Key Insights:
Social status quos will likely remain difficult to normalize to pre-COVID levels.
Economic underpinnings such as record level corporate bond issuances, historically high M2 supply, 14-year high housing prices, mature bear steepening environment, increasing inflationary expectations, potential for rising rates and a Fed tapering of QE can generate “Economic Recovery Risks.”
“Economic Recovery Risks” include rising rates diminishing returns on longer maturity bonds, transitory inflation, increased opportunity for credit risks for overleveraged companies, stock market volatility, continual slide of the USD, Fed tapering (after 2022) widening mortgage and corporate bond spreads (like 2013’s taper tantrum).
Short-term bond, legacy non-agency RMBS, convertible bond, floating rate, commodity focused, and gold linked strategies all have unique characteristics to weather dynamic “Economic Recovery Risks.”
So far in 2021, we have experienced record-breaking vaccine inoculations, robust global economic recovery, and the preclude to normalcy. However, it is vital to remember how long this “anomaly” has lasted and the lingering social and economic repercussions that follow.
As I have discussed prior, social status quos will remain challenging to break as excuse maintenance of present circumstances for many will likely linger for years. Permanent changes to the 5-day work week, city living, suburban population increases, and significant public events will probably take many years to normalize as the stigma of COVID-19 will remain challenging to ignore. The behavioral decision-making of individuals and organizations may subconsciously or deliberately change their decision-making nexus when it comes to everyday tasks, school, work, investing, and retirement. The taboo of working from home seems to be permanently abolished as many companies, and their employees proved to remain efficient throughout COVID-19.
These society illustrations aside, COVID-economic and post-COVID economic dynamics remain the most visible. Throughout COVID-19, interest rates fell to historic lows, the Federal Reserve (Fed) initiated an aggressive quantitative easing (QE) program, buying $120B per month in Treasuries ($80B) and MBS ($40B) in an attempt to keep short-term rates near zero to ignite economic growth. With rates (including mortgage rates) at historic lows, corporate bond issuances and mortgage refinancing/prepayments reached historic levels. This ideal economic backdrop enabled corporate bond issuances to skyrocket to record highs in 2020. Corporate bond issuances increased approximately 62.6% to a total of $2,282B corporate bonds issued by the end of 2020, continuing at a similar rate through the first half of 2021. In short, a strong corporate bond supply continues to meet strong corporate bond demand. Thus, corporate bond supply in the U.S. investment grade and high yield markets are poised to mirror record 2020 levels in 2021. In 2020, existing U.S. home sales hit its’ highest point since 2006, delivering a frothy and at times overvalued housing market. The housing market saw outsized gains due to shifts in behavioral/social circumstances (safety, more room during quarantines, etc.).
Meanwhile, economic underpinnings also experienced repercussions. Modern monetary policy cratered the M2 money supply to reach historic levels because of extended stimulus programs.
Source: U.S. Bureau of Labor Statistics (FRED) 06/02/21
Unsurprisingly, 10-year breakeven rates skyrocketed well past pre-COVID levels, indicating inflationary expectations.
Source: U.S. Bureau of Labor Statistics (FRED) 06/02/21
Additionally, our case for a bear steepening environment matured as the yield curve widened as long-term interest rates increased faster than short-term interest rates due to the Fed’s current steadfast QE program (despite Fed recently announcing the start to sell $13.7B corporate bonds and ETFs). The bear steeping was just another indicator of inflationary pressures present within the dynamic economy. Amid a robust corporate bond supply, breakeven rates surpassing pre-COVID levels, and a bear steepening environment metastasizing, inflationary pressures became palpable, illustrated by two of the ten most significant increases in the Consumer Price Index (CPI) having occurred in Q3 2020 with a 133% increase and in Q1 2021 with an 86% increase.
Source: Catalyst Capital Advisors 06/02/21
This inflationary increase has further been supported by the Fed’s preferred measure of inflation, personal consumption expenditures (PCE), increasing to 0.6% with core PCE inflation at 3.1% (for the first time over 3% since the early 1990s).
However, with global economic data illustrating signs of a recovery as The Organisation for Economic Co-operation and Development (OECD) increased GDP expectations for the EU, U.S., and China amid vaccine mobilizations, leading economic indicators (LEI) ( forward-looking forecast) growing to 1.6% MoM, employment numbers gradually improving, decreasing global negative-yielding debt, and lighter socioeconomic restrictions may cause rates (Treasury and mortgage) to eventually rise as the Fed tapers off QE. This will subsequentially increase corporate bond yields as inflation remains a transitory threat and credit risk likely to become more topical throughout industries (as is historically evident during economic recoveries). From a near-term macro standpoint, the potential post-COVID-19 economic growth slowdown appears atypical as it will likely consist of stronger than historical average growth (illustrated by solid improvements from OECD’s global economic outlook) coupled with improving balance sheet fundamentals and continued dovish economic policy (through at least 2022). Additionally, recent and expected early discussion of a tapering event regarding the Fed’s QE program is likely to occur after economic recovery reaches a point of saturation (like 2013).
