The Fed vs. Fundamentals

Financial market performance and economic fundamentals were at odds in Q2 2020. Markets rallied hard despite continued deterioration in the underling fundamental data, both at the company level and in the broader economy.  The single most important reason for the divergence was Fed intervention.  Since the last podcast three weeks ago, markets took on a more “risk off” tone in equities and rates while investment grade spreads held in much better.

Transcript

Jeffrey Addis:
Welcome to our podcast. My name is Jeffrey Addis. I am the President and Chief Operating Officer of Merganser Capital Management. Before we begin, a few important regulatory disclosures. This presentation is for informational purposes only and should not be considered as investment advice or a recommendation of any particular issuer, security, strategy or investment product. Now on to our podcast.

Andy Smock:
Hello and welcome to the Merganser podcast. Today is June 29th, 2020. My name is Andy Smock, CIO. Of course, the focus remains on the path of reopening and the developments of the virus. We have seen a continued increase in cases, a new record single day count last week. Certain states are worsening more than others, particularly large states that can make a large impact and which may have opened too quickly. It's hard to call it good news, but the death rate remains low. New jobless claims have been falling, while continuing claims remain high at nearly 20 million. It's hard to believe, but it's almost July 4th, and because of that, the all important non-farm payroll number is going to come up Thursday instead of Friday. Recall last month's huge positive surprise. The market's looking for further improvement to three million jobs, but data remains noisy and not without virus related methodology issues.

The second quarter of 2020 will go down as the worst quarter for the global economy since at least World War II, but a strong one for the financial markets. For the month of June, the long end of the yield curve is a few basis points lower and the S&P 500 is essentially flat. This sideways action has not been in sync with credit markets. Virtually all investment grade fixing home sectors have seen significant rallies in June. The only broad sector to underperform US treasuries in the Bloomberg aggregate has been in agency RMBS, which is struggling with interest rate volatility and started the month with much more rich valuations than other sectors.

The reason for the disconnect between credit performance and other metrics is largely due to the Fed. The Fed, as expected, left policy rates unchanged at the recent meeting. The biggest news from the meeting was buying a broad and diversified portfolio of corporate credit without requiring the issue to "opt in". To the negative, they dramatically lowered their economic growth outlook. They see the unemployment rate at over 9% at year end 2020, and five and a half percent at the end of 2022. Further, they lowered their inflation expectations to 1% for 2020 versus 2% target. Given that the Fed is missing their inflation target and missing their max employment mandate, it makes sense that they don't expect to raise rates through 2022. I think it's safe to assume that they will risk overshooting their 2% inflation target before raising rates again. It also sounds like they still don't consider negative rates a good policy option. This is good news.

While the Fed's outlook has come down, not all news is bad. As the economy continues to heal, the City Economic Surprise Index is, at all time highs as data has been strongly better than expected. Of course, part of this is due to low expectations. We saw a blockbuster retail sales number for May. Auto and gas was up 12%, which is more than twice what was expected, yet still down 6% year over year. The CFPB reported that the medium unemployed person received 134% of pre unemployment earnings. While this softens a blow of a lost job and supports the economy through spending, there's concern about it being a disincentive to work that can prolong the recovery and the unemployment situation.

While the Stimulus and CARES Act payments have kept low income expenditures may be expiring soon, it's hard to see politicians allowing that to happen in an election year. There's talk of a potential one trillion infrastructure plan, and we continue to hear about improvements in treating COVID patients. Every day we are one day closer to a cure or a vaccine.

Andy Smock:
If you've been holding out for negative mortgage rates, you may be disappointed. Housing data has rebounded strongly with current 30 year rates at 3.1% near record lows, but still rather high given where treasury rates are. A general pullback in mortgage credit risk taking, along with logistical challenges of underwriting mid-pandemic, has made the spread wider than usual. We'll learn more about mortgage credit risk this week with the first post COVID single family mortgage credit risk transfer transaction from Freddie Mac. This corner of the mortgage market shut down in the early days of the pandemic and saw very poor performance, but then a strong recovery in secondary markets. New issuance has been very slow to recover. This is a critical piece in the puzzle to understanding what happens to mortgage rates, to say nothing about the drop in non-bank mortgage lending. Both of these are critical to a diversified housing finance system that took a decade to nurture and develop after the last crisis.

Taking a step back from the minutia of mortgage credit risk to fixed income in general, the market seems priced for a return to moderate growth and very low inflation for a long time. With it fixed at 33, only modest levels of implied market volatility and high yield pricing in less than recessionary risk, it feels as if these levels are inconsistent in an environment of extreme uncertainty. While the Fed has been successful in stabilizing markets so far and remains a powerful buying force, the shape of the fundamental recovery remains to be seen. To the good, there's still a lot of capacity under the programs that have been announced so far. The Money Market Mutual Fund, Paycheck Protection Plan, Corporate Credit Facility, Main Street Lending and municipal lending programs are combined, less than 50% utilized. The push and pull between technical, Fed buying, and fundamental, pace of reopening, factors will be dramatic through the rest of 2020 and at the forefront of fixed income investors' minds.

Thank you for listening to Merganser's second podcast. We aim to produce timely and digestible information for our community of investors. Take care and have a happy and safe 4th of July.

Jeffrey Addis:
This commentary contained or incorporated by reference certain forward-looking statements, which are based on various assumptions, some of which are beyond our control. Opinions and estimates offered constitute our judgment and are subject to change without notice as our statements of financial market trends, which are based on current market conditions. No part of this presentation may be reproduced in any form or referred to in any other publication without the express written permission of Merganser Capital Management. For more information, please visit our website at www.Merganser.com. Thank you.