Forward-looking Markets and Backward-looking Economies

On August 6, we sat down with Dominic Nolan, senior managing director of Pacific Asset Management, to get his latest insights on the disruptive effects of the pandemic and what those mean for credit.

The market had an incredible run in the second quarter, and it moved even higher in July, despite a major surge of Covid-19 cases. What happened?

As we’ve talked about before, since 1940, there have been nine instances when the S&P 500® index 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%. July has essentially been a continuation of the second quarter, and it certainly continued the recovery trend with the S&P 500 up 5.5% for the month and turning positive for the year at 2.4%.

What propelled the performance?

Large-growth stocks. They were up more than 7.5% in July and are now up more than 18%. I think that is just amazing. Conversely, small value stocks, while up 2% in July, certainly lagged and is still down 22% year-to-date.

What about credit?

The credit trade continued to be positive. Investmentgrade credit was up another 3% in July, and long credit was up 6%. Year-to-date, U.S. credit is up 8%, and long credit is up 12%. U.S. high yield was up about 4.6% in July, and also turned positive for the year. So we had the S&P 500 and high yield turning positive for the year in July. Bank loans were up 2% in July, but still remain down about 2% year-to-date.

Again, July’s performance was a continuation of the second quarter trend with a couple key indices now flipping to positive for 2020 so far.

How do you see the Federal Reserve’s (Fed) involvement in the markets going forward?

My observation is that the Fed will support the markets for as long and as much as needed. A recent example that reinforces this position is the July announcement for the extension of the primary-market and secondary-market facilities through the rest of the year (they were set to expire at the end of the third quarter).

The Fed’s unwavering support has been hugely important. They’re comfortable in that support and have shown themselves to be flexible. Whether central bank policy is appropriate or not can be debated, but from the standpoint of market support and liquidity, the Fed has certainly shown themselves to be comfortable, unwavering and flexible.

In the secondary-market facilities program, why has only $12 billion of the $250 billion been tapped into?

Back in March, the Fed’s actions indicated that they would support the markets, especially the credit markets, and this provided a backstop or a sense of a cushion that made the market itself comfortable enough to provide liquidity. The reality is signalling was enough to stabilize the markets. As market conditions improved, the need to purchase bonds was muted. I don’t know if you could ask for a better outcome given the circumstances.

How are U.S. companies doing amid the pandemic?

According to Credit Suisse, expectations going into the second quarter were for revenues to be down 10%, earnings to be down 35%, and earnings-per-share growth to be down 35%. Today, with about three-fourths of the S&P 500 market cap reporting, earnings in the second quarter have exceeded estimates by 23%, and more than 80% of the reported companies have outperformed their lower projections.

Digging a little deeper, four of the five largest companies (Apple, Amazon, Google and Facebook) have reported strong revenue growth and earnings year-over-year—all during the worst quarter of the pandemic for markets. The top line was up almost 10%, and the bottom line up 50%. They are demolishing other companies as the pandemic has served as a massive digital accelerant to a trend that was already in place.

Do you see this kind of performance having long-term effects on the market?

I think most traditional investors have viewed that risk premia of growth companies should be higher because they are riskier. In other words, investors would need to get compensated more to invest in a typical growth company. I don’t know if that’s the case anymore. Would I rather lend to a digital company or lend to a traditional brick-and-mortar company? There’s certainly a legitimate argument that traditional businesses may be riskier in many ways than some of the digital businesses. Who knows how this will play out?

I think most traditional investors have viewed that risk premia of growth companies should be higher because they are riskier. In other words, investors would need to get compensated more to invest in a typical growth company. I don’t know if that’s the case anymore. Would I rather lend to a digital company or lend to a traditional brick-and-mortar company? There’s certainly a legitimate argument that traditional businesses may be riskier in many ways than some of the digital businesses. Who knows how this will play out?

What about the performance of Covid-19-impacted companies? Let’s start with amusement parks.

For sporting events or concerts, crowds aren’t allowed, so amusement parks are really about the only place where you can have a large gathering in a controlled private environment. For the national companies—Disney and Universal—their parks are more reliant on people flying to them as a destination. They had planned reopening with 10% of park capacity, and they didn’t even achieve that.

