Transcript:

Hello, everyone, and welcome. Now, all of us have seen the strength and performance that we experienced in the second quarter. What I want to do is begin by revisiting the three pillars that we’ve talked about previously, that I believe drove that strength: the first pillar being our efforts to flatten the viral curve, the second to support the victims of social distancing from our largely shut-down economies, and thirdly, to open up capital markets and liquidity again. Those last two were largely addressed by a massive joint fiscal and monetary effort from the U.S. government and the Federal Reserve. To the U.S. government side, over $2.5 trillion in programs, and we saw an immediate benefit when the first Payroll Protection checks went out. That directly synced up with an increase in consumption. And on the Federal Reserve side of the ledger, a lot of programs were introduced, many of which we saw from the global financial crisis, but what was different was literally the size and scale of it all and the speed with which it came out. But, much like the ‘08 financial crisis, as the Fed’s balance sheet grew, so did financial markets, and specifically, as the Fed started to talk about its credit-support facilities, credit spreads fell and bond prices rose. And most importantly, bond market issuance was unlocked for borrowers across most of the corporate spectrum. And then if you finally add that into the economic reopenings that started to take place, we saw true economic stability. The unemployment rate fell, and the expected original hit to economic growth was lessened.

And so translation, the three pillars were hugely successful as we made our way through the second quarter. But the critical question that I introduced a few months ago was the notion of if it would be long enough and strong enough to get us all the way to the other side of the viral impact? And that’s really important now because we’re starting to see some cracks. Let’s first start with the pillar that I don’t see a lot of cracks in, and that’s the Federal Reserve. They’ve indicated they’re going to do whatever it takes. Rates are going to be at zero for a long time. There’s lots of capacity in their existing programs. And believe me, if any of them are not quite right, the Fed will adjust them accordingly.

Cracks exist within fiscal and obviously within viral. From a fiscal perspective, as we’ve seen some level of stability over the last few months, and as we get closer to the election, that original drive to enact fiscal support has been replaced by a lot of disagreement around the amount that is still required. And that’s unfortunate because we believe there’s still a lot of fiscal support needed. There are still a lot of Americans that are unemployed, and in our economy that means a massive income, and therefore consumption, and therefore GDP hole, that needs to be filled.

And I’m also adding to that now the viral pillar, because as everyone watching the news or living in many of the affected areas knows, several states are beginning to see upward pressure in cases, which is putting pressure on medical resources. And if you take it to its natural conclusion, ultimately that can cause unwinds in both the economy and in the market gains that we’ve seen so far. Now, we’ve been dealing with this idea for a while. How do I balance the fat-tailed nature of strong potential returns against a significant risk that we’ve seen? But given all of the market strength, it adds even more question marks in the minds of investors with what’s been developing.

I focus on portfolio construction that relates to sequence-of-returns risk, and I think today is not only no different, but it’s heightened. In fact, I think it’s more important today than ever to choose portfolio ingredients that can generate reasonably solid returns but with strong downside protection: the first is quality and the second is credit. As it relates to quality, the data on its performance versus broad markets is very clear. Over the last quarter century, the factor has outperformed broad markets meaningfully and, most importantly, has done so through outperformance at significant downturns. That’s not in question. What’s in question is how do you define quality? Because the reality is quality is a characteristic and not a metric. In today’s COVID world, I have three ingredients that I think are important and play well together: the first is going to be high and stable growth, the second is going to be free cash flow generation, and the third is going to be strong balance sheets. Clearly, if you put those together, you get the notion of how those types of companies could be more resilient against the economic question marks that we have.

And then on to credit. High yield as an equity de-risk, in today’s world with elevated spreads, is perhaps more attractive. Notice that when spreads are at about 600 basis points, like they are at the time of this recording, that the forward 12 and 24-month performance of high yield versus equities is dominant, and again, with much greater downside protection. So first, today’s COVID world offers better return potential. Secondly, your portfolio shouldn’t be all high yield today, because the reality is there are other areas of the markets that recover more slowly. So, I think it’s more of a pie with different slices. Within this corporate credit space, I’d have a focus on higher-quality high yield and even some triple Bs and with an emphasis on fallen angels because they tend to perform really well, and we’ve seen that happen thus far this year. But the other pie slices are securitized debt and emerging market debt. Within the securitized space, residential and commercial real estate has struggled to recover as quickly as corporate credit, and I think there’s meaningful opportunity there. And likewise for emerging market debt, with a focus on U.S. dollar-denominated credit, both sovereign and corporate issuers. Taken together, that combination, even if blindly put together, has more yield than high yield with a higher credit quality. That’s clearly something we should be looking at.

But this is not just a playground for total-return-seeking investors. This is also a survival tool for income-seeking investors. And the reason is because right now high-grade yields are running below the rate of inflation, and that is not going to change anytime soon. And so, for an income-seeking investor looking to get yield above the rate of inflation, which we critically should be doing, you must add credit. Now, we’ve talked about this a lot, blending high grade and high yield, it’s a credit barbell. And typically, it’s a really efficient structure. But today, it’s a critically important structure. We believe the Federal Reserve has indicated that you should probably be thinking about a credit barbell, because it is supporting the rates market so strongly and it has direct programs in support of credit. So this is an area I’d be looking at very, very strongly for credit investors and also for income-seeking investors.

Look, I’m always going to tell you about sequence-of-returns risk, and I always believe it’s going to be important. But until we get to the other side of the virus, there is no way to escape that there are going to be tremendous potential returns that we could see if things stabilize and there is tremendous risk to our portfolios otherwise. Until we get to the other side, make sure to keep a keen eye toward ingredients like this and put them through this COVID lens. I think we’ll benefit from it as investors. Thank you again for joining, as always, and I will talk to you next quarter.

Capital Markets Outlook: 3Q:2020

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