- During these unprecedented times, we are reminded of the true value of portfolio diversification.
- With the continued uncertainty caused by the pandemic and the current state of the global economy, elevated tail risk appears to persist, and it will be critical for investors to manage such risks.
- To navigate the current environment, we continue to manage disciplined, well-balanced and diversified portfolios for our clients.
This month’s main article, The Power of Diversification, discusses why portfolio diversification is important during these unprecedented times.
The Power of Diversification
Renuka Kumar, CFA, Head of Portfolio Management
One question I have been getting over the past few months is, “What have recent events taught investment managers?”
Without hesitation my answer is, “the importance of diversification.” Or rather, the pandemic has simply reminded us of the true value of portfolio diversification.
The events that unfolded in financial markets back in March can be classified as classic tail risks. Some have even been referring to the coronavirus pandemic as a Black Swan event. At first take, this seems reasonable given the outlier nature of the event and its extreme magnitude, and the other qualifying factor of rationalization in hindsight. This classification has been challenged by some on the notion of how predictable this was, but regardless, it’s critical for investors to manage for such risks—foreseen or unforeseen.
To be clear, fixed income markets took a sharp turn in March emphasized by the Federal Reserve’s quick and broad response to the market turmoil, including slashing interest rates to zero and launching an array of other measures. Prior to those actions, the Fed had indicated it was on hold with regard to further interest rate changes. The Fed had recently completed three consecutive “insurance” cuts in 2019 to provide economic support in the midst of escalating trade tensions. Heading into 2020, economic headwinds had diminished with progress on the trade front with a Phase One deal with China. Brexit also seemed to be headed to an orderly resolution, with the UK moving negotiations forward with the European Union.
Furthermore, the domestic economy was in a position of strength, with continued low unemployment and healthy consumer spending. With a subdued Fed, we underscored the potential for event risk and volatility and, as such, maintained a balanced approach in our clients’ portfolios.
For the average investor, it’s easy to get lulled into complacency and overweight risk assets when times are good. But we know that tail risks and uncertainties remain.
Preparing for the future
So how does an investor prepare for these uncertainties? The answer is through portfolio diversification, which can take many forms in a practical application. Asset class is just one way to diversify, and the Callan chart below clearly illustrates the importance of spreading risk. Sector diversification, country diversification and issuer diversification also play a combined role in achieving a diversified investment portfolio. It’s not just about reaching for the highest return in good times, but it’s about having a balanced approach. And this is important for dynamic and high growth companies that place a high importance on liquidity and capital preservation.
This approach was confirmed back in mid-March when liquidity was strained in credit markets for a period of time. Although credit fundamentals remained solid, we saw the liquidity impact on corporate bond and commercial paper bids. For companies that needed quick access to liquidity, the allocation to government money funds and US Treasuries afforded the luxury of having access to cash and locking in portfolio gains.
It’s also a good idea to consider portfolio diversification in terms of duration. Rather than overweighting investments in one part of the yield curve, it’s important to take a balanced approach to duration, especially in times of market uncertainty with the future direction and timing of interest rates.
Given the current state of the pandemic and global economy, it appears that we will be hanging out in the tails of the bell curve for some time. There is a great amount of uncertainty that remains and we can envision both bullish and bearish market scenarios. Regardless of the market scenario, a disciplined, well-balanced and diversified portfolio is key to navigating the current environment.
Jon Schwartz, Senior Portfolio Manager
Everybody wants to know if the market is properly handicapping a V-shaped economic recovery, or whether it’s just a false start. It’s a tough situation to read. Certainly, the economic backdrop has shown signs of improvement since the depths of the crisis in March and early April. In the early stages of reopening, a significant spike off the lows would be expected, but recent data have been significantly stronger than even the rosiest of expectations. Starting with the employment backdrop, analysts expected May nonfarm payrolls to decline by 7.5 million, with unemployment rising to 19 percent. The actual nonfarm payroll number came in at plus 2.5 million new jobs and unemployment declining from 14.7 percent to 13.3 percent. That’s an outperformance of 10 million jobs! Not one of the 78 economists polled in the survey expected a positive payroll number. This clearly supports the thesis that the employment downturn bottomed in April.