As low as their expectations were, people still didn’t go. Some of the regional parks, such as Six Flags and Cedar Fair, targeted 20 to 25% park capacity, and got about 15%.

In the end, people still aren’t going to amusement parks. Now that’s the bad news. The good news is the safety measures seem to be working. There has not been reports of any significant infections among employees. It’s looking like 2020 is just going to be scrapped for these parks.

What about hotels?

On the higher end, Hyatt and Hilton have reported their second-quarter earnings and revenue-per-room are down 80% with occupancy being in the 40 to 45% range. Business travel is certainly strained as these are hotels in cities people have typically flown to. In the fall, when business travel traditionally picks up, you will probably see low occupancy continue.

On the bright side, leisure travel could remain strong as kids may be online with schooling, and a lot of parents have the ability to be flexible with vacations. Occupancy for regional or drive-to hotels is actually climbing. In June, occupancy was about 50% and about 60% for July. Regional hotels certainly seem to be faring better than national hotels at this time.


I think the story for the airlines is that they were all burning close to $100 million a day, and that has significantly reduced. Their liquidity is still in place for the next year. At the same time, there may be long-term issues around business travel, which may extend beyond 2021. It’s going to be tough sledding for a lot of the airlines because the business travel dynamic has been impacted so greatly.

How much economic damage is the spike in new Covid-19 cases causing?

Let’s look at some of the data we get from the credit card companies. This is from Bank of America’s daily data: At the start of July, total card spending was down about 12%, and now, entering August, it’s down about 5%.

Getting more specific, airlines and entertainment saw basically no change from early July to August 1 and were still down over 80% year-over-year. From early July to August 1, lodging slightly improved from down 50% to down 40%. Restaurants and bars have basically experienced no change and are down 15 to 20% year-over-year. Revenue for many sectors kept fairly level in July. One thing I found interesting was as we enter August, clothing is down 20% year-over-year, which is lower than early July. I attribute that, in part, to a reduced need for back-to-school and back-to-work clothes.

Not surprisingly, online electronics, home improvement, groceries, and general online retail continue to be strong year-over-year.

Do you see opportunities in the intermediate investment-grade space?

The short answer is yes. Before I explain, I want to frame where we sit today in global bonds. Eighty-six percent of the global bond market is currently trading with yields of less than 2%, and that is a $60 trillion market. So sourcing yield is extremely difficult. The percent of bonds that trade worldwide with yield of more than 5% is 3%. It’s pretty staggering when you look at what people are faced with from a yield standpoint.

So how does that play through the investment grade? Year-to-date, AAA credit is up 7%, and AA and A rated credit is up 9%, so it is progressing. Then you get to BBBs. They’re up 6% for the year. So BBB’s are still under performing, and again, these companies have access to liquidity. They’re strong businesses that typically have a deep bench. I think credit still has room to run, but will start to come across an absolute yield “conundrum.”

What about high yield?

One of the stats I found interesting was high yield is slightly positive for the year. Fallen angels—which the press just hammered on—are up 19% within high yield, and a lot of that has to do with many of these investment-grade companies getting downgraded. They had longer duration bonds, they were among higher-quality high yield, and they did enter with wider spreads. Yet the news still bashed them and generated negative headlines.

High yield has BBs that are now inside of 4%. There’s still opportunity because of the global-bond market. Only 3% yielding more than 5%, and high yield generally trading now with yield of more than 5%. Whether or not you believe it is an appropriate compensation for the risk, I think looking at flows and demand for yield, it shows there’s still potential opportunity.

And loans?

Loans are currently yielding 50 basis points more than high yield. Historically when that happens, loans tend to outperform because you’re taking less interest-rate volatility so you should have a lower yield in theory. But again, there’s more specific nuances as it relates to that, but there is certainly opportunity within credit in my opinion.

For financial professional use only. Not for use with the public.

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Past performance does not guarantee future results.

Pacific Asset Management LLC is the sub-adviser for the Pacific Funds Fixed-Income Funds. The views in this commentary are as of August 6, 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. 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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