September 11, 2020
Another market high, with expectations for a “V”accine-shaped recovery.
On September 3, we sat down with Dominic Nolan, senior managing director of Pacific Asset Management, to get his insights on the markets’ performance in August, sectors impacted by the pandemic, and opportunities in fixed income.
Can you give us your thoughts on the stock market’s performance in August?
August continued the upward trend we’ve seen since late March. When you look through the August performance, the S&P 500® index was up a little over 7% and closed August up 9.7% year-to-date—led again by the Russell 1000® Growth Index. That part of the market was up over 10% and closed August with a year-to-date return of 30.5%. It is unbelievable, right? The Russell 2000® Value Index, which has been the laggard, was up a little over 5% in August and for the year remains down almost 18%. The pandemic continues to serve as a digital accelerant, benefitting large technology companies.
Also in August, Apple became the first company to reach a $2 trillion market cap, resulting in a weighting of 6.5% in the S&P 500. That broke a record held by IBM in the early ’80s (At its height, IBM represented 6.4% of the S&P 500). Apple’s $2 trillion market cap represents about 98% of the Russell 2000® market cap. So Apple by itself is almost as big as the Russell 2000. Staggering in my opinion.
What about fixed income?
High yield was up about 1% in August and is up 1.6% for year-to-date. While last month was above coupon, we certainly saw credit slow down. Loans were up 1.5%, slightly better than high yield, but remain down about 1.3% year-to-date.
Investment-grade credit was down 1.25%. Long credit was down more than 3%, but year-to-date, credit is up 6.7%, with long credit up 8.5%. There are a couple of factors to consider. There was significant issuance in the market as companies once again sought more liquidity. Additionally, with markets rallying on reopening expectations, Treasury yields climbed. As a result, there was some rate pressure and supply pressure.
Any shift in the Federal Reserve’s (Fed) stance in August?
The biggest news out of the Fed last month came from the annual Jackson Hole Economic Symposium. Even though nothing really changed in relation to their actions, there was a shift in long-term strategy. The Fed implemented average-inflation targeting, which provides more flexibility to stay accommodative.
To give you some context, the Fed didn’t raise interest rates after the Global Financial Crisis until December 2015. So it took seven years for the central bank to lift rates off of zero after the crisis. At that time, the narrative was “we’re going to normalize policy.” This was when unemployment was 5%, and the Consumer Price Index was less than 1%.
So if the Fed had embraced their recently announced strategy back in 2015, it probably would have meant that they wouldn’t have raised interest rates—and there is an argument that they may not have raised rates for years. Most of the media are saying current rates will remain through 2021 or 2022, but the experience from the Great Financial Crisis indicates that they will stay low for much longer.
Where do we stand with liquidity?
There’s certainly liquidity in the marketplace. The Fed’s balance sheet as a percent of the Bloomberg Barclays U.S. Aggregate Bond Index is now over 30%—one owner for 30% of the investment-grade bonds. If you think that sounds high, the European Central Bank balance sheet as a percent of the Euro aggregate is almost 60%. So how big can central bank balance sheets get? Essentially, Europe’s central bank represents almost two-thirds of investment-grade European bonds and their rates are negative. So there’s argument our Fed can certainly increase its balance sheet substantially higher, resulting in further declining rates.
Does this mean more inflation is on its way?
Let’s hope. There hasn’t been a developed economy that has figured out how to reflate in over 30 years. And I’ve always felt that Ben Bernanke, former Fed chair, knew it deep down that containing inflation is not the real challenge, creating it is. I think Janet Yellen, another former Fed chair, knew it as well. I think current Fed Chair Jerome Powell knows it. And they’ve thrown so much at this challenge and still aren’t able to get the right mix of growth and inflation.
It seems to me the Fed is blamed for pretty much everything, but you can’t create demand with what they do. The Fed has done their job as it relates to liquidity. Whether you agree that the amount of liquidity is right or not, that’s up for debate. But I think there are other problems that reflect demand the Fed can’t control, and they can’t force banks to lend. There are other factors that will contribute to inflation.
Net-net, certainly when you throw more money at things, it should be, in theory, inflationary, but there are many other things that are getting in the way of that inflation-and-growth equation. I would say, “Let’s hope we get a little inflation.”
What interesting trends do you see within sectors?
I’ll start with gaming in Vegas. The Las Vegas Convention and Visitors Authority reported in July year-over-year Las Vegas auto traffic is down 10%, which isn’t much. People are more comfortable driving, they are getting on the road, and they are staying in hotels. Occupancy is not down much.
