Rebound or Recovery?
The longest expansion on record began in June 2009 and lasted 128 months until February 2020, according to the National Bureau of Economic Research. A global pandemic ended it, pushing the U.S. economy off a precipice. Monetary and fiscal policies cushioned the fall that at times felt bottomless. As lockdowns were eased and businesses reopened, the economy began its rebound. Many continue to work from home, and some are going back to their offices, bringing back much needed life to cities across the country. But the economy has to climb out from a deep hole and some risks are flaring. The acceleration of new COVID-19 cases, especially in Florida, Texas, California, and Arizona presents a serious challenge, and it could derail the transition from rebound to recovery.
Financial markets bottomed on March 23, 2020. Since the low point, the S&P 500 returned almost 39%, Investment-Grade and High-Yield Corporate spreads tightened 155 basis points1 and 440 basis points, respectively. Oil prices went through an astonishing ride; after one-month contracts on the West Texas Intermediate (WTI) dropped from $60 to $20 in Q1, on April 20th, contracts traded at -$39 as the cost of storing oil temporarily surpassed the price of the commodity itself. By the end of Q2, WTI contracts approached $40.
Inflation markets had a strong quarter. Real yields rallied 72, 45, and 24 basis points in the 5-, 10-, and 30-year parts of the curve, respectively. In absolute terms, TIPS returned 4.24% in Q2, outperforming nominal Treasuries by 3.7% on a duration-adjusted basis. From its low of 0.55% in March, the 10-year breakeven inflation rate increased to 1.34%. For the year, the TIPS market absolute return is 6%, a remarkable result considering that the asset class declined more than 5% in the worst days of March.
Portfolio management and performance
Managing our portfolios in Q2 required a few adjustments in comparison to normal times. First, we did not trade based on CPI seasonality. Since TIPS accrue non-seasonally adjusted CPI, we often position portfolios to collect higher seasonal carry in the first half of the year. The disruptions caused by the pandemic made it impossible to assess the seasonality premia across inflation-linked securities. Second, we increased our allocation to on-the-run securities. In normal times, we keep a relatively high allocation to off-the-runs, which tend to trade at a small discount, but also offer more room to maneuver. As their liquidity deteriorated, we moved toward more liquid on-the-runs to improve our ability to raise cash if needed. Third, we took advantage of the Federal Reserve (Fed) buyback calendar, selling directly the Fed, thus executing at good entry points while reducing exposure to off-the-run securities.
In terms of performance; our duration underweight, driven by our smaller-than-benchmark allocation to long-duration securities, detracted from performance. Furthermore, as the liquidity premia attached to on-the-run TIPS widened, our remaining exposure to off-the-runs became a detriment to relative performance. Finally, our real yield curve strategy of favoring intermediate securities over long securities paid off and added to performance. For the quarter, our accounts returned about 4% on an absolute basis, but lagged behind their benchmarks.
The decision to shut down the U.S. economy to manage the COVID-19 health crisis triggered the deepest contraction since the Great Depression. Our preferred measure of economic activity, the three-month moving average of the Chicago Fed National Activity Index reached -7.5 in April, several times worse than the lowest point following the Great Financial Crisis (GFC). A value below zero for this index means the economy is growing at below-trend levels, and a value below -0.7 indicates an increased likelihood that the economy has entered a recession. By this metric, the COVID-19 recession is in a category of its own.
The reopening process sparked a rebound, but the transition to a true economic recovery faces a headwind: the rising number of COVID-19 cases. Since mid-June, the weekly average number of new cases at the national level reached fifty-five thousand. The trajectory of new cases in Florida, California, Texas, and Arizona is especially troubling. When combined, these four states account for almost one-third of the U.S. GDP.
The labor market showed strong gains in May and continued to improve in June, with the unemployment rate falling to 11.1%, after reaching 19% in April. Moreover, nonfarm payroll added about 7.5 million jobs in May and June. One explanation for the hiring is that firms laid off too many workers in April in response to the lockdowns but rehired them to benefit from the government’s Payroll Protection Program (PPP), a $350 billion program included in the $2.2 trillion CARES act signed on March 27th.
