recovery in risk assets doesn't require a very strong economic recovery, in our opinion. What we believe it requires is that investors start to see some light at the end of the tunnel.

On April 16, 2020, Lord Abbett hosted a webinar for investment professionals that provided macroeconomic and investment insights into the current investment landscape—one of the most turbulent periods in global financial market history. This week’s Market View presents selected highlights from the discussion. We encourage you to listen to a full replay of the event

The Geometry of Recovery
Giulio Martini, Partner and Director of Strategic Asset Allocation

“We are in the midst of an unprecedentedly negative global economic shock caused by a health care crisis, the COVID-19 pandemic. The fundamental dynamic is that, at least for now, the stress on the health care front is making the economic downturn worse.

“To try and counterbalance that and provide some relief, the United States has put into place extremely large monetary and fiscal programs—in an attempt to cushion the first round effects of the economic downturn and stabilize the economy. The key question now is: Will those programs eventually support a full economic recovery?

Observation 1: History shows that an economic recovery doesn’t have to be powerful for risk assets to rally.

“The geometry of the eventual economic recovery – whether it is V-, U-, or L-shaped, or some combination—is yet to be determined, but doesn’t matter as much as many investors seem to believe, in my opinion. In fact, history shows clearly that an economic recovery doesn't have to be powerful [i.e., V-shaped] for risk assets to rally.

 

Figure 1. Historically, With One Exception, U.S. Stocks Have Rallied Strongly Before a Recession Ends.

Source: National Bureau of Economic Research, Bloomberg, and Lord Abbett. “Real Stock Prices” are as adjusted for inflation. First column = the date the S&P 500 Index hit bottom. Second column = the date of the lowest point of the recession. Third column= the number of months between the bottom of the S&P 500 Index and the bottom in the economy.  Fourth column = the magnitude of stock market rallies. Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

“Figure 1 shows real stock prices [as represented by the S&P 500® Index] around business cycle troughs. In every case except one, stock prices hit bottom before the economy hit bottom.

“And in the fourth column, you can see the magnitude of the rallies—on average, a 15% rally between the bottom in stocks and the bottom in the economy. The key point is that in some of the weakest recoveries we've ever had we've actually had some of the strongest rallies in stock prices.

“In fact, risk assets started to rally not when the economy hit bottom but when investors could start to see light at the end of the tunnel for the economy, about three to four months before the absolute bottom. Are we there yet? Is the worst behind us? Well, that's not something we can give a definitive answer to at the moment.

Observation 2. One of the catalysts for a rapid recovery, consumer spending, was hurt by the economic shutdown.

”Certainly the unprecedented level of monetary and fiscal support contributes to a hope that we could see an early recovery. But the current recession could also easily top the worst part of the 2008-2009 recession. Part of the reason is in Figure 2, which looks at the average U.S. recession, and two very severe recessions: 2008-09 and 1974-75. Figure 2 shows that, typically in a recession, including the two that I've singled out, U.S. consumer spending on services has been the key factor cushioning the economy during the downturn.

 

Figure 2. V-Shaped Recoveries Have Been Driven by Strong Consumer Spending.
Contribution to U.S. GDP growth (SAAR)* in the first half of U.S. economic recoveries

Source: Bloomberg. SAAR=Seasonally adjusted annual rate.

 

“Unfortunately, we’ve shut down much of the consumer economy—restaurants, entertainment, sporting events, to some extent universities and schools. So consumer spending is actually leading the downturn this time around. And there are some very good reasons why consumer spending may not be picking up any time soon, even as lockdowns are phased out, suggesting to some that we are in for an extended bear market.

“For one, rapid viral transmission may resume when aggressive social distancing ends. And that's going to cause businesses to be very cautious, even when we start to increase the number of people who go back to work and start to open up a lot of service establishments again.

“It's also entirely plausible that people could choose to increase precautionary saving in response to the shock and the huge uncertainty that's been created by the health care crisis and the blow that it's created in the economy and the increase in unemployment.

“There’s also likely to be a period during a recovery of constrained spending and trying to rebuild balance sheet strength. The increase in unemployment insurance payments, the lump sum payments to households, and the aid to businesses—all have a due date that's pretty close in the future. When those programs roll off—after the economy stabilizes, it's going to hold back economic activity and consumption.

