by Edward D. Perks, CFA, Franklin Templeton Investments
Listen to our latest “Talking Markets” podcast to hear the discussion between Ed Perks and our Katie Klingensmith.
Transcript follows.
Katie Klingensmith: COVID-19 has really taken the market for a rough ride this year. And without asking you to make medical predictions, to be an epidemiologist, what do you see happening going forward right now?
Ed Perks: Well, certainly the global pandemic caused by COVID-19 is really unlike any other event we’ve experienced, especially as it relates to its impact on the economy. And then, along with that has come record levels of volatility and dislocations across a broad range of financial markets. First, maybe it’s worth just discussing the current environment as the US economy is really experiencing a depression-level contraction in growth. And, unfortunately, a similar-type increase in unemployment.
I think what’s made this event so unique is, one, that it’s a global crisis and it’s the result largely of government orders to shelter in place, broadly, across the economy in order to stop the virus from spreading. And, thankfully, those efforts have been successful and certainly have saved numerous lives. I think looking forward, now, unfortunately may come the hard part of kind of picking back up the pieces of getting the economy functioning, all while still trying to be diligent about the virus and certainly the risks that exist around a reacceleration of infections or second waves. That certainly could lead to additional measures to quarantine/shelter in place. So, you know, while I think we are starting to take important, meaningful steps forward, we must also kind of be prepared for occasional steps backwards.
I think as we look at financial markets, the first half [of the year] will certainly be remembered for the extreme record level of volatility, the broad dislocations that we’ve experienced across markets, the sharpest-ever correction from a record high in equity markets, to what now has been an equally ferocious recovery—at least in US equity markets—with broad benchmarks recovering as much as two thirds of the drawdown.
As we think more about the second half of the year, especially from current valuation levels, I think we have to learn to balance this need to reopen and recover some of the jobs that have been lost while also changing behaviours to prevent further second waves of infection.
So, as we’ve seen, I think markets are going to remain very sensitive to advancements in treatment and therapeutics. And certainly, the path to vaccine discovery, and while we all can remain very optimistic and hopeful, I think we really have to acknowledge that, you know, tremendous challenges lie ahead and that it’s highly unlikely that all the news flow we will be getting will be positive.
Katie Klingensmith: Just staying right there and thinking about the second half of the year, you noted, how a lot of the difficult times could still be in front of us, but markets, as you noted, came back in terms of the way. What drove markets up so quickly and is it really in excess of optimism or more about the relative value of fixed income?
Ed Perks: On that latter point, the relative value of fixed income. You know, I do think there’s certainly an element of asset class reallocation. I think that’s a bit more a result of the dramatic underperformance of equities, particularly in the first quarter, thinking about markets bottoming in the latter part of March.
I actually think what’s kind of more surprising is, despite the very low yields that we’re experiencing in fixed income markets, there’s been tremendous interest and activity levels just in these past five to six weeks. A great example of that is the record level of issuance, particularly in investment-grade corporate markets. So, to kind of unpack that a little bit and think about what’s driving it, I think we really have focus on just the tremendous policy response that we’ve gotten from both central banks and governments’ fiscal response.
The key, I think, issue for markets is really kind of twofold. The breadth, the scope, the magnitude of this policy response, especially when compared to say, a calculation that is how much maybe lost economic activity there’s really been that is really profound. And then, maybe secondly and more importantly, the response time that we took was really measuring it more in weeks in terms of getting the policy response into the markets, into the economy. And that is really a key difference to the experience that I think many investors have pulled upon, which is the most recent crisis. Certainly the 2007-2008 financial crisis that really played out much, much more slowly.
Now, I think what we have to come to grips with is that policymakers, while incredibly effective, have really just created a bridge for us over a deep, deep chasm in the economy. And I think, with that bridge, many investors have been willing to look beyond the current reality. So, the economic data that we are seeing here, you know, on a daily basis, is pretty grim and will remain so for, for quite some time, possibly showing some modest improvements as we move ahead. But, the reality is well below where economies had been functioning. So, you know, I think the key question we now face is, is one the bridge that’s been established or created by policy, is it enough to carry us to the other side? And you know, I think we all understand that policymakers possess additional tools to support the economy and markets. I think the risk is the longer this contraction persists, the greater likelihood there is that there’s real structural damage done, particularly to labour markets. And, I think the record pace at which jobs have been lost, we’re really unlikely to see them return as quickly and that will be a really important aspect of the path forward here.