As much as we welcome improvements in the employment situation, we note that there is a long and arduous path ahead. There are still 18 million people who lost their jobs since March. This collapse in employment is also in a category of its own. The exhibit on the right compares the percentage change in employment relative to each pre-recession peak. In 2020, employment remains several percentage points below the lowest point of the 2007 path, which took more than 80 months to get back to its pre-recession peak. Going forward, we do not expect employment gains to continue at such rapid pace. With the PPP expiring at the end of July, and with State and Local governments cutting headcount to help balance their budgets, we would not be surprised to see layoffs rise once again.
How about inflation? With close to 90% of the American population in some form of lockdown during Q2, downward pressure on prices exerted by decreasing demand overwhelmed inflationary pressure coming from supply disruptions. As a result, the Consumer Price Index (CPI) fell in April and May; with apparel and airline fares driving core CPI down 0.4% in April, its largest monthly decline since the series was created in 1957. As of June, year-over-year headline and core CPI are 0.6% and 1.2%, respectively.
In our inflation coverage, we follow alternative measures of underlying inflation published by regional Federal Reserve banks. One measure we find informative is the Underlying Inflation Gauge (UIG) published by the Federal Reserve Bank of New York. The UIG-Full, a version derived from a combination of CPI components and financial data is at 1.05% as of June; and the UIG-Price, a version derived only from CPI components, is at 1.95%. This difference represents the impact financial variables have on underlying price trends. In other words, the low inflation prints we have seen are largely the product of stressed financial conditions in Q2. Once we remove that component, underlying inflation trends seem healthier than what CPI suggests, indicating potential adjustments in CPI going forward.
The Fed stabilized financial markets and restored liquidity with a combination of large-scale asset purchases and various lending facilities. As a result, the size of the Fed’s balance sheet is about $7 trillion, of which about $4.2 trillion are U. S. Treasuries. On the fiscal side; the to Coronavirus Aid, Relief, and Economic Security (CARES) Act, mitigated the impact of the lockdowns on American households and businesses. Following its implementation, net Treasury issuance totaled $2.7 trillion. About 70% of this net issuance was absorbed by the Fed. Such level of debt monetization has raised concerns about accelerating inflation in the future.
In the aftermath of the GFC, similar concerns were expressed when the Fed responded with lending facilities and three rounds of quantitative easing. Nevertheless, except for a few exceptions, inflation remained below target for the entire decade that followed. This time around, two elements may tilt the risks toward higher inflation. One is the degree of monetary and fiscal policy coordination. The other is the fact that policy involves direct transfers to households. This increases the level of potential consumption at a time when households are less leveraged than in the GFC. At the moment, households have increased precautionary savings rather than consumption, but this decision may prove transitory.
With the Fed funds rate at 0%, future monetary policy will likely continue to rely on asset purchases. The Federal Open Market Committee minutes, released on July 1st, suggest that the Fed will emphasize forward guidance before focusing on alternative tools such as yield curve control. Interestingly, the minutes also highlight the Fed’s interest in linking forward guidance to inflation:
“A number of participants spoke favorably of forward guidance tied to inflation outcomes that could possibly entail a modest temporary overshooting of the Committee’s longer-run inflation goal but where inflation fluctuations would be centered on 2 percent over time. They saw this form of forward guidance as helping reinforce the credibility of the Committee’s symmetric 2 percent inflation objective and potentially preventing a premature withdrawal of monetary policy accommodation.”
Persistent social distancing into the second half of 2020 and the scarring (damage to supply potential) from the hit during lockdown, will indeed preserve policy accommodation making sure it is not removed prematurely.
The slow pace of the reopening process may keep downward pressure on prices for some time. The pace and path of the post-COVID economy remains unknown, though coordinated monetary and fiscal policy accommodation will be a feature for a long time ahead. Combined with a less globalized world where goods will be more expensive to produce, the pre-conditions are being set for healthier inflationary trends to return once a sustainable economic recovery takes hold. As always, we will be ready to benefit from these opportunities with our time-tested investment strategies and disciplined investment process.
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IM-08176-2020-07-20 Exp. Date 10/31/2020
1Basis point (bps) is a unit that is equal to 1/100th of 1% and is used to denote the change in price or yield of a financial instrument.