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Bear-Market Bond Adjustment

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By Roman Chuyan, CFA, Model Capital Management

  • Economists are competing for the gloomiest projection, with some expecting a -25% GDP in Q2.
  • Our Credit model gave a Buy signal, and we shifted from T-Bills to corporate loans and bonds.

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Financial markets continue to march to the drumbeat of news about the coronavirus pandemic. Its exponential spread has taken a heavy toll in both human life and economic activity. As testing becomes more available, known infections have risen sharply and the US jumped to first place globally in total infections. New York City emerged as the new epicenter of the disease, and multiple states have closed non-essential businesses. In addition to the halt in all travel, entertainment, and public events, the entire manufacturing and retail industries were shuttered in several states, forcing employers to furlough millions of employees.

After protecting our clients against this downturn, we continue to be defensive in our tactical strategies. Our Credit model turned positive after bond prices fell in March (see Fixed Income section), and we bought investment-grade bonds and loans.

Years of over-investment in risk assets – stocks, bonds, asset-backed, high-yield – had to be unwound as the downturn began. Many investors trying to sell at the same time made the selloff especially steep earlier in March, resembling closely the steep selloff in October of 2008. The 2008 episode wasn’t the end of that bear market, and this might not be the end of current one. Bear markets last for awhile, and ultimately result in a significant destruction of wealth: the S&P 500 dropped by at least 47% in the past two bear markets.

Economic Focus

Just two weeks ago, I think most of us expected a mild-to-moderate economic downturn because of virus-containment measures. In my previous report, I wrote that major banks would project a recession. It turned out to be a contest for the gloomiest projection. Many economists now expect around a 10% annualized contraction in Q1 and 25% in Q2. Goldman Sachs is winning the contest, announcing on March 31st that it expects the US economy to shrink by an annualized 34% in Q2 and unemployment to soar to 15%. If anything close to that occurs, it would be the largest economic downturn since 1946 when GDP fell by 11.6% as the manufacturing of war materiel ended. The deepest recent quarterly downturns occurred in 2008 (-8.4% annualized), and before that in 1958 (-10%).

Economic numbers for March are only beginning to come in, with initial jobless claims soaring to 3.3 million last week – by far the largest weekly job loss on record. We’re in uncharted territory.

Initial Jobless Claims

Source: Ycharts

Some media reports are beginning to point to “warning signs” that appeared before the pandemic began of a fragile economy, high stock valuation, and excessive borrowing. Of course, these signs were obvious to anyone who cared to look. We wrote about them for most of last year and were defensive based on our models, which protected our clients against this downturn. But the economists at major banks and securities firms were too busy cheerleading the rising market. There should be no surprise, however – economists follow markets.

Fixed Income

We have just experienced a bear-market adjustment in bonds. Corporate and high-yield bond prices began to fall sharply in mid-March along with other risk assets, as years of overinvestment started to be corrected. Credit spreads widened: the investment-grade to 400 basis points (from 100 bps previously) and high-yield to 10.9% (from 3.5%), their widest since 2009. Around the same time, the Fed launched massive stimulus efforts, including zero rates and quantitative easing. In response, Treasuries rallied, but not corporate or high-yield bonds as risk aversion persisted.

Credit ETF Prices, 3 Years

Source: Ycharts

The Fed then launched on March 23rd an unprecedented program of buying, through the US Treasury, bonds and bond ETFs. The Fed has never done this before, although the Bank of Japan has been buying bonds (and equities) since 2008. This program eased liquidity concerns and credit spreads began to come back down: corporate to 300 bps and high-yield to 8.8% (see chart below). Although volatility might resume in the short term, given the Fed/Treasury unlimited buying power, this virtually insures against further significant declines in bond prices/rise in their spreads.

Credit Spreads, 2007-2020

Source: Ycharts

We rely on our fixed-income models for bond allocations. Our Duration and TIPS models continue to be negative due to extremely low Treasury/TIPS yields (see chart). However, our Credit model now gives a Buy signal as corporate spread jumped above 300 bps:

Source: Model Capital Management LLC

About Model Capital Management LLC

Model Capital Management LLC (“MCM”) is an independent SEC-registered investment advisor, and is based in Wellesley, Massachusetts. Utilizing its fundamental, forward-looking approach to asset allocation, MCM provides asset management services that help other advisors implement its dynamic investment strategies designed to reduce significant downside risk. MCM is available to advisors on AssetMark, Envestnet, and other SMA/UMA platforms, but is not affiliated with those firms.

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