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Key Takeaways:
- A return to a pre-COVID-19 economy is likely by the end of 2021, creating the potential for large equity rotations from COVID-19 resistant sectors (technology, healthcare, consumer products, etc.) to sectors hardest hit by COVID-19 headwinds (hospitality, energy, non-essential retail, entertainment, automotive, etc.)
- In the fixed income market, the potential for quick vaccine-led economic recovery can lead to upward movements of long-term interest rates, exposing many long-duration bond investors to return underperformance.
- A “bear steepening” environment is likely amid current Federal Reserve (Fed) accommodation on short to intermediate-term rates, potentially enabling short duration managers to outperform their long duration counterparts.
The tail end of 2020 has started to show signs of a potential end to the uncertainty and fear beset by the coronavirus pandemic. Most notably are upbeat FDA documents and early-stage Pfizer/BioNTech’s COVID-19 vaccine mass inoculations in the United Kingdom and authorization in Canada, upbeat peer studies on AstraZeneca-Oxford University vaccine results, and numerous other biotechnology firms in late-stage clinical trials. Though fantastic developments, economic recovery signs can cause equity sectors to rotate and U.S. bond yields to steepen as the market adjusts to a rapid return to pre-COVID normalcy.
Equity market drawdowns after one of the longest bull markets in history displayed a visible reaction to the onset of COVID-19 in the United States. As discussed in more detail in “Winners and Losers of November’s Uncertainty,” some sectors lead the rapid recovery, continuing to retrace losses while other sectors succumbed, only to be beaten up during this unprecedented environment:
Collectively, investor forecasts for a likely path forward through 2021 appear scattered. Some investors view the “new normal” as an acceleration of the inevitable adoption of specific subsectors such as e-commerce and electric vehicles. However, others question equity market overvaluations and sustainability amid continued COVID-led uncertainty and a widely administered vaccine.
The rapidity of a vaccine and additional stimulus injection talks (amid declining November jobs data) could cause an exaggerated sector rotation away from perceived overvalued technology, healthcare, and other COVID-19 resistant sectors towards the undervalued sectors hit hardest by the pandemic (as illustrated above). A glimpse of this “violent rotation” occurred on November 9th, 2020, after Pzifer announced that its vaccine was over 90% effective, causing investors to overcompensate for the sudden onset of clarity at the end of the “uncertainty” tunnel.
Amid this debate and uncertainty, fixed income spreads, specifically corporate bond spreads, have been on a quick path to recovery following spreads widening to accommodate the risk of uncertainty priced into the market. Since mid-March, corporate bond spreads have tightened to near pre-pandemic levels as seen below:
Though we have seen signs of an economic recovery in both equity and fixed income markets, there is still a long way to go before this recovery becomes systematic.
As the vaccine developments continued to remain upbeat with first rounds of vaccine inoculation unfolding, an accommodative Fed keeping short-term rates suppressed, and a potential revitalization of stimulus talks amid Mnuchin’s $916 billion relief plan proposal (including state aid) can all contribute to a “bear steepening” of the yield curve. This occurrence is evidenced by the spread between 2-year and 10-year U.S. Treasury yields steepening.
A bear steepening is a situation where the widening of the yield curve is caused by long-term interest rates increasing faster than short-term interest rates. Historically, a “bear steepening” situation suggests rising inflationary expectations- or a widespread rise in prices throughout the economy. Inflation expectations have been increasing, evidenced evident by the 10-year breakeven inflation rate (spread between 10-year Treasuries and TIPS-Treasury Inflation-Protected Securities) modestly rising since mid-March (as seen below):
The rise of inflation can lead the Fed to increase interest rates to slow prices from rising too fast. In turn, investors who sell their existing long-term bonds as yields will become less attractive in a rising rate environment, subsequentially depressing prices on long-term bonds and damaging returns for holders of these long-term bonds. For instance, let’s discuss corporate bonds current environment.
The strength of the U.S. corporate bond market continues to be robust as debt capital markets remain busy with companies looking to issue and refinance debt during fluctuations in the coronavirus and historically low rates. Corporate bond spreads to Treasuries have continued to narrow across the curve (as described above). Short-term bonds within the current environment can see increased outperformance as the asset class continues to have a direct backstop from the Fed’s Secondary Market Corporate Credit Facility (targets bonds maturing within 5 years). Based on the Fed’s commentary and guidance, we see the Fed keeping short-term rates at the lower bound through at least 2022, which favors short-duration bonds and funds. With that said, the Fed can take increased action by directly intervening in this market if there is further deterioration in the economy amid persistent COVID-19 related uncertainty. As described above, it can be argued that potential risk is lurking in the tail end of the treasury curve. We now know that there is light at the end of the tunnel in 2021 regarding a widely administered COVID-19 vaccine. However, with yields so low, a modest bond selloff amid investor “risk-on” revitalization could exert upward pressure on the long end of the yield curve as we emerge from this pandemic driven recession. A vaccine-led economic recovery may cause yields to rise, pushing down prices and, with interest rates so low, suppressing returns for bondholders at the longer end of the yield curve. During this past quarter through November 30th, longer-term rates have already shown signs of steepening. 10-year rates have increased by approximately 16 basis points (bps), and 30-year rates have increased by approximately 11 bps. Meanwhile, 2-year rates have only increased by approximately 2 bps, and 3-year rates have only increased by approximately 3 bps.
Yellow line: End of Q3 (9/30/20)
Green Line: Month-end (11/30/20)
Yellow Bar: Basis Point difference between two curves (line)
Bloomberg, 12/08/2020
Thus, short-term bonds display a reduced exposure (vs. long-term bonds) to total return underperformance amid an expected 2021 economic recovery. Therefore, short-term corporate bonds could continue to remain attractive as they are supported by the Fed while minimizing the risk of lower returns during a vaccine-driven economic recovery.
Though this is only one example of an extended economic recovery’s impact on markets, it seems profound. However, there are some pitfalls. Finding yield on the shorter end of the curve may continue to prove difficult. However, that does not mean that yield is not available. Managers can find value in the current environment by using a rules-based, fundamentally driven approach. As described in “Finding Yield in a Low Yield Environment,” “historically, as an asset class, short-term investment-grade corporates have a lower risk of default than longer-term issues during periods of volatility. Short duration’s drag to par insulates principal losses even though spreads widen to meet immediate liquidity needs.” Therefore, short-duration investment-grade corporate bonds could be the answer to combat continued economic uncertainty (spread widening) or an economic recovery (spread narrowing) amid the current monetary and fiscal policy accommodations. Furthermore, focusing on company-specific fundamentals such as insider buying, improving cash flows from operations, and fortified balance sheets can depict the “real” quality of these investments, providing the information necessary to find issuances with higher yields compensating investors for unfairly assumed risk.
All in all, economic uncertainty remains as coronavirus cases continue to rise as we enter the flu season. However, the optimistic sentiment of a 2021 return to normalcy seems to a notable possibility amid recent vaccine successes. As investors, we have to remain cognizant of the return impacts on COVID-resistant asset classes and the bond markets gradual normalization. Finding opportunities in this rapidly changing and dynamic environment can be difficult, but being prepared for all possible outcomes could enable investors to outperform during a continuation or improvement to the current thematic backdrop.
