It’s been a big week for financial markets with the U.S. election, several central bank meetings—including the Federal Reserve (Fed), and ongoing pressure from COVID-19. The increased prospect of an orderly transfer of presidential power in the U.S. along with a politically divided U.S. Congress, ongoing central bank support, and hopes for a COVID-19 vaccine all conspired to create a surge in riskier assets and a sell-off in low-risk assets. For fixed-income investors, the short takeaway is the pre-election trends of a steeper yield curve, a weaker U.S. dollar, and tighter credit spreads reasserted themselves and are likely to continue into year-end.
- Money market and short duration. Expect low yields to persist because they are being anchored by the Fed, and investors may need to search for yield in lower-rated credit securities.
- Municipals. Control of the Senate will dictate the fortunes of muni investors, with attention focused on the outcomes of the Georgia run-offs. In the meantime, single-A and triple-B credits with direct taxing authority should perform well, as should select opportunities in the transportation sector.
- Multi-sector investment grade. Upward pressure on rates continues as a “risk-on” environment takes hold and the cost of fiscal stimulus remains a concern. Post-election, we expect the downward pressure on credit spreads to persist.
- Multi-sector plus. Credit spreads for many sectors still remain wide compared with three-year averages (see chart below). We see this as an environment best suited to broad income diversification across sectors such as U.S. high yield, triple-B corporates, and structured products.
- High yield. We believe high-yield markets are poised to perform well going forward. In particular, we look for opportunity in COVID-19-affected sectors such as health care and energy.
- European credit. We are constructive on the European sectors of investment grade, loans, and financials as U.S. election fears subside and COVID-19 turns the corner, hopefully!
Money markets and short duration
The Fed has demonstrated a commitment to ensuring the smooth functioning of capital markets. Therefore, we think it would likely be very accommodative in the near term if uncertainty over the election leads to market volatility. The Fed is also wedded to maintaining a low interest rate environment for at least the next two years or more, judging by policy statements as well as the collective forecast contained in the dot plot (the graph of the Federal Open Market Committee projections). In addition, the recent adoption of the Flexible Average Inflation Targeting, a flexible form of average inflation targeting that aims for the inflation rate to average 2% over time, as a fait accompli has raised the bar for further tightening, reinforcing a bias toward lower rates for a longer period. Consequently, we do not believe the outcome of the election per se will influence Fed policy.
The actions of legislators after the election, however, may influence the degree of accommodation the Fed is prepared to make. In the absence of further fiscal policy, or a smaller-than-expected package, the Fed may be more accommodative than current practice. Conversely, a large amount of fiscal accommodation may allow the Fed to ease up or remove some of its liquidity measures.
The March 23, 2020, announcement of the Fed’s Corporate Credit Facility greatly contributed to the recovery in the corporate bond market. Front-end corporates and asset-backed securities are now officially part of the Fed’s toolkit, the psychology of which has been hugely positive for prices and spreads and negative for price volatility. At this point, we believe that the market would not react overly negatively if the Fed were to cease its extraordinary measures in yield-advantaged sectors. However, it is unclear whether the Fed would do so following its emphasis on the functioning of the financial system in its Statement on Longer-Run Goals and Monetary Policy Strategy, which was released August 27.
There are currently two vacancies on the Fed’s Board of Governors, one dating to 2014 and the other to 2018. The incoming U.S. president may have the opportunity to nominate individuals to fill those seats if the current nominees fail to be confirmed by the Senate. However, the political persuasion of any such candidates may not be meaningful, as the Fed, in spite of a 4-1 Republican composition, has fiercely resisted politicizing its policy decisions.
- Liquidity is key. Consequently, we do not anticipate making any strategic changes as a result of the election. Although portfolio liquidity levels may be slightly elevated through the certification of the election, we will continue to pursue a strategy consistent with the current interest rate and risk environment.
- Front-end taxable yields. It may be difficult to pass another large stimulus plan with a divided government. We therefore expect yields to grind lower. Newly reborn deficit hawks under Senator Mitch McConnell may balk at significant stimulus, leaving the U.S. Treasury bill market to slowly grind toward even lower yields as net issuance declines over time.
