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Money doesn't grow on trees

RICH CONSUL 04-Jun-2020

Between March 4 and March 23, the S&P 500 fell an astonishing 28%, including three jarring 9%-plus daily swings. During this historic market sell-off both Congress and the Federal Reserve were forced to take unprecedented steps to shore up the seizing financial markets. During the week of March 16, the Federal Reserve cut the Fed Funds rate to zero and announced another round of quantitative easing (QE4).


Since then, stocks have rallied strongly as most investors now believe the Fed is willing to inject unlimited amounts of money to buoy financial markets (i.e. the Fed put). Some investors are wondering if the unprecedented scope of the Fed’s actions is worse than simply allowing financial markets to sell off and adjust to lower expectations? More importantly, investors want to know if they need to take corrective action in their portfolios.


The Fed’s intervention is not new as it began purchasing securities (the original QE1) back in the 2008-09 Global Financial Crisis. The Fed has done so repeatedly since then, but the scale of this current operation is unprecedented. In fact, the Fed is set to double its balance sheet in 2020 by purchasing high yield and corporate debt ETFs (among other investments), and the pace of the projected growth rate of its balance sheet has gone vertical.

Federal Reserve Balance Sheet2
Image courtesy of Visual Capitalist


On top of that, Congress kicked in with a $3 trillion fiscal stimulus plan in an effort to restart the stalled economy and help the 26 million-plus Americans that have lost their jobs due to this pandemic.


No one is denying the need for such measures. Yet money does not grow on trees. Thus, the U.S. Treasury plans to issue some $4 trillion of new debt—both short-term notes and longer-term bonds—over the next three months alone. Will there be sufficient demand to buy such a huge quantity of Treasuries in such a short period? Will yields need to jump in order to attract buyers? And if yields begin to rise, what then? Will this usher in a new era of higher inflation?


These are all challenging questions that investor should be contemplating today, because the asset allocation and portfolios built at year-end 2019 may no longer be appropriate.


One area often overlooked by investors is convertible bonds, which don’t necessarily fit neatly into traditional asset class boxes. Simply put, convertibles are corporate bonds with an option to be converted into a fixed number of common stock shares at a specified price. Thus, they exhibit qualities of both bonds and stocks—including some inflation-hedging characteristics. While convertible bonds have may be more sensitive to interest rate changes than other types of bonds, investors may want to consider how convertible bonds—and specifically high-quality investment grade convertibles—might play a role in an updated portfolio.


Ultimately, no one knows how the next phase of this pandemic will play out, nor how robust any economic rebound will be. However, the Fed has telegraphed its intent to massively expand its balance sheet, and the ramifications thereof suggest that higher yields may be on the horizon. Investors need to consider if they need to do their own pivot as well.


Victory Capital, Inc. is a Registered Investment Advisor. The information in this article is based on data obtained from recognized services and sources and is believed to be reliable. Any opinions, projections or recommendations in this report are subject to change without notice and are not intended as individual investment advice. Not to be used as legal or tax advice.

©2020 Victory Capital Management Inc.