In late February, our Bond Asset Allocation/Tactical Fixed Income model prompted us to sell out of high yields and instead take up a defensive position. Apart from two brief periods in government bonds, at the end of the 1st Quarter we found ourselves positioned in money markets and cash.
By stepping to the sidelines, we avoided the severe downturn in March as high-yield bonds, stocks and other risk assets plunged. Our Select Bond Asset Allocation/Tactical Fixed Income portfolios (where we have discretion over security selection) also benefited from our hedged posture prior to turning defensive; before selling out of high-yield bonds entirely, we held a portion of the assets in government bonds.
Together, these portfolio shifts served to achieve a minimal level of drawdown in our flagship tactical fixed income strategy for the quarter.
The COVID-19 crisis brought an end to a record-long bull market in stocks. Severe uncertainty continues around the health crisis and its economic effects. We will comment further below about our current take on the economic situation. First, we’ll touch briefly on our model.
What our models told us in late February
On February 25, BTS issued a “sell” in the high-yield bond sector. The primary influence in our model turning “negative” was the rate at which the stock market was falling—a rate not seen since 2008.
We follow stock prices closely at BTS, including in the models we use for strategies that do not include stocks. High yield bonds are generally correlated with stocks. On average, they are about one-third as volatile as stocks—though more like two-thirds, recently.
In our view, a true tactical strategy involving high yield bonds must necessarily be a broad-based endeavor. It isn’t enough to simply analyze creditworthiness of issuers or movements in credit spreads. Anyone who thought they were taking a “tactical” approach without a broader analysis was likely sorely disappointed as the latter half of the quarter unfolded.
During the first quarter we saw many firms that had traditionally marketed themselves as strategic or tactical managers sit passively through the major market correction. Investors likely look for quantitative managers to understand that when prices go negative their model must also go negative. To us, the market volatility in the first quarter was not a time to override models but instead focus on preserving clients hard earned capital.
Current positioning
The Dow Jones Industrial Average declined over 37% from its peak to the recent low as COVID-19 pushed the economy into recession. With such a strong downward move, it’s natural to wonder if it’s time to reenter risk assets.
Our view is “no,” and at the end of the 1st quarter we believed remaining on the sidelines was the most prudent decision. Following are brief highlights on why we see reentry into risk assets as premature:
- GDP will be negative during the first and second quarter of 2020. Moreover, the outlook is not clear. The QE4 package will be about equal to the QE1 QE2 and QE3 packages combined—and expanded to include not only government and mortgage-backed bonds but also municipals and even corporates. The Federal Reserve is even supporting investment-grade bond ETFs with a “bid,” through a third-party trade vehicle to bypass rules that prohibit it from purchasing corporate bonds.
- The Federal Reserve has also increased liquidity in the repo market. Back in September, the federal funds rate spiked higher as overnight lending between banks and broker dealers diverged from the Fed’s benchmark discount rate. The Fed’s response was to set up a repo window with billions available for overnight and short-term loans. This resource is now further supported with newly added initiatives to keep the front end of the curve functioning properly…which is essential for the longer end to remain in good order.
- These and other drastic steps are all in addition to the Fed having cut short-term rates to zero. With the launch of such aggressive ‘liquidity’ initiatives, one could think a ‘V’ shaped recovery in the stock and high-yield markets is reasonably likely. After all, when the Federal Reserve stepped in with a rare policy change after the sell-off in 2018, a quick rebound followed.
- However, we normally see a series of strong “dead cat bounces” in the stock market during a true bear phase. Accordingly, we adjusted the weightings of our indicators last year to tilt toward a defensive posture that requires some trend confirmation before embracing risk.
- So, while the magnitude of QE4 may suggest a quick ‘V’ shaped recovery in both the economy and stock market, we see a ‘U’ shaped development as more likely.
- Consider, too, that while the monetary response is impressive, the fiscal response necessary to support unemployed workers and small businesses is equally so. Unemployment claims have for the duration of the expansion since 2009 been under 300,000. We have now seen weekly claims of three million and more, which we believe suggests unemployment rate will spike to 10-15% level—more than the 2008 Great Recession level.
- It’s important to keep in mind that the recovery since 2008 has been consumer led—and consumption will take time to rebuild. We are likely to see the unemployment rate move very high as COVID-19 infections peak in April and May, which will take a heavy toll on corporate profits.