- Front-end tax-exempt yields. We think the potential for reversals to 2017 Trump tax cuts could boost blue state finances and increase the attractiveness of tax-exempt securities.
- Risks. If Biden is confirmed president, his financial regulatory team could take a tougher approach to financial industry regulation. This may increase the chances of regulatory reform targeted toward money market funds in the future.
Over the weekend, news outlets declared Vice President Joe Biden as the next U.S. president, capping a week of election limbo. This will result in a change in control of the executive branch in January. While the Trump administration continues to challenge certain election results and tabulation processes, we believe that the results will stand. Less unclear is the makeup of the Senate as two Senate races in the state of Georgia will go to run-off in early January 2021. Should Democrats pick up both Senate seats, the Senate will become a 50/50 tie that requires Vice President Kamala Harris to cast the tie-breaking vote, effectively allowing the Democrats to control both the executive and legislative branches. If Republicans are able to save at least one of the two Georgia seats, Republicans will retain control of the Senate and a divided government will prevail. Given the fluidity of the situation and election fatigue, it’s difficult to handicap the outcomes of the two races. As a result, we believe the impact of the 2020 election on the municipal market will be bifurcated based on the outcomes of the Georgia run-offs. We provide below the effects on the municipal market based on these two outcomes:
- Republicans hold Georgia. If either of the two Republican candidates are able to hold their seats in the Senate, the Republicans will maintain control of their majority in the chamber. Under such a scenario, the scope of additional stimulus will be markedly smaller than the Democratic proposal with much less support for state and local governments. Longer term, under a divided government, we believe the opportunity set of Democratic policy priorities will be drastically diminished in the face of a Republican opposition in the Senate. A wholesale rework of health care, including “Medicare for All,” appears to be off the table and other Biden policy initiatives, including tax reform, energy, and infrastructure, will be subject to vigorous Republican Senate opposition. A divided Congress is bearish to neutral for more marginal credits, including weaker state and local governments and lower-rated health care. The return of tax-exempt advance refundings appears to be more remote, resulting in continued heavier taxable supply.
- Democrats win both Georgia Senate run-offs. Two Democratic wins in the Georgia Senate run-offs will result in a blue wave. Stimulus could be delayed to after inauguration in order to fully fund Democratic relief priorities. While the delay will have real credit impacts on the most marginal credits in the municipal market, we believe the market overall will benefit significantly from the size and scope of a Democratic stimulus package. Biden’s policy proposals include bolstering health care, a rollback of the Trump tax cuts, green energy initiatives, and significant infrastructure spending—all of which would be net bullish for municipal credit (save for a Medicare for All health care plan, which would be a negative for the muni health care sector). The potential for the return of tax-exempt advance refundings would increase tax-exempt supply, which could temper market technicals, but we believe, based on Biden’s tax proposals, this would be more than offset by increased demand for munis from high-income earners. Under a Biden administration, we would expect local general obligation bonds, transportation, health care, and munis in high-tax states to disproportionately benefit, while coal-heavy utilities and tobacco settlement bonds could face additional regulatory scrutiny.
Multi-sector investment grade
A political split between the executive and legislative branches looks increasingly likely, which we would expect to drive a tightening in credit spreads. Upward pressure on rates continues as a “risk-on” environment takes hold and the cost of fiscal stimulus remains a concern.
U.S. Treasury yields have risen and credit spreads have responded positively to preliminary election results. Even with a contested U.S. presidential election, spreads have tightened as investors see a clear path to an election outcome. Preliminary results point to a political divide between the Democrat-controlled executive branch and House and the Republican-controlled Senate. We expect interest rates to challenge the 1% level on 10-year Treasuries as the removal of election uncertainty creates a “risk-on” environment and the cost of fiscal stimulus remains a concern. Further rate increases from here will be limited because we think rates above 1% will be deemed attractive by global investors. A divided Congress may also limit the regulatory impact Washington may have on corporations, which should be positive for risk assets. We expect very strong technicals to remain supportive of U.S. credit into year-end. Periodic bouts of volatility should continue to create security selection opportunities within the investment-grade credit space.