Revenue-per-available-room, or RevPAR, is down 60%. Some of the reasons people are traveling are it’s cheaper, they’re getting discounts, and they get more for their money in Vegas. The part that is troubling is convention attendance is down 100%. Air traffic is off 65%. And that’s where you get into the struggles. Families are still going, people are vacationing more by auto, but the business element of the equation is significantly down, which flows through to air travel, convention attendance, RevPAR and certainly profitability.
You mentioned air travel. How are the airlines doing?
Traffic remains down about 70%, according to recent TSA checkpoint travel numbers. Airlines announced potential layoffs. The CARES Act moratorium for layoffs expires at the end of September, so you’re seeing the announcement of about 16,000 planned layoffs at United Airlines and about 17,000 at American Airlines. With the CARES Act moratorium expiring five weeks before the election, I’m of the camp that the airlines will be trying to strike a deal for more government funds: “We won’t lay off these folks if you give us money.” I absolutely think that’s the play for them in October. We will see.
Housing is a sector that’s of interest to many. What are you seeing?
Housing is, in a nutshell, crushing it. Let me lay out some numbers from the U.S. Census Bureau first going back to 2005, so pre-financial crisis. When you think about demand, assume typical demand in the U.S. is in the range of 1.5 million homes per year. In 2004 and 2005, during the rise of the housing bubble, the U.S. was building 2 million homes annually. So there was ample home supply when the financial crisis hit. The post-crisis reset from building 2 million homes a year down to about 600,000 homes a year. Since then, we’ve ramped from 600,000 to about 1.3 million.
So for the past 10 to 12 years, we’ve been flushing out the supply made in the ‘04, ‘05 range, but we still haven’t built enough homes to match annual demand—1.5 million. So you’ve had this lack of supply that’s been building over a decade. Now rates are down, making the cost more affordable.
You also have millennials who are entering their home buying years, and middle-class professionals who haven’t lost their jobs and are looking to buy.
We now have many people working from home, which the homebuilders are calling “nesting.” People are spending more time in their homes, and they want a nicer place to live. They are also more inclined to work remotely, so they’re more flexible in where they live. The nesting dynamic is really impacting suburbia. They’re not really building in the cities due to land constraints, and most new homes are in the suburbs. Now throw in artificially suppressed supply because of the government mandate stopping foreclosures or evictions.
Back in February and March, the belief was that new home sales were going to be weak because of the economy. This transitioned to pent up demand fueling purchases in late spring, but widely viewed as a short-term spike. Mentality has now shifted to the notion that home sales might be in good shape for the foreseeable future. You’re certainly seeing a tailwind for housing and homebuilders.
Finally, what are your thoughts on opportunities in fixed income?
On the high-grade side, we had a lot of supply in August—it was the most amount in any August in history. At the same time, you’re seeing defaults rise within high yield. Looking at defaults from year-to-date standpoint, retail accounts for 20% of the default volume—that’s the highest. Energy is about 16%. Leisure/entertainment stands at about 8%. So those three sectors give you 40 to 50% of the defaults, according to our analysts’ research.
Credit markets started to slow in July. Meanwhile, the S&P 500 reached a record high on Sept. 2, and I’m of the camp that credit tends to be ahead of equities. Now you’re seeing the S&P 500 fall a little bit. Spreads are still wide on the high-grade side. I feel you have a little more to squeeze there.
Let’s be honest. The opportunity is less than it was over the past few months, but now the role of credit and general fixed income is going to be around providing a hedge from equity volatility, some total-return opportunities with spreads being wide, and for high-yield yield (which was a 5.3% yield as of two days ago), current income. With regard to high yield, higher quality high yield is a more comfortable risk-return. Many of the lower-rated high-yield issuers simply have too much debt and will probably not get through this period, resulting in further defaults. Implied defaults and forecasted defaults are now in similar ranges. We’ve used forecasted defaults versus implied defaults since March as a measurement of dislocation, and implied were significantly higher, meaning the bond markets were pricing in a much worse scenario than what will probably happen. Now the bond markets are pricing in a slightly worse situation than what is being forecasted, which makes sense given how far things have come.
Pacific Asset Management LLC is the sub-adviser for the Pacific FundsSM Fixed Income Funds. The views in this commentary are as of September 3, 2020 and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Any performance data quoted represents past performance which does not guarantee future results. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Sector names in this commentary are provided by the Funds’ portfolio managers and could be different if provided by a third party.
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