All told, we believe the current rally from the recent lows is a strong counter-trend rally that will give up its gains as negative data points (e.g., unemployment) and updated corporate earnings guidance pressures markets lower.
That said, a quicker recovery and end to the COVID-19 crisis would increase the chance of positive GDP in the fourth quarter of this year and, in turn, GDP growth of potentially 1-2% in 2021. Another possible support to risk assets would be an end to the oil price war and oil holding recent gains off its 68% decline in WTI. We are positioned to react to and capitalize upon such a scenario.
Potential for government bond trades
During continuing volatility, there may be opportunities to trade into government bonds during periods of pronounced flights to quality. Such trades may help offset what we call “upside risk,” meaning not participating in gains in risk asset prices while maintaining a defensive posture.
However, with rates so low, the hedge value of governments may be somewhat compromised—a point that serves to underline the importance of a flexible approach to capital preservation. Furthermore, low-risk trade opportunities into governments have been scarce recently due to volatility and liquidity issues. However, a move to new lows in the stock market would theoretically help, as would added liquidity across all durations.
As we continue to see downward pressure on rates across the globe, we think the possibility rises that we will see a 0% yield on the 10-year US Government Bond. The decision by the Federal Reserve to move forward with an “Unlimited QE” program will continue to put a bid on Treasuries that will create additional downside pressure on yields. We are watching this dynamic closely as it could potentially support a trade opportunity.
At BTS our trades to governments tend to be shorter-duration, and we focus on seeking to reduce any drawdown and negative trades. Despite the lower absolute yields in governments and the continuing volatility, we think the “risk-off” backdrop may setup a trade opportunity near term.
Also, in our Select programs, we expect our models to continue employing government bonds for hedging purposes when the time comes to reenter high-yield bonds.
Conclusion
A great danger in overweighting risk assets is getting forced out of the market due to permanent loss of capital—because there’s no time to make up the losses. Our objective at BTS has always been to preserve capital while participating in upside potential.
We do so with a focus on high yield bonds because we believe they can be an even more productive focus for technical analysis than stocks, as we seek to sell high-yield bonds during sustained downside price moves and then buy back into high-yield after credit spreads have widened.
Historically, opportunities to “buy back” have been especially favorable in the periods following significant downturns, once an upward trend in risk assets has been reestablished.
During past major drawdowns, we have seen advisors and their clients proactively positioning into high yield strategies that offer risk management. Often clients are overweight stocks going into bear markets and are concerned about overall exposures to risk assets. We believe all the characteristics of our approach that advisors have found appealing at past junctures are equally relevant now.
Thank you for the opportunity to manage your assets.
Sincerely,
Vilis Pasts
Matthew Pasts, CMT
Isaac Braley
Co-Portfolio Managers
DISCLOSURES
This commentary has been prepared for informational purposes only and should not be construed as an offer to sell or the solicitation to buy securities or adopt any investment strategy, nor shall this commentary constitute the rendering of personalized investment advice for compensation by BTS Asset Management, Inc. (hereinafter “BTS”). This commentary contains only partial analysis and should not be construed as BTS general assessment or outlook with respect to the topics discussed herein. This commentary contains views and opinions which may not come to pass. To the extent this material constitutes an opinion or assumption recipients should not construe it as a substitute for the exercise of independent judgment. This material has been prepared from information believed to be reliable, but BTS makes no representations as to its accuracy or reliability. The views and opinions expressed herein are subject to change without notice. Returns for specific BTS portfolios are available upon request.
It should not be assumed that investment decisions made in the future will be profitable or guard against losses, as no particular strategy can guarantee future results or entirely protect against loss of principal. There is no guarantee that the strategies discussed herein will succeed in all market conditions or are appropriate for every investor. Investing in BTS portfolios involves risk, including complete loss of principal. General portfolio risks are outlined in BTS’ Form ADV Part 2A and specific strategy brochures, which are available upon request. You should review these risks before deciding to invest in BTS portfolios.
BTS Asset Management is affiliated with BTS Securities Corporation, member FINRA/SIPC. Securities are offered through BTS Securities Corporation and other FINRA member firms. Advisory services are offered through BTS Asset Management, Inc.
PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS.
© 2020 BTS Asset Management
© BTS Asset Management
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