On July 9, we sat down with Dominic Nolan, senior managing director of Pacific Asset Management, to get his insights on the Covid-19 pandemic’s economic impacts and what those mean for credit in the near- and long-term.
Now that it’s in our rearview mirror, what are your thoughts on 2020’s second quarter?
Second quarter was as unbelievable as the first quarter when you look at how capital markets have performed. The S&P 500® index was up more than 20% during the quarter and entered July down just 3% for the year.
Any clear outperformers in equities?
The Russell 1000® Growth Index, which is dominated by large-tech companies. It was up almost 28% during the second quarter and is up almost 10% for the year. Conversely, small-cap value stocks were up about 19% for the second quarter. While it was a very strong showing, they are down over 23% for the year. The big names have been dominating, and smaller companies have had significant struggles through all this. Unfortunately, it is a continued theme from the past decade, and more accelerated.
What about fixed income?
The Bloomberg Barclays U.S. Aggregate Bond Index was up about 3% for the second quarter and is up 6% for the year. High-yield bonds were up over 10% for the quarter, but down about 4% for the year. Same story for bank loans: up 10% for the quarter, still down about 4% for the year.
The top fixed-income asset class, in my opinion, has been long credit, which was up over 11% for the quarter and about 6% for the year. It’s amazing to me that if you have a balanced portfolio made up of just the S&P 500 and Bloomberg Barclays U.S. Aggregate Bond indices, you’re up for the year—quite a staggering outcome during a global pandemic.
What is your outlook for the third quarter?
I’ll share with you a fun fact courtesy of Goldman Sachs. Since 1940, there have been nine instances when the S&P 500 has been up more than 15% in a quarter. Following each of those quarters, the index had been positive all nine times with an average return of close to 9%. The empirical data would suggest the strong second quarter will likely result in a positive third quarter. It’s all a truly stunning turn of events since mid-March.
Can you give us a progress report on the Federal Reserve (Fed) programs undertaken to stabilize the economy?
From a directional standpoint, I think the Fed programs are progressing as people expected. From a timing standpoint, I’m a bit surprised how delayed everything has been. Remember, the Fed programs we’ve been focusing on are the Primary Market Corporate Credit Facility and the Secondary Market Corporate Credit Facility.
The Fed’s actions signaled support for corporate credit markets and liquidity, but so far, they’re purchased only a de minimis amount of bonds. In fact, the Fed had been purchasing around $300 million a day in bonds since mid-June and have since reduced that to $200 million a day, primarily due to improving market conditions. As it relates to the actual impact of the Fed’s buying, it has been small, but the impact of their signaling has been significant.
Only $10 billion of the $750 billion package has been deployed, leaving the Fed with a lot of dry powder should the economy dip between now and at least Sept. 30, when the credit facilities are scheduled to be shuttered. I think it’s fair to say that many people expect that endpoint to be extended, especially given how little of the funds they deployed so far.
How are the sectors impacted by Covid-19 doing?
It’s really a story of concentration, both good and bad. On the equity side, if you removed tech and telecom, the S&P 500 is down 9% so far this year. If you look at the sectors that have done well, technology is up 17% this year, anchored by Microsoft and Apple. Consumer discretionary is up double digits as well, anchored by Amazon. And communication is up single digits, anchored by Google and Facebook.
When you go through the sectors that have been hit hardest, energy is down 40% year-to-date, financials down 25%, industrials down 16%, utilities down 11%. Those are significant employers in the U.S. economy, and they haven’t fared as well.
I share this because headlines, at least from index-level returns, have been very encouraging, but when you look at average or smaller companies, the picture isn’t nearly as rosy.
Do these mixed results also play out within the sectors themselves?
Yes. The consumer discretionary sector provides a telltale story. In the S&P 500, that sector is up 30% for the year. But when you start to drill down, online retail is up 57%, turbocharged by Amazon. But department stores are down 55%. Luxury goods are off 45%. Casinos and gaming have dropped 42%. Apparel retail is down 20%.
So you could say, “Oh, that sector’s doing really well” from a point-to-point performance standpoint, but as you dig down, it’s not an encouraging sign. And I think that’s being reflected in the equity markets.
Can you tell us the health of certain industries, starting with the airlines?
The airlines illustrate a common pattern found today throughout the economy. Coming off the March lows, the initial phase of the rebound was quite encouraging for airlines. And then we saw a spike in new Covid-19 cases in mid-June, leading to a bit of a stall.
In early June, American and United had increased their capacity to 40 to 50%. But just within this past week, they said they’re probably going to ratchet that down to 30 to 40%. International flights are still pretty much dead. Also, it’s been almost all leisure travel, which is not nearly as profitable as business travel.
Looking at industry employment figures, the four major airlines employ about 350,000 to 400,000 Americans. Without the CARES act provisions, expect layoffs of probably at least 20%. That’s not a pleasant picture.
On the flip side, at its worst, American Airlines was burning through about $100 million a day; it’s now gotten that down to about $35 million a day. So they’ve significantly reduced their daily burn through cost reduction and a little improvement in incremental travel. We’ll see how long this lasts, but it seems like they have enough liquidity. I think the next inflection point for them is when the CARES Act restrictions on layoffs expire about six weeks before the November election.
How about dining?
Similar theme from a couple months ago. As the economy reopened, casual dining started to pick up, and now, with the stall, will see fewer diners. Quick-serve restaurants—your Taco Bells and McDonalds—will probably be benefactors of that, as well grocery stores. As an anecdote, Open Table reservations are down about 66% since the beginning of the lockdown (they were down more than 90% in April).