Adding to the good news were surging retail sales during May, rising 17.7 percent month-over-month. This is a positive sign for consumer spending, and it’s encouraging to see this consumer behavior as the economy continues to reopen. Naturally, the trend toward online spending accelerated during the shelter-in-place restrictions, but online spending growth continued in the month of May. Clearly this “Amazon effect” on spending is not solely driven by an inability to visit physical stores. The rebound in retail sales was further supported by very strong auto sales, as dealership sales grew 44 percent over the prior month. Although it will be challenging to return to pre-COVID-19 levels of activity in restaurants and bars, sales rose 29 percent in this category as well, albeit from very depressed levels. Although some housing indicators were lackluster for the month of April, there were some encouraging signs heading into May. Even with elevated unemployment at 13.3 percent, it’s impressive that home purchase applications rebounded to the highest levels since late 2008 and home builder sentiment showed a net expansion in activity as it rose by a record 21 points in June to 58.
The Federal Reserve delivered its first Summary of Economic Projections (SEP) since the crisis began. While Chairman Powell has made it clear that these projections are an aggregation of each Fed governor’s expectations for the economy and not a road map for them to change their near-term outlook, it provides a helpful litmus test for future economic growth. As the accompanying table shows, most Fed officials believe that growth will rebound sharply in 2021 and continue at a robust pace the following year.
We are clearly seeing green shoots in the economy, but we cannot ignore the downside risks. The risk for a virus resurgence is very real and has the potential to become more evident as the summer goes on. Many states are currently experiencing growing cases and rising positive testing rates (e.g., Alabama, Arizona, Florida, Georgia, Mississippi, South Carolina and Texas). This, paired with finite hospital capacity, has increased the risks associated with a virus resurgence in several states. In addition, cases continue to rise above the seven-day average in the US, not to mention flare-ups seen in Latin America, Southeast Asia, India and other countries. From an economic perspective this matters as concerns of a virus resurgence weigh on consumers’ minds and influence their spending habits.
We are still in the early days of a potential recovery, but the recent economic data suggest we may be on a path to a V-shaped recovery. Of course, challenges remain, and it’s too soon to declare victory. The “V” could easily become something more like a “U.” Consumer behavior will be dependent on business spending, which ultimately leads to hiring. For now, companies are being conservative and are expected to pull back significantly on machinery and equipment spending as we move through 2020. This will not boost the employment rebound or aid productivity growth. But for now, it’s encouraging to see the trend as we attempt towards some version of normalcy.
Tim Lee, CFA, Senior Credit Risk & Research Officer
Credit card asset-backed securities (CC ABS) investors are facing hiccups in collateral performance, thanks to rising unemployment and lower consumer spending as a result of the COVID-19 containment efforts. Yet when stepping back to view the bigger picture, we believe that any deterioration in credit metrics in coming months is nothing to worry about. In other words, no reason for investors to hold their breath.
So what, exactly, is grabbing investors’ attention? First, delinquencies are likely to rise, as cardholders who have lost jobs or wages will be unable to pay on time. Second, monthly payment rates should fall, as more vulnerable cardholders may choose to pay less each statement period. Third, many cardholders, who have had to adhere to shelter-in-place orders, will have lower utilization of their cards, given the restrictions on travel, entertainment and shopping. Fourth, excess spread may fall, as lower card utilization will result in reduced interchange fee revenue. And lastly, charge-offs are expected to rise, and some delinquent accounts will eventually be written off.
CC ABS data for April and May, which reflect the initial wave of COVID-19 shutdowns, show some signs of stress, but we are not overly concerned about a larger negative trend. Using our index of major CC ABS issuers*, we note that delinquencies thus far remain muted, most likely as a result of a combination of card issuer forbearance programs, expanded federal unemployment benefits, and federal government stimulus payments. Delinquencies will likely rise through the rest of the year, though we expect they will not breach the levels experienced during the previous recession in 2009.
