It helps that we know the unknowns
The March 26 weekly jobless claims number totaled nearly 3.3 million, more than 10 times the average of the last 60 months, and the subsequent week saw claims jump more than 6.6 million, bringing the 2-week total to almost 10 million—wiping out all the nonfarm job gains over the past four years and confirming what investors already had figured out. A virtual government shutdown of the economy due to Covid-19 is going to produce extraordinary downside statistics and continued volatility in markets.
This extreme economic reality created wide divergences in the various segments of the fixed-income markets during the first quarter, concentrated in the final six weeks, with the high-quality Bloomberg Barclays Government Index registering a total return of 8.15% while the Bloomberg Barclays High Yield 2% Constrained lndex returned -12.7%. This greater than 2,000 basis points difference happened only once before—the fourth quarter of 2008 amid the global financial crisis.
At the beginning of the year, we felt things were about as good as they were going to get for most of the credit sectors. With the economy and corporate profits continuing to grow, there was potential for more upside. But given historically rich levels across the corporate credit universe, the potential reward wasn’t much relative to the risk of something possibly going wrong. Hence, our multi-sector fixed-income model was underweight much of the credit market.
We were a little cautious, but not for this reason
In no way is this meant to suggest we were prescient—we did not foresee the cataclysmic impact a new coronavirus being reported in central China ultimately would have on the global economy and assets. But at least our portfolios had reduced exposure in corporate credit as the virus crisis exploded, wreaking havoc on all risk assets and causing yield spreads relative to comparable-maturity Treasuries to gap out. Outside of cash and very short-term Treasuries, there were few places to hide.
On an absolute basis, few win when the markets are going down so far and fast. Pricing dislocations and liquidity/cash flow issues almost always detract from regular investment processes. But on a relative basis, our sector performance benefited precisely because we had taken steps to limit exposure. We even picked up alpha in the quarter’s closing weeks after raising our exposure where we saw potential value at beaten-down levels, with shifts to overweight in mortgage-backed securities (MBS) and neutral in both investment-grade credit and commercial MBS. We also lightened our underweights to high yield and emerging markets.
Where do we stand now? Somewhat in a holding pattern. As the inaugural week of the second quarter has shown, the markets are going to remain volatile until there’s an all-clear. The good news is we know what the unknowns are—when will the virus curve peak? When will the economy start to recover? How bad will it get first? How long will the Fed keep the benchmark rate zero bound? How much will it grow its rapidly expanding balance sheet? With Phase 3 in the books and Phase 4 in the works, how many more phases will Congress and the White House push forward?
Pulling out the ’08-09 playbook
As we attempt to answer these questions, we’ve pulled out our playbook from the 2008-09 global financial crisis, which we entered with underweights across the credit complex and tactically shifted to overweights on signs that crisis was abating. This active management process proved beneficial over the course of the subsequent recovery and expansion, with our credit and duration positioning providing significant sources of alpha.
While we realize no two crises are exactly alike, we would anticipate making similar adjustments in the months ahead.