The good news is a lot of the big firms, including Caesars Entertainment, MGM Resorts, Wynn Resorts and Las Vegas Sands Corp., have liquidity. Right now, a little more than half of the Las Vegas strip is open, and capacity was initially doing well. Now it’s starting to dip a bit because of the pickup in Covid-19 cases. Las Vegas’ McCarran International Airport had a low of 110 flights per day in April, then went to 145 in May and 200 in June. Projections are for 280 in July and 330 in August. We’ll see how new coronavirus cases will affect the number of flights in the coming months.
In the hotel industry, the concern now is that the rebound is going to take a little bit longer, which may lead to downgrades. Companies have raised liquidity, but if they don’t have enough occupancy, then that debt they took on to get through this period will start to impact leverage. Some good news: industry occupancy in April was 21%, in May it moved to 30%, and 40% in June. By June 21, industry occupancy was around 46%. Again, we’ll await the impact of any stall.
What does the bankruptcy picture look like?
In June, 15 companies defaulted with about $24 billion in debt. That’s the sixth highest month on record. Some of the names include Chesapeake Energy Corporation ($6 billion in debt), Valaris plc (about $6 billion in debt), and 24 Hour Fitness ($1.3 billion in debt). Combined, second quarter defaults ended up being about $82 billion (first quarter was $80 billion).
High-yield has reached a 10-year high in trailing defaults at 6.2%. Bank loans have reached a 5-year high of 4%. Digging deeper, energy and retail sectors account for a third of the defaults, and telecom and cable account for a quarter of the defaults. Together, those four industries accounted for nearly two-thirds of the defaults. We expect defaults to continue.
When it comes to defaults, are there any parallels to the Great Recession of 2008?
The default waves for high-yield and loans occurred in 2009, which was the same year they had record-setting performance. Economic loss usually occurs prior to that. I think our current situation is going to be more volatile because it all happened so quickly. Twelve years ago, we saw erosion in 2008 with defaults in 2009, and essentially an asset price rebound in 2009. Now we seem to be compressing all of this into just months: we saw erosion in the first quarter of 2020 and rebound and defaults in the second quarter.
What about recovery rates?
Recoveries have been pretty consistent with 2008-2009, per JP Morgan. Typically, high-yield bonds usually recover 30-40 cents on the dollar; so far they’re recovering about 17 cents. That is a bit lower than 2008-2009 recovery. Bank loans, which have historically had 60 to 70% recoveries, are coming in at 47 cents on the dollar.
How critical is July for the recovery?
July is going to be important for a few reasons. We’ll see what steps our federal, state, county and city governments take to address the coronavirus and the economy, and we’ll find out how consumers behave, which leads to how the market behaves. Also, some employee benefits are scheduled to stop July 31. It wouldn’t surprise me if we see another stimulus package approved this month that includes an extension of some of the unemployment benefits.
Where do you see corporate credit going?
I still feel constructive on corporate credit, especially investment-grade. Let’s think about the variables: risk-free rate, spreads and fundamentals.
The risk-free rate is pretty much the same today as it was in mid-March. On March 9, the 10-year Treasury was 50 basis points. Now you had some noise in the liquidity crunch, but on March 31, the 10-year Treasury was 70 basis points. We’ve had a pretty significant run in equities, one of the best quarters for the S&P 500, and the 10-year U.S. Treasury yield is lower. This tells me that downward pressure on rates will continue.
Now let’s get to investment-grade spreads. The pandemic originally blew them out to 200-plus, and now they’re sitting about 130-140. They’re still wider by 50 basis points this year. So in a normal economy, a functioning economy like we had in 2018 and 2019, spreads should be tighter.
When you factor in a better economy—not necessarily in three months but in a year or two—I expect spreads should be tighter. I’m of the position that if we don’t get pressure on the Treasury side, the economy will be better in a year or two, ergo spreads are tighter which tells me there’s still a total return opportunity in investment-grade credit.
With high-yield bonds, yields are now at about 6.5%. Spreads are still wider this year by 140 basis points today. Now, what’s the appropriate level for spreads? That’s debatable. We are going to see more and more defaults, but defaults tend to lag. We have to adjust for the violent nature of this economic and health crisis. High-yield is yielding about 6.5% with a duration of 3 or 4 years and 5-year Treasuries are extremely low, generating a 500-to 600-basis-point spread. To me, one could make a case for attractive yield in this asset classes.
What’s your best-case scenario for a sustained recovery?
Unfortunately, in dealing with this pandemic, policy has been politicized, resulting in a fragmented, uncooperative, and unsuccessful path for our economy. It might just be wishful thinking, but I would love to see some unification on a policy path (remember that policy is different than politics). The CARES Act was passed with bi-partisan support. Agreeing on a health policy path, even at a high level, could help turn the page toward a more normal functioning economy. Otherwise, this will continue to be more painful than needed.
Do you have a closing, noneconomic thought?
There’s an old adage that “idle hands are the devil’s workshop.” In my opinion, so much of the angst and anxiety the country has been going through during the pandemic is the result of just being weary and being still. Now, especially, is the time we need to stay active both mentally and physically and be productive the best we can. I believe that if we are able to fight and push through urges to do less, we will come out with a healthier mind and body.
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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 July 9, 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. 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 Funds’ 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. 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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