Post-election, we expect the downward pressure on credit spreads to persist, as hopes of a relatively quick election resolution come to the fore. In addition, the aforementioned political gridlock should limit major changes to the regulatory backdrop after four years of easing under President Trump. Beyond political considerations, supply/demand technicals in the bond market remain favorable despite a massive upsurge in issuance in 2020. Lastly, the recovering economy could get a meaningful boost from the development and mass-scale distribution of a COVID-19 vaccine. Conversely, drawn-out, contested election results can lead to uncertainty, unrest, and spread volatility, as could a resurgence of COVID-19 and a “false dawn” for a vaccine.
While the final outcomes remain to be decided, there are a few things that have become clear since Tuesday’s election. First, the media pronounced Joe Biden the winner of the presidential election. Second, the prospect for a pronounced “blue wave,” which had risen steadily over the past several months, has faded with ultimate control of the Senate to be determined by run-off elections in January.
The chances of a radically progressive policy agenda have been reduced because a divided government suggests continued gridlock and partisan wrangling. We expect the economic recovery to continue in the U.S., though the pace of the recovery will likely continue to slow. The jobs lost and businesses shuttered by the pandemic will be difficult to fully recover, and we may be entering the “slow grind” phase of the recovery from here. Promising news about the COVID-19 vaccine could boost growth over the next few quarters, assuming wide availability and effectiveness in line with clinical trial estimates.
There may yet still be additional fiscal stimulus on the horizon as the U.S. economy recovers from the brutal contraction earlier in the year. The results of the election, however, diminish the likelihood of a huge surge of additional spending. This could prove difficult for municipal issuers who were counting on additional stimulus to fill budgetary gaps, and for industries such as airlines or hospitality that may have been looking for additional support as the pandemic continues to upend their business models. The potential for smaller and/or delayed stimulus also portends less near-term Treasury issuance. The tail risks around inflation are greatly diminished, and the opportunity to trade curve steepeners (longer-term yields increase more than shorter-term yields) as a result of the election is likely gone for now. We remain close to neutral in duration across our portfolios and don’t expect yields to move significantly in either direction.
Overall, the outcome of the election is likely a modest positive for credit markets. The Fed remains supportive and the global hunt for yields persists, which is driving technical support across many sectors and markets. The industries that were poised to see the most harm from a blue wave scenario—energy, health care, communications, and technology—will likely see renewed market interest. Credit spreads for many sectors have tightened significantly since their wide levels seen earlier in the year but remain wider than their longer-term averages, and many are higher than where they started the year. We continue to see this as an environment best suited by broadly diversified positioning across sectors.
High-yield markets responded favorably to the growing possibility of a Democratic president and divided Congress with tighter credit spreads and lower yields. The sharing of power should limit the risk of extreme political outcomes and also encourage all parties to pivot to the center to tackle the economic, health, and social challenges facing our country. Beyond the election, the Fed and other global central banks stand ready, willing, and able to do what they can to help support economic growth, buffer the economic consequences of the global pandemic, and provide sufficient liquidity to ensure functioning financial markets. Concurrently, the health care industry is working feverishly to find a vaccine for the virus. With these macro currents surging through the system, it’s no surprise that high-yield returns have bounced around quite a bit in 2020. However, as each current aligns and settles down, a few basic investment principles emerge. One, the U.S. economy is in recovery mode, albeit a COVID-19-dominated recovery, but a recovery nonetheless. Two, the Fed remains the most dominant force in fixed-income markets, with a very strong (positive) influence on credit markets. Three, the global search for yield remains firmly in place. These three factors should support high yield as we head into 2021 regardless of the final presidential outcome.
Due to the idiosyncratic nature of high yield, macro strategies tend to take a backseat to micro strategies. That said, a few sectors should shine brightly given the macro backdrop described above.
- Position for steeper yield curves. The Fed remains firmly in control of five-year and shorter yields. As such, low yields at the front end should help stabilize bond prices, while the search for yields causes spreads to narrow. Further out the curve, yields could rise. Over time, “insurance protection” against political shocks and more dire COVID-19 outcomes are likely to be unwound as each are resolved. The latter could last much longer than expected, which would keep yields low, but conversely, a vaccine could emerge.