And then secondly, valuations. I think as we look at equity markets in the recovery that we’ve seen, the robust move higher, I think low [interest] rates are certainly very supportive of that. And, does this create a natural kind of tendency: the low return, potential of fixed income is steering more investors to equities? I think that is certainly a dynamic that forward earnings, the discounting of forward earnings of equities, is certainly supported by very low rates. But I think we have to balance that with the likely path for the recovery. And then more importantly—and I know our analysts are working very diligently on this—is really trying to figure out profitability levels of corporates, you know, going forward and what surely will be a new and kind of very different world that we’re all living in.
Katie Klingensmith: And do you think that this really implies longer-term changes to market expectations and asset allocation?
Ed Perks: I think one of the bigger challenges that multi-asset investors have is just what role, what potential, do traditional fixed income investments have, or can they play in portfolios in balancing the risk that exists within equity markets. I think the biggest challenge that many investors have is staying true to a broadly diversified portfolio that can offer that balance. I think certainly the very low [interest] rate environment that that exists today in many ways has challenged that. But, I think it has to be put in the context of—as we’ve just seen in a very short period of time—a very, very steep, increase in the volatility. The risk of holding equity securities, [is] a tremendous drawdown that that ultimately challenges all types of investors in terms of their asset allocation plan, and really staying on a path that helps meet their longer-term goals.
Katie Klingensmith: Especially with what could potentially be even more pervasive negative interest rates, correct?
Ed Perks: Yeah. Now, while we did see very short-term rates kind of tick negative briefly, but we really are not currently expecting to see negative rates in the US. I think particularly when we’re talking about benchmark 10-year US Treasury yields, they did tick down to kind of record-low levels of about 55 basis points1 or so in late April. Well, today we sit a bit closer to 75 basis points, but to put that in context, we began the year at around 1.9% on the 10-year Treasury. And if I were to take an average over the last several years, really much closer to 2.5%. So, you know, a tremendous decline.
Now, I think recently we have had the opportunity to hear Fed Chairman Powell actually address this issue around the concept of rates moving negative in the US and, you know, I think he did a really adequate job of dispelling it for the time. And I think, reminding us that the Fed at this point does continue to prefer other tools and believes that it has those to continue to address the crisis, particularly if we ever see its duration extend or severity worsen. I think we also fall back and we kind of think about where rates have been negative in other parts of the world for what is now a fair number of years. And, you know, I think we just don’t have the evidence that that points to negative rates are really being a constructive backdrop or mechanism for the economy. I think we remain concerned that one, they can just be overly disruptive to the financial system as a whole, certainly playing a role in weakening the banking system and then maybe even bleeding into a negatively impacting both consumer and business confidence in spending. So, I think it’s really something that we don’t expect at this point in time.
Katie Klingensmith: What are the implications of this massive monetary and fiscal response for long-term inflation or deflation if the economic activity is so depressed?
Ed Perks: That is certainly going to be one of the longer-term challenges that we face, and really that key focus of what structural damage is being done to the economy over the longer term. In the US, you know, we’re coming from a starting point where we had an economy functioning generally at capacity, with very, very low unemployment, certainly issues in terms of income inequality that I think are going to be really important going forward to address. But you know, as we come out of this, there are both short- and kind of long-term structural changes that we’re seeing. And I think certainly the hardest-hit sectors, whether we’re talking about things like restaurants and other kind of leisure and entertainment kind of service-related industries, at some level, lower-wage earners have been really disproportionally hit by the shutdown. And I think that that has to be a focus as we move forward to prevent a more protracted, recession.
But you know, as we come out of this, to see employment levels return to where we were prior to the global pandemic, I think will be very, very difficult small- and medium-sized businesses in particular, they account for a very substantial amount, maybe as much as 40% of GDP [gross domestic product]. And, I think they’ve had a much more difficult time accessing capital and liquidity that really is critical to surviving and making it through this crisis. So that while we’re looking at financial markets and seeing record levels of issuance and strengthen in equity prices, I think there’s a very significant part of the economy that is not represented by that kind of robust recovery that we’re seeing.
So, I think more is going to have to be done to help those businesses reopen and really bring back as many of the jobs that have been lost. I think longer term we’re, we’re a bit more muted in our expectations around that, and do think aggregate demand levels will certainly be somewhat weaker or below where they were prior.
Now, you know, I think it’s a longer-term impact on inflation. There are just so many other dynamics we can kind of get into some that we think have really been in place. Things like global supply chain dynamics and repositioning. Certainly, some of that related to US/China trade tensions that we spent a lot of time thinking about and talking about in 2019. You know, I think some of those issues have been maybe magnified and brought back to the surface, if you will, from the standpoint of the impact that the pandemic is having.