*Constituents in the SVB CC ABS Index are: American Express Credit Account Master Trust (AMXCA), BA Credit Card Trust (BACCT), Citibank Credit Card Issuance Trust (CCCIT), Chase Issuance Trust (CHAIT), Capital One Multi Asset Execution Trust (COMET), Discover Card Execution Note Trust (DCENT), Barclays Dryrock Issuance Trust (DROCK), Synchrony Credit Card Master Note Trust (SYNCT). Data from SEC filings.
Monthly payment rates have fallen, though they remain comfortably above the average base case assumptions from S&P or Moody’s. Payment rates should stabilize further, if the reopening continues and economic activity begins to gain momentum in the second half of the year.
While actual losses are too early to tally, we note that charge-off levels are currently far below the base case assumptions from either S&P or Moody’s. Even with an expected fall in excess spread, we estimate that structural credit support provides a comfortable margin of safety against a meaningful increase in net charge-offs from May 2020’s index net loss levels.
Although we expect performance to be uneven and possibly even deteriorate over the next 12 months, we believe the ultimate credit impact will be superficial. This is primarily due to the age of the credit card accounts that collateralize major CC ABS. On average, 93 percent of the outstanding receivables from the major CC ABS issuers in our index are from accounts that have been opened for at least 60 months. In some cases, the average account age runs as high as 20 years. These older accounts indicate that the cardholders have been successful in servicing their balances for an extended period of time. Some accounts have even weathered two prior US recessions largely unscathed. In our view, these older accounts should help smooth over much of the potential negative financial impacts associated with the current downturn to support the credit standing of AAA-rated CC ABS from issuers in our index.
Hiroshi Ikemoto, Fixed Income Trader
As the second quarter came to a close, perhaps the most stunning aspect in the credit market has been how quickly it has recovered. It was only March when we basically saw the bond market shut down. Even now, with news that many parts of the world are scaling back their reopenings and with the resurgence in COVID-19 cases dimming optimism, demand for corporate debt has continued to thrive. Credit spreads between investment grade and junk-rated bonds continue to tighten, as investors look for any excess income vs. historically low Treasury yields. Two major factors have fueled the rising confidence in credit markets: the record amount of low-interest debt issued by both healthy and struggling companies and the unprecedented amount of monetary stimulus the Federal Reserve has provided throughout this pandemic.
In the US with cheaper funding rates providing the opportunity to build cash reserves, investment grade companies have issued $775 billion in bonds during the second quarter of 2020 alone, roughly the same amount of all new investment grade debt issued in the first half of 2019. As the oversubscription of most new bond sales illustrates, investors are seeing this inflow of excess cash as protection against default risks in the near term, and they are betting that this financing bridge will get companies through the current uncertain economic environment.
The other factor that has instilled confidence in investors has been the Federal Reserve’s unprecedented stimulus that was provided to the economy and the credit market. There are too many new emergency facilities to name here, but all have provided liquidity and backstops to almost all sectors of the bond market, including mortgages, municipals, exchange-traded funds (ETFs), primary and secondary bonds, and commercial paper. Although many of these programs have not been fully utilized yet — which is probably a good sign — the knowledge of their mere existence has put many participants at ease and encouraged a risk-off mentality.
Obviously, the current pandemic is nothing we have seen in our lifetime, and things can and do change rapidly. Unemployment is still near record highs, and the speed by which the economic reopening continues is uncertain. In these times, our philosophy and investment strategy remain disciplined with respect to our chief mandates of capital preservation and liquidity. We continue to focus on diversifying portfolios, both in terms of sector allocation and duration, which should help weather against any potential headwinds while still providing income.
|Treasury Rates:||Total Returns:|
|3-Month||0.13%||ML 3-Month Treasury||0.01%|
|6-Month||0.13%||ML 6-Month Treasury||0.02%|
|1-Year||0.15%||ML 12-Month Treasury||0.05%|
Source: Bloomberg, Silicon Valley Bank as of 6/30/20