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What, me worry?

ED GOARD, CFA 19-Aug-2020


What, me worry? That seems to be the mantra from financial markets heading into the dog days of summer. After experiencing one of the most dramatic sell-offs in market history during the first-quarter of 2020, global equity and debt markets recovered nearly all their lost value in the second quarter. All this despite the U.S. economy experiencing its highest unemployment rate since 1940, corporate defaults approaching levels last seen during the great-recession of 2008, and residual concerns about a second wave of COVID-related closures slowing the economic recovery.

So, what’s behind the unbridled optimism? The key driver in sentiment is all about the Federal Reserve’s accommodative monetary policy, as well as the Federal government’s fiscal stimulus. This has reinforced investors’ notion that the “Fed put” (the belief that the Federal Reserve’s interest rate policy can rescue financial assets) is alive and well.

Also spurring optimism is the belief (or hope) that the economy hit bottom in April and is continuing a promising recovery. And while the trajectory appears encouraging for the moment, questions remain whether the abrupt economic slowdown earlier this year caused any lasting structural damage. This may not be fully understood for several quarters. Yet the lack of clarity doesn’t seem to be bothering markets, which are myopically focused on recovery numbers that thus far are rebounding faster than expectation.

This simply reminds us that markets are forward expectation pricing mechanisms, and what the market is clearly concerned about today is not the most recent unemployment numbers or last quarter’s GDP print, but rather the pace of the economic recovery and the promising development of COVID-19 vaccines and therapeutics. Although the initial rebound in economic activity has exceeded expectations to date, many forecasters still believe the U.S. economy will take 18-24 months to recover to pre-COVID production levels.

Given this potential for a prolonged recovery schedule, many strategists view risk assets as overvalued versus fundamentals. Although we believe they may be correct as of late July 2020, the impact of a massive fiscal and monetary stimulus should not be discounted. Nor should the fact that the Federal Reserve for the first time in its history is buying both investment-grade and high-yield corporate bonds and ETFs. This overwhelming amount of stimulus has driven 10-year Treasury yields to all-time lows, dis-incentivizing investments in U.S. Treasurys and creating a “TINA” (There is No Alternative) environment for risk assets.

This has very real ramifications for fixed income investors, who may be less than enthusiastic about buying and holding short- and intermediate-term U.S. Treasurys yielding less than 1%. For those fixed income investors with ongoing income needs, there may be few other reasonable alternatives but to invest in high-quality corporate and consumer credit. Still, investors should not be caught off guard by continued bouts of volatility. We believe that the keys to managing the uncertainty and expected future volatility are by building portfolios based on quality, balance and diversification. 

©2020 Victory Capital Management Inc.