Reopening and Rebound?

Pacific Asset Management's Dominic Nolan gives his views on the market.


On June 5, we sat down with Dominic Nolan, senior managing director of Pacific Asset Management, to get his insights on the current state of the economy and markets amid the Covid-19 pandemic.

Where is market liquidity currently?

When you think about it, the economy has gotten worse over the past two to three months, but what’s improved substantially is liquidity. We’ve gone from almost no liquidity to arguably excess liquidity. The Federal Reserve (Fed) balance sheet is now $7.1 trillion—remember we entered this year with a Fed balance sheet under $4 trillion. According to Bloomberg, projections are for the Fed balance sheet to be over $9 trillion by year end.

Along with that, the European Central Bank’s balance sheet is $5.6 trillion and expected to be close to $7 trillion at year end. Combined, it’s close to $13 trillion on the balance sheet with year-end projections of $15 to $16 trillion, according to Bloomberg.

How are the Fed’s corporate-credit facilities working?

The “signalling” effect by the Fed has been tremendously effective, though not a single bond has been purchased through the primary or secondary market corporate-credit facilities. The Fed has started buying exchange-traded funds (ETFs) at a pace of around $250 million a day. Thus far, they have purchased close to $4 billion of credit ETFs. I think there’s a bit of trepidation from companies that are worried about a negative stigma. Plus, there doesn’t seem to be a need for it right now.

And individual company issuance?

There has been $1 trillion issued in investment-grade debt this year. To give a little perspective, in 2019 we didn’t cross that mark until October. So here we sit in June, with a global pandemic, catastrophic gross domestic product (GDP) number coming for the second quarter, and corporations still have significant access to liquidity.

When you look at today versus three months ago, there are a couple of interesting data points. Let’s start with Amazon, which recently issued three-year bonds at 40 basis points. When you add up their cumulative coupon for that issue, they’re going to pay 1.2% in interest over three years. These are getting to be all-time lows on the short end.

In mid-May, Royal Caribbean issued three-year bonds priced at 11.7%. In early June, they issued additional bonds at just over 9%. In less than 30 days, they were able to issue more debt at 2% less. If you were to come in and buy those mid-May bonds, your investment would be up over 8 basis points.

Another data point: Limited Brands issued five-year bonds this week priced at 6.87%. We find that interesting because they were a weak retailer going into this, and obviously Covid-19 has accelerated that weakness, yet they were still able to issue debt even though a lot of their stores have closed. To put into perspective how far we’ve come, on March 20, Bank of America had short-duration debt that traded at 6%.

How do you see the economy’s macro picture?

At this point, I think the general view is direction matters over levels. Most of the data coming in shows the economy coming off the lows. Today’s job number is a significant surprise. Just to give you some context, per the U.S. Department of Labor, economists were expecting the unemployment number to increase close to 20%, an 8 million job loss. The job’s number came in today with a 2.5 million increase. All in, the delta was over 10 million jobs.

The recovery started earlier than most economists predicted. I would say the rebound, thus far, has been surprising to the upside, and the velocity is better than we’re seeing coming out of China. The macro direction seems to be overwhelming the fundamental story.

What about the health of the sectors hurt the most by Covid-19?

Generally better. According to our analysts’ research, on May 1 casual-restaurant revenue was down 75% year-over-year, and now they’re down approximately 40%. Fast food at its low was off 35% year-over-year, and now it’s down 5%. Lodging was down 80% at the beginning of May, and now it’s off 60%. Down 60% is obviously still a large hole, but the direction is constructive. Clothing spending went from down 45% in the beginning of May to off 20% today. Furniture, which was flat May 1 and is now up 20% year-over-year.

Conversely, groceries were up over 20% at the beginning of May, they’re up only 10% now. According to Bank of America, on April 29, total credit-card spending was down 21% year-over-year; by May 29, total credit-card spending was down 9%. The laggards that we haven’t seen pick up meaningfully are travel and entertainment with large gatherings still on hold. Airlines are significantly depressed, but we’re beginning to see a pickup there.

The Atlanta Fed predicts GDP growth for the second quarter to be negative 53%! I thought minus 10% GDP growth would be stunning. Negative 53% is an unbelievable number. Conversely, the S&P 500® index is up 21% so far in the second quarter. So there’s a massive gap between looking backward and looking forward. To reiterate, direction is what matters at this point.

What’s your biggest concern for the economy?

My view has always been this is a health crisis that caused economic strain leading to liquidity problems. We’ve addressed the liquidity issue in spades over the past couple of months. Economically, we’re seeing the rebound begin. But there’s still a health crisis, and the biggest fear is the potential and/or degree of a second wave.

Where do you see asset-class opportunities? Is there still an opportunity in investment-grade corporates?

The short answer is “Yes.” To give you context of where they sit, spreads are still wider year-to-date. They have come in recently, and we have retraced a little over half of what we gave up in spread. Year-to-date, the Bloomberg Barclays U.S. Credit Index is still 70 basis points wider, BBB rated issues are still 100 basis points wider for the year, so there’s still opportunity in the investment-grade space.

Investment-grade companies need liquidity. They’ve gotten it.

As for high-yield and bank loans, they need the economy to recover, and now that it’s rebounding, they’ve been rallying substantially. High-yield is still yielding over 7%, and spreads are wide—almost a 200 basis-point increase from the beginning of the year. So the opportunity is certainly not over.

We’re starting to see Covid-19 impacted companies, the really depressed names, do well. The bonds of companies still in a decent position have rallied, though yields are certainly much lower than 7%. There’s certainly opportunity in high-yield bonds.

Final thoughts?

The part I like in credit right now is that if we start to see the rebound begin to sputter, you have that protection with a coupon structure and now liquidity. If an investor is concerned that equity valuations are too high, credit can offer a risk-return balance.

Again, we’ve seen liquidity dramatically improve; the economic picture is mixed but I’d say overall slightly positive because directionally we’re in a better situation.

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Pacific Asset Management LLC is the sub-adviser for the Pacific Funds Fixed-Income Funds. The views in this commentary are as of 6/5/20 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. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Sector names in this commentary are provided by the Fund’s portfolio managers and could be different if provided by a third party.

About Principal Risks: All investing involves risks including the possible loss of the principal amount invested. Corporate bonds are subject to issuer risk in that their value may decline for reasons directly related to the issuer of the security. Not all U.S. government securities are checked or guaranteed by the U.S. government, and different government securities are subject to varying degrees of credit risk. Mortgage-related and other asset-backed securities are subject to certain rules affecting the housing market or the market for the assets underlying such securities. Corporate bonds are subject to liquidity risk (the risk that an investment may be difficult to purchase, value, and sell particularly during adverse market conditions, because there is a limited market for the investment, or there are restrictions on resale) and credit risk (the risk an issuer may be unable or unwilling to meet its financial obligations, risking default). High-yield/high-risk bonds (“junk bonds”) and floating-rate loans (usually rated below investment grade) have greater risk of default than higher-rated securities/higher-quality bonds that may have a lower yield.

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