Scott Rubin, PEI’s Director of Research, shares market and investment observations amid coronavirus-fueled market volatility.
While equity markets have previously experienced declines of greater magnitude, the velocity of this decline is unprecedented. The S&P 500 declined 35.4% from the February 19, 2020 high to the March 23, 2020 low. The energy sector dropped more than 60% during this period as WTI Crude fell from approximately $60 to $20 per barrel, due in large part to a price war between Russia and Saudi Arabia. Financials have also been hit hard during the crisis, as banks have been negatively impacted by the decline in interest rates and lower lending volumes. The global weakness in the energy and financial sectors has led to growth continuing to outperform value across both domestic and international markets. Large cap stocks have also globally held up better relative to small caps during the market sell-off. Smaller companies tend to have weaker balance sheets and less access to capital, and many (about 35%) did not generate a profit in 2019. As would be expected, the worst performing stocks during this period have been higher beta stocks, or stocks with higher volatility. For example, within large cap domestic stocks in the Russell 1000 Index, the highest beta quintile has underperformed the lowest beta quartile -38.1% vs. -26.1%. In the Russell 2000 Index, for small cap stocks, the difference is -51.0% vs. -30.1%. Companies with higher levels of debt and weaker balance sheets have struggled across global markets, whereas stocks with higher levels of profitability and free cash flow have performed the best.
Portfolio managers have used this market environment to opportunistically initiate or add to positions that they feel have been oversold and are trading well below their intrinsic value. A common theme that PEI has heard from managers is a re-focusing on their fundamental research. This includes a re-examination of company balance sheets to understand how long businesses can operate under the current environment, focusing on supply chains to identify potential stress points and deeper dives into company-specific liquidity risks. Several managers have also stated that they believe depending on the severity of the recession and the velocity of the recovery, industry leaders may emerge stronger than they were pre-virus, due to the bankruptcies of weaker players and/or the ability of the market leaders to acquire cheap assets during the decline.
2019 was another strong year for corporate credit amid an environment where interest rates broadly fell and credit spreads tightened. As the fixed income markets started to react to the COVID-19 outbreak, interest rates fell further and credit spreads widened significantly amid a flight to quality. For a short period on March 9, 2020, the entire yield curve was under 1%. Credit spreads had their worst month ever; abruptly widening to levels seen only during the financial crisis. Investment grade corporate bonds declined by over 13% in less than a month. Core plus bond funds which were underweight (short) duration and overweight corporate credit have underperformed relative to strategies that were neutral to long duration and neutral or defensive on credit. At present, the majority of core and core-plus bond fund managers that PEI have spoken to are positioned with an underweight (short) to duration, as the expectation is that the Fed does not want to implement a negative interest rate policy. Moreover, many of our managers have noted they have used the recent spread widening to take of advantage of opportunities found specifically within Agency Mortgage-Backed securities (“Agency MBS”) and investment grade corporate bonds. While spreads in high yield have moved considerably wider, managers have stated that they will be slower to add to high yield positions, as they are monitoring increases in defaults and/or downgrades. With respect to defaults, the expectation is they will be most prevalent within the energy space.
Many managers have noted that what we are seeing in fixed income markets in terms of liquidity, or lack thereof, is unprecedented. While managers are used to seeing credit markets tighten up when a recession is looming, what has been surprising this time around is that the lack of liquidity is not just in the credit markets, but also in Agency MBS and the Treasury markets. Liquidity in Treasuries has thinned in recent weeks, leading to sharp price movements. Treasury market dislocations have led to bouts of illiquidity that several managers have said led to levels they didn’t even see during the financial crisis. The Fed stepped in with a rate cut in early March, followed by increasingly drastic measures to bolster returns. Among these measures is a never-before seen intervention in the “real” American economy. The Fed will purchase corporate bonds, backstop loans direct to companies and will roll out a program to get credit to small- and medium-sized businesses. The Fed will also purchase Treasuries and agency MBS, thus creating a buyer of last resort to take pressure off dealers’ balance sheets, which have already been full. While fixed income strategies have been seeing some redemptions, all managers we have spoken to have noted that they have been able to meet redemptions without a problem thus far. Additionally, they noted while they have been able to transact, the cost of execution is higher than in normal periods.
Stable Value / Money Market
The stable value market was very healthy going into the year and has remained so despite all the volatility during the quarter. At this point based on conversations with many of the leading providers in the space, there are not any of the issues that occurred during the financial crisis. There continues to be ample wrap capacity, unlike what happened during and following the financial crisis when some wrap providers either left the space entirely or cut back on capacity. Market to book values also are still above 100. Most stable value funds had market to book values in the 101-104 range, however more strategies are closer to the bottom of that range now due to widening credit spreads. Most stable value funds had experienced net cash outflows for the last several years as investors chased the rally in equities. However, several managers told PEI they received $1-2 billion of net inflows in the second half of the first quarter as volatility spiked. Managers are holding off on investing most of the cash in order to remain defensively positioned and to avoid any forced liquidations to meet potential redemption requests. Some firms have told PEI that they have observed liquidity challenges in the securitized and corporate sectors for selling securities. However, that has not been an issue for them as they have not had to sell positions due to the cash inflows.
On March 18, 2020, the Fed announced they were establishing the Money Market Mutual Fund Liquidity Facility (“MMLF”), in order to assist prime money market funds in meeting investor redemption requests. Within government money market funds, portfolio yields have continued to decrease along with the drop interest rates. Following the global financial crisis, money market funds had to waive their management fee for a period of time in order to avoid negative net returns for investors, or risk “breaking the buck.” At this time, based on discussions with several managers, portfolio yields on government funds remain high enough to cover all fees and expenses, however policies such as fee waivers will be considered should they be needed.
Target Date Funds
Given the market environment, it is not surprising that target date funds that employ more risk in their glide paths have lagged other more conservative funds to start the year. This has especially been the case in the years approaching retirement, where the deviation in risk among providers really starts to widen. Target date funds, specifically active and hybrid suites, have mostly lagged their strategic indices during this period due to out of benchmark positions in asset classes such as high yield and emerging market debt. Target date managers have told PEI they don’t plan on making any material changes to their offerings as a result of the market volatility. Instead, they are focused on rebalancing their funds back to desired target weights. In most normal market environments, most target date managers can rebalance their funds primarily through incoming cash flows. However, given the extreme daily market moves of late, many target date fund managers have had to take further action to rebalance their portfolios. This rebalancing can vary between active and passive target date funds. Some passive target date providers have stated they may temporarily slightly deviate from their typical rebalancing for reasons such as limiting trading costs. Active target date managers have stated they also may be slightly more gradual with their rebalancing in order to take advantage of market opportunities based on continued volatility. As has been the case during other periods of market volatility, managers have stated thus far they have not seen a spike in participant activity within target date funds.