Market Commentary

The recent Pfizer vaccine announcement (followed swiftly by Moderna’s) was the gamechanger. With claims of a 95% efficacy rate, it heralded the definitive beginning of the end of COVID-19. If a year ago no one could imagine a world engulfed in a pandemic, now it is hard to envisage a world without Covid. And this spectacular breakthrough could not come at a more propitious time. Covid cases are spiraling all over the world. Europe has had renewed broad-based lockdowns. The US is considering regional lockdowns. Fortunately, the death rate continues to recede. But the sheer magnitude of case increases is leading the death toll to mount. As investors, our particular challenge is how to weigh the benefits of a Covid-less future with the still profound difficulty in getting there.

Our inclination is that markets are very forward looking. Risk markets have been rallying since the depth of the crisis in March, as sentiment and expectations that the war against Covid and the enormity of the policy response to maintain economic momentum would carry the day. Even as Covid resurgence brings more cautious economic behavior, and slack in the global economy remains dangerously high, markets are trying to calibrate to a future that should look meaningfully different from the present. Our strategy, simply put, has been to own assets that would benefit from this calibration to a brighter future, while pursuing complementary strategies that would help mitigate the potential setbacks on the road to that future.

What has changed is the timeline. Our Coronavirus Task Force still believes the difficulties in getting vaccine production, acceptance, distribution and widespread global vaccination will take the better part of a year. But as the medical focus on front-line workers, those with preexisting conditions and the elderly begins to broaden, the economic anxiety of society and the need for recurrent lockdowns may vanish.

We thought all the major risk sectors of fixed-income were badly oversold in the fear that followed the global pandemic. Our belief has been that policy support coupled with a meaningful recovery from a very depressed condition would eventually benefit all these sectors. We moved to add investment-grade corporates primarily and noncyclical high-yield credit additionally with a view that specific policy support would reinvigorate these sectors even in what might well prove to be a very extended recovery. We recently have added to specific positions in both the reopening sectors in high-yield and some areas of structured products. Going forward, we feel markets will extend their optimism more broadly in these areas. We intend to rotate away from more fully valued investment-grade and high-yield securities very selectively into those aforementioned sectors. The other area where we are optimistic is emerging market (EM) debt, which we believe is a highly undervalued space. Despite the enormous medical and fiscal challenges EM countries face, the steadily increasing probability of a global economic recovery will entice investors into EM debt.

To balance the risks of potential bouts of economic weakness or market pullbacks, we believe it is prudent to only partially hedge risk positions resulting in a duration overweight. In essence, include not only some positive “soft” duration (from spread sectors) but also explicit Treasury duration as an insurance policy. In the immediate future, the Covid crisis is increasing. In the intermediate future, as the Covid vaccination process extends, the willingness to provide ongoing massive fiscal support should wane. In the longer term, the need for fiscal retrenchment—think higher taxes—will likely emerge.

What will remain constant? The historically unprecedented asymmetric nature of monetary policy, particularly in the US, will keep interest rates ultra-low for years. Central bankers from developed countries around the world have been extremely explicit in guiding markets for a “lower-for-longer” rate environment. Concerns over higher, more permanent levels of unemployment are first and foremost. “Scarring”—the inability to easily regain employment or career traction—will persist. The monumental workforce change of utilizing technology will also slow labor force reabsorption.

Nowhere is this commitment to accommodative monetary policy more evident than in the US. The Federal Reserve (Fed) came into the year already poised to ease 10 years into an expansion due to the chronic undershoot of inflation. The Fed then massively expanded its balance sheet, easing more in three months than during the entire aftermath of the global financial crisis. The Fed’s battle cry was “we will do whatever it takes.” Then the Fed used its long-term policy review to change its reaction function in an even more structurally dovish direction. On inflation, the Fed is committed to seeing actual realized inflation of at least 2% before hiking—but it must also be judged to be able to continue this above-target level for a sustained period of time. (Is this one year? Two years?) In combination with that higher bar of inflation, the Fed also upped the ante on unemployment. Now full employment must be achieved for every segment of the population, most particularly for the lower-income and disadvantaged groups. Fed Chair Jerome Powell specifically noted last week that this took six to seven years in the last economic expansion. Clearly, if there are bumps in the road, the Fed will do more. If the recovery proceeds apace, the Fed will be extremely careful before “even thinking about raising rates.”

The combination of truly extraordinary news on the vaccine front, reasonable current economic momentum and probable further fiscal help should support fixed-income spread products. The Fed’s determination to prevail against strong disinflationary forces is encouraging, even if the task will prove difficult. The enormity of the Fed’s commitment to its asymmetric approach also supports the likelihood of the sustainability of the recovery even given the immediate growth challenges from the Covid crisis. This “very low, for very long” commitment also enhances the prospects that Treasury duration can be a useful complementary portfolio asset.

...