On Thursday, March 12, Rick Raczkowski, co-lead portfolio manager of Core Plus Fixed Income participated in a conference call with clients to discuss recent events and market activity. He discussed that while there is a lot of fear and uncertainty in the market right now, he and co-lead portfolio manager Peter Palfrey are maintaining their discipline of managing through the cycle as they have for the past 20 years.
Three shocks combined to hit the markets hard: a supply shock from China, a demand shock from the effects of COVID-19, and the energy shock caused by the price war between Saudi Arabia and Russia. We are expecting a pretty negative environment and are starting to see that being priced in the marketplace.
Last year, credit markets were doing well based on the assumption the economy was going to be okay. Now the credit markets are saying the economy is not okay and there's a lot of concern. We've seen some pretty dramatic moves and we've also seen a big reduction in trading liquidity. Our director of US rates trading, Michael Gladchun, says the past few sessions have been worse than 2008 in terms of trading Treasurys. That's very unusual in the market. So I think the markets have just been gripped by the fear of the impact on the economy.
(Post-call update: on Sunday, March 15, the Federal Reserve cut the target range for the federal funds rate to 0.00% – 0.25% and announced a formal quantitative easing (QE) program. We welcome this necessary, quick reaction.)
The Fed had an emergency cut (March 3) and we expect to see another pretty aggressive cut. We think the Fed will probably wait until the March 18 meeting. While it could be sooner, it won’t be later. Right now the market is pricing in a full four cuts by the end of the year and we think those will be front-loaded. The Fed also announced that it was going to expand its $60 billion Treasury bill purchase program, which had been ongoing, to buy coupons in the broader Treasury sector and the entire coupon stack. We consider this QE 4. There have also been repo operations to try to create liquidity in the market. We believe the Fed is going to be aggressive. When it sees Treasury liquidity start to deteriorate, that really gets it to take notice.
We had been taking risk down over the past few years and are positioned defensively, particularly in the credit side. But given what we were seeing in the economy and with an accommodative Fed, we were still positioned for the late cycle. We had reduced credit with an underweight in investment grade credit and an allocation of 3% in high yield bonds and 3% in bank loans, which is very much on the lower end of the range (maximum allocation is 20%). In addition to that, we were finding other opportunities to add potential value including a modest position in Mexican government bonds, which could add incremental potential yield. We also built a Treasury inflation-protected securities (TIPS) position, based on the idea that inflation risks were being mispriced in the marketplace, particularly with the Fed being very accommodative. We've got a lot of dry powder in terms of Treasurys and government bonds.
Energy is obviously a concern with the reduction in oil prices, and certain other industries that are affected, including travel, autos and leisure. We have reduced our energy exposure over the years and are close to a benchmark weight at this point. We think from an industry perspective we are well positioned, but there will be a lot of volatility and potentially some distressed situations in the credit markets. We also have to keep in mind that since the global financial crisis, we've seen a huge increase in debt, mostly in the investment grade area, which is one reason we are underweight US investment grade companies. High yield debt has grown significantly, but not as much. So we do have a lot of debt out there, certainly in BBBs and that's been an area of concern for the market. We are not overly concerned right now about a massive downgrade into high yield, but it's a potential risk, particularly if the economy gets worse. Overall, we do think that we're likely to see more volatility and some liquidity issues.
It is different than 2008. Right now, the banks are in much better shape in terms of capital, so we don't think that this is a systemic type of crisis like we saw in 2008. This is more of a downturn.
Dislocations may also create opportunities for us. What we tell our clients is that we strive to deliver value to them over the course of the cycle. Now we're not going to be able to time every move in the cycle correctly. But what we did do as we moved later in the cycle, was to bring down risk. Then when we see the cycle start to turn, and it looks like it could be turning here, that's where we want to start using all the tools in the strategy to help take advantage of the downturn and dislocations in the market.
We have positioned ourselves like we tell our clients, and we feel we have the liquidity to take advantage of the market. The way we're approaching this is to sequence the portfolio moves. When downdrafts occur in the market, we don't go immediately for those things that are most directly affected. We start by finding ideas that are solid. For example, student loans, which are government loans and not really tied to the economy. Then we could start to move into cyclicals as valuations start to look reasonable, and eventually we could buy in the energy sector or airlines as they may potentially be an opportunity. That's how we're thinking about starting to dial risk back up. Not aggressively going after risk, but waiting for the opportunities. We think non-US-dollar-denominated debt could eventually present an opportunity but I think it would be toward the end of our sequencing.
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