“So I think there are quite a few, what I find to be, pretty convincing arguments to suggest that this is not going to be a powerful economic recovery. More like something between a U and an L than it is like a V. But we believe that is not the key issue for risk assets and for markets. The key issue, in our opinion, is not how strong the recovery will be or what shape, but how and when we get there.

“Nonetheless, there are reasons for cautious optimism. Massive resources are being spent to develop a vaccine and to provide therapeutic treatments and tests. We think these efforts will reach fruition ultimately, permitting a lasting economic recovery to begin. And, as I pointed out earlier, a huge amount has been done on the fiscal and monetary side to limit the secondary financial distress that could make the economic downturn even worse.

“In that respect, I think there's a case to be made that we have gotten the necessary assurance and support from policymakers and from the health care system, along with the corporate and public entities that support that system. We could still see a rapid recovery. Or we could still see an extended bear market. It’s just too early to know which is more likely. At any rate, for investors, it’s important to remember that markets tend to recover before the economy gives the all-clear signal.

Positioning Portfolios in This Environment
Tim Paulson, Investment Strategist

“Given the uncertainty in the economy, we've seen some historic moves in asset prices—both in equities and in credit. So how should investors think about positioning portfolios in this environment? Markets, as Giulio just highlighted, tend to be forward looking. That seems to be something that the financial media forgets, as illustrated by the headlines claiming the recent market rally doesn’t make sense because the economic data, such as the unemployment numbers, are so negative. Needless to say, the market had already priced in that data and was moving on.

“Nonetheless, there's a lot we don't know—in terms of how this pandemic will play out, the extent of the economic shutdown, and the shape of this recovery. The one thing we do know is that policymakers are being very aggressive, helping to build a bridge from the period of shutdown to whenever it ends and to make sure that as much of the economy as possible remains intact and able to ramp back up as quickly as possible.

Observation 3. Global companies and banks were hoarding cash.

“One very critical part of the economy and of markets in general is short-term credit, and the Fed [U.S. Federal Reserve] is determined to support it. During the height of the current volatility in March it became apparent that companies and banks around the globe were hoarding cash (particularly the U.S. dollar) and cash-equivalents.

“Figure 3 offers a snapshot of what we saw happening at the end of March. We’ve seen some recovery since then. The yield between ultra short credit instruments and U.S. Treasury bills diverged to historical levels in a very short period of time. Suddenly, investors were getting significant spread, or yield higher than Treasuries, in instruments with very low credit risk.

 

Figure 3. In March, Ultra-Short Bonds Were Offering Excess Yield with Very Low Credit Risk.
Bloomberg Barclays & ICE Data Indices, LLC. (Data from December 31, 2013-March 27, 2020)

Source: Bloomberg Barclays & ICE Data Indices, LLC. 1Bloomberg Barclays USFRN <18mos. 2Bloomberg Barclays 3 Month U.S. T-Bill Index. 3ICE BofA ABS 0-3 yr Fixed Rate Index. Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

“This was a divergence that had nothing to do with the financial viability of some of these companies. It simply reflected the fact that investors needed to sell securities to raise cash, and often the safest and shortest instruments are the easiest assets to sell. The redemptions out of money market funds were a perfect example of that flight to cash.

“One major difference between today’s market and the problems in 2008 is that we see no concerns about systemic risk in the financial system. In many ways, the banks are as healthy as they've been at any point in many of our lifetimes. So that's not where the stress is coming from. Instead now what we're seeing is that banks don't have as much balance sheet to be able to lend to one another, in part because of some of the safeguards created in the wake of the 2008 financial crisis. That means there's still a lot of blockage in the system when it comes to cash and liquidity that's impacting asset prices.

“The divergence between some of these asset classes from Treasuries will likely recede over time. And that convergence will be the result, in large part, of the measures the Fed has undertaken to get liquidity back into the system. That means we can at least have confidence that some of the shorter-term asset classes are not going be buffeted around going forward like they were in March. So, short-term credit is likely to be an area where we continue to see a return to normalcy in markets.