And then, just longer term, the impact that this will have on government budgets, which, today bear virtually no resemblance to where they were just three months ago. So, I think it’s fair to say that over the longer term, higher taxes—whether it be corporate or income taxes— certainly seem to be necessary to kind of right the ship. I do think there are some offsets that certainly can prevent a deeper contraction, a deeper, longer term, deflation-type scenario. And, and you know, certainly productivity.
I think one real positive that stands out to me is talking about just how much digital transformation that’s happened. I think that’s enabled a lot of business to be far more resilient during this crisis, as well as I think provide some real benefits over the longer-term in terms of productivity. So, I think it’s a really fair point that we’re going to spend a lot of time over this next several years thinking about and understanding the risks for the economy and markets.
Katie Klingensmith: Absolutely. And I appreciate your point about the human cost and the GDP implications of the destruction in small businesses. But, thinking about big businesses and specifically investment-grade and high-yield bonds, how big of a risk is there right now that we’re going to see a wave of downgrades and defaults?
Ed Perks: Yeah, I think this is a real risk, and it’s also happening real time. But you know, I think, maybe first as an investor in investment-grade and high-yield corporate debt, I think it’s important to acknowledge that, look, markets generally discount these events well in advance. So from the standpoint of movement and pricing and performance, the event of the downgrade or default often turns out to be somewhat of an old-news phenomenon. I think that’s certainly reality, and we’ve seen that dynamic in corporate markets where the real risk of defaults, the real risk of downgrades, is reflected quite swiftly by markets.
Now, I think downgrades are very interesting, from investment-grade to high-yield. And I think the real risk there is that the sheer magnitude or size of the investment-grade corporate market in the US relative to the non-investment high-yield corporate market is staggering.
So, just decomposing that lower-rated segment of investment grade that with a downgrade risk becoming high yield and therefore triggering substantial selling, substantial dislocation. We think there’s as much as US$400-US$500 billion of potential downgrades over the next 6-12 months. And, you have to think about that relative to a total high-yield market of roughly US$1.6 – US$1.7 trillion. So as much as 20-25% of the market. And that, clearly, the risk is that that kind of overwhelms the marketplace, it widens credit spreads, and it ultimately increases the broader cost of capital for companies.
And that’s why I think when we look at the policy response, back to just how effective they’ve been. I think had we entered this crisis and you’d asked, would the Federal Reserve create programmes like the primary markets, corporate credit facility, like the secondary markets, corporate credit facility, and be directly engaging in those markets, specifically looking to help support the companies that could create that kind of dislocation being downgraded from investment grade to high yield resulting in dislocation resulting in markets that were not able to function.
I think the purpose of the policy was really to signal an intent. We don’t think the Federal Reserve wants to be an aggressive buyer of lower-rated investment grade and even high-yield non-investment grade-rated corporate debt. But I think putting the facilities in place, signalling the intent to markets has really been effective and really sought to kind of calm and create markets that can continue to function. And in the case of investment grade, to function at extraordinary levels that are likely to lead to, you know, record levels of issuance.
Now, you know, I think to pivot maybe from the downgrade dynamic and specifically address defaults. I think we certainly will continue to see defaults rise. I think coming into the year, broadly expectations were generally pretty benign, call it 2.5%- 3% or so, in terms of expected to fall rates within high yield corporate debt. That has risen and now I think the expectations are generally in the upper single digits, call it 8%-10% of defaults. And I think certainly that’s in industries and companies come most directly in the cross hairs, whether it be leisure, entertainment, travel, energy, restaurants. I think certainly those are areas that are seeing an elevated level of activity, but I think there is this concept that we certainly have to think about of moral hazard for policymakers. And I think while stepping in to support markets and to establish capital markets that can function and provide capital where it’s needed, I think there’s also a desire to really not step in and be supporting companies that have been chronically over-leveraged or that may be backed by financial sponsors that have kept companies very highly levered while also you know, paying themselves kind of handsome dividends. So I think it’s a more complex issue as we think about the more highly leveraged companies and the role that policymakers should play. And in kind of keeping those markets functioning or keeping companies, enabling companies to kind of ride through this contraction.
Katie Klingensmith: Well, Ed Perks, thank you so much for joining us.
Ed Perks: Thank you.
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1. A basis point is a unit of measurement. One basis point is equal to 0.01%.
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