- Health care. Health care is a hot-button sector for both Democrats and Republicans. The overall high-yield health care sector tends to trade tight versus the rest of the market, which requires astute subsector strategies and issuer selection. Across the sector, we see several ways to position for a divided government and favorable macro backdrop. Acute-care hospitals and managed care organizations (MCOs) are less likely to see benefits of expanded coverage, but the near-zero probability of Medicare for All creates stability and, to a certain extent, certainty. As such, current valuations of the highly leveraged acute-care sector and MCOs appear in line for these credits to retain their triple-B/double-B credit quality. Prescription drugs are likely to remain in the crosshairs of both parties’ efforts to curtail pharmaceutical pricing power with legislation. To mitigate these risks, high-yield investors may want to consider generic pharmaceutical companies over specialty pharmaceuticals, particularly those with heightened revenue concentration.
- Energy. High-yield energy is a market unto itself. Fears of a political backlash against fracking and the acceleration of decarbonization initiatives subsided considerably with the possibility of a Republican Senate. However, investors should expect renewed focus on renewable energy with a Biden administration. That said, supply rationalization over the past two years has created new winners and losers. Oil and gas producers may experience an upsurge in demand as the economy recovers, especially if a COVID-19 vaccine emerges. Higher crude oil prices help reduce the risk of costly, prolonged creditor battles in bankruptcy. We believe oil producers with positive convexity/uncapped upside and natural gas producers should perform well in the current environment.
- We want to buy on weakness because technicals and fundamentals remain supportive of European credit.
- International investors’ focus from here will be on COVID-19, its impact on the global economy, and the race for a vaccine. We expect some bouts of volatility along the way.
- Central bank support, low interest rates, and the continued hunt for yield will continue to underpin European credit into next year.
For European investment-grade credit strategies specifically, we entered the U.S. election broadly neutral-weighted to U.S. risk, with a bias to communications and globally diversified real estate investment trust sectors and an underweight to U.S. energy. From here, we believe positive market technicals and the modest issuance that is expected for the remainder of 2020 should support credit spreads as investors continue to be starved of yield opportunities. Secondary Market Corporate Facilities, as well as those put in place by the European Central Bank (ECB) continue to provide support and stability. We will look to deploy cash into market weakness, avoiding the sectors more affected by COVID-19, such as food services, travel, and leisure.
Turning to our loans and high-yield bond strategies, supportive fundamentals such as continued monetary and fiscal support in the face of COVID-19 are likely to continue to be in place as Biden takes the helm in the U.S. When looking at historical data for European loans, the average returns for the one-, three-, and five-year periods following the point in time when spread levels have traded within 50 bps of current spread levels, we have seen returns of 5% or more per annum for subsequent years.1 Therefore, we view European loans as attractive in this current environment with security selection remaining the key to success as we continue to look to exploit single-name dislocations that have increased in the secondary market as a result of increased dispersion.
Finally, for our financials credit strategy, we remain constructive because the major supportive factors for the sector remain unaffected post the U.S. election result—namely, strong balance sheets; government support for borrowers hit by COVID-19 lockdowns; and the ECB and the Bank of England’s support through regulation, liquidity, and quantitative easing. If we see market weakness, we believe it will be an opportunity to add risk, especially as central banks have promised further support going forward.
The ratings indicated are from Standard & Poor’s, Moody’s Investors Service, and/or Fitch Ratings Ltd. Credit-quality ratings: Credit-quality ratings apply to underlying holdings of the fund and not the fund itself. Standard & Poor’s rates the creditworthiness of bonds from AAA (highest) to D (lowest). Ratings from A to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the rating categories. Moody’s rates the creditworthiness of bonds from Aaa (highest) to C (lowest). Ratings Aa to B may be modified by the addition of a number 1 (highest) to 3 (lowest) to show relative standing within the ratings categories. Fitch rates the creditworthiness of bonds from AAA (highest) to D (lowest).
1 WFAM Credit Europe and S&P European Leveraged Loan Index as of September 30, 2020.