Observation 4. Markets were pricing in a probability that more than half of high yield companies would be gone in five years.

“One way to quantify the negative economic outlook that markets were pricing in can be observed in Figure 4. We had a period in March where markets were pricing in a probability that more than half of the companies in the high yield universe would be gone in five years. That's pretty extreme. We've never seen a default rate like that before. As Figure 4 shows, during the financial crisis of 2008-09, the peak number of cumulative defaults over a five-year period was just above 20%, and in 2000, not quite 30%.

 

Figure 4. High Yield Spreads Had Already Priced In a Severe Default Outcome.
Implied cumulative default analysis (data as of December 31, 2019)

Source: Moody’s and Lord Abbett. Data most recent available. Implied cumulative default analysis assumes 5 year term and 30% recovery. Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

“In light of that, does a 50% default rate in the current recession make sense? Could this be a good entry point to get in the high yield market? These are questions investors should be asking themselves.

Observation 5. Small caps and innovative growth stocks may be compelling opportunities.

“Small cap stocks have had a rough go of it for many years now, lagging mega caps considerably. Investors who believe the recovery has begun may want to consider small caps as a way to express that view.  Historically, they have performed extremely well coming out of bear markets, and with the Fed rolling out their Main Street lending facility, which is dealing with smaller, mid cap companies, they are now able to tap into this extraordinary governmental support. You can see in Figure 5, that small cap companies (and frankly, a lot of these are the ones that are making up the high yield index) tend to bounce back very sharply after a recession.

 

Figure 5. Historically, Small Cap Stocks Have Performed Extremely Well Coming Out of Bear Markets.

Source: Furey Research Partners and Factset. *Average and % Positive figures for forward periods exclude first quarter 2020.Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the effect of fees and expenses, and are not available for direct investment.

 

“Given all of the stimulus, and the potential recovery that may arise from it, small caps are a very interesting way to think about re-entering the stock market.

“Another interesting angle for re-entering the market is by investing in innovative and disruptive kinds of industries—a growth trend that has already been in place for some time. Some of the changes being created in this COVID-19 era may be accelerating these trends, with both short-term and long-term ramifications for such areas as e-commerce, cloud technology, virtual empowerment, and biotechnology. Long-term investors who are trying to figure out how to stay invested in volatile markets, but be positioned for the potential of both short- and long-term success, may want to re-think traditional growth/value tradeoffs by investing in some of the potential winners from permanent changes that we can expect to see going forward.

 

The views and information discussed in this material are as of March 31, 2020 unless otherwise indicated, are subject to change, and may not reflect the views of the firm as a whole. The views expressed are at a specific point in time, are opinions only, and should not be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general. Information discussed should not be considered a recommendation to purchase or sell securities.

The information in this presentation is only for illustrative purposes and is intended to provide general investment education and is not intended to provide legal, tax or investment advice. It is not intended to be relied upon as a forecast or research regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment or serve as a recommendation or offer to buy or sell securities.

Risks to consider: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk. Credit risk is the risk that debt issuers will become unable to make timely interest payments, and at worst will fail to repay the principal amount. U.S. Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

Credit Quality Ratings range from AAA (highest) to D (lowest). Bonds rated BBB or above are considered investment grade. Credit ratings BB and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.

Glossary of Terms

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point). .

A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.

The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

The Russell Top 200® Index measures the performance of the 200 largest companies in the Russell 1000 Index, which represents approximately 68% of the total market capitalization of the Russell 1000 Index.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

The Bloomberg Barclays 3-Month U.S. Treasury Bill Index is a component of the U.S. Government Index, which includes public obligations of the U.S. Treasury.

The Bloomberg Barclays Capital US FRN < 18 Month Index is a subset of the US Floating-Rate Note (FRN) Index, which measures the performance of USD denominated, investment-grade, floating-rate notes across corporate and government-related sectors.

The ICE BofA ABS 0-3 Year Fixed Rate Index measures the U.S. asset-backed securities in three subsectors: credit and charge cards, autos and utility.

ICE BofAML Index Information:

Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofAML INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofAML INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD ABBETT, OR ANY OF ITS PRODUCTS OR SERVICES.

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

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