How do Investors manage the current and potential market/economic policy-induced risks?
Regardless of the Fed’s shift in policy, our narrative does not change. A short-term bond strategy hedges risks associated with this natural economic recovery process. One (of many) positive byproducts is an increase in corporate bond yields, potentially creating a more accommodative yield environment for bond investors as rates rise. With the recent steepening of the front end of the yield curve, short-term bond strategies with the ability to provide moderate exposure to 5-to-6-year maturities enable attractive opportunities to capture roll down (steepness in the curve for maturities that are slightly further out). Furthermore, short-term bond strategies focus on maintaining low duration (average maturity on the short end of the yield curve), reducing interest rate risk, and lowering duration risk.
On the other hand, legacy non-agency RMBS indirectly hedges inflationary pressures and bond price drawdowns due to low correlations with the overall market. As mentioned in “Fixed Income’s Year Ahead 2021: Short-Term Corporate Bonds & Legacy Non-Agency RMBS”:
“Non-agency RMBS remains supported by less extended corporate and sovereign balance sheets while essentially providing one of the few plays to capitalize on the economy’s household sector (COVID aside, households have been deleveraging since the Great Recession). The intuition that the longer a mortgage borrower stays in a home, the safer (as amortization structures illustrate) the underlying mortgage amid an improving macroeconomic backdrop (despite a COVID hiccup) remains supportive. Due to legacy non-agency RMBS’s uncorrelated returns to other assets and low return volatilities, as seen throughout an unpredictable 2020, the sector will likely continue to outperformance in 2021 due to reduced bullet risk, amortization deleveraging from mortgage payments, a higher percentage of senior loans, and high demand and tight supply in the housing market).”
Furthermore, a hidden gem among fixed income markets post-COVID is convertible bond strategies. With risk-on markets prevailing (and potentially continuing in the near-term as the U.S. economically recovers), volatility anticipated, and market pullbacks expected convertible bonds remained a defensive way to gain exposure to growth-oriented segments with less comparable volatility.
Meanwhile, floating-rate strategies remain a clear outperformer in a rising rate and flat rate environment with rising, flat, and falling rate environments all experiencing positive returns. As seen below, the floating rate index (Credit Suisse Leveraged Loan TR Index) has a roughly 20-year annualized return of over 5.54%.
Source: Catalyst Capital Advisors 06/02/21
Therefore, specific fixed income strategies such as short-term corporate bond strategies, legacy RMBS strategies, convertible bond strategies, and floating-rate strategies remain the most robust fixed income allocation to hedge inflation, combat rising rates and capitalize on dynamic Fed monetary policy.
Furthermore, other alternative strategies can provide attractive value in the current and near-term environment. Commodity strategies and gold-linked strategies remain pivotal to hedge against inflationary woes while also capitalizing on the arbitrage opportunities created by the recent commodity “supercycle” and accommodative fiscal policy (infrastructure plan) as illustrated in “Are Commodities on the Brink of a ‘Supercycle.” In addition, to inflationary expectations, the skyrocketing of M2 supply, the continual downtrend of purchasing power, a weak U.S. dollar, and negative real rates (what gold prices are based on) all present a very strong case for Gold reserves.
Source: U.S. Bureau of Labor Statistics (FRED) 06/02/21
As explained in both “Gold Continues to Shine” and “The Inflation Debate: A Macro Perspective on Finding Value in a Hazy Economy,” with real rates turned negative, gold’s 0% interest rate becomes increasingly more attractive (as seen below). Therefore, gold’s divergence from real rates can be driven by a potential shift in U.S. Federal Reserve inflationary bias amid the current thematic backdrop. Additionally, in the long-term, the dollar could continue to slide, and gold will likely continue to remain a better cash reserve, especially with the spread between the inflation-adjusted value of gold tripling that of the inflation-adjusted value of the USD.
Source: Catalyst Capital Advisors 06/02/21
Conclusion
In summary, as we start to emerge out of a COVID-economy, an investor must be aware of the risks associated with economic recovery. As inflationary expectations increase (though likely to be transitory), rates rise, bond yields increase (prices decrease), market volatility persists, U.S. dollar poised to continue to slide, real rates remaining negative and a taper tantrum event naturally expected, all investors must position their portfolios to weather the inevitable “recovery” storm. Therefore, short-term corporate bond strategies, legacy non-agency RMBS strategies, convertible bond strategies, commodity-focused strategies, and commodity-linked strategies remain the alternative ways to weather the risks associated with an economic recovery while also providing the opportunity to deliver positive returns.