Loomis Sayles’ Full Discretion Team Talks COVID-19, Policy, Credit and New Territory

On Thursday, March 12, Loomis Sayles’ Full Discretion team held a conference call to discuss current conditions, upcoming challenges and potential portfolio positioning and solutions. Here, portfolio managers Matt Eagan and Elaine Stokes summarized a few key points.

The five stages of COVID-19

There seems to be a pattern to how countries and populations are reacting to COVID-19. We’ve identified five phases:

1. As cases start getting confirmed, denial. Governments take limited steps, hoping for a limited outbreak.
2. Escalation of illnesses can lead to panic across communities and financial markets.
3. Governments finally implement containment and mitigation.
4. As containment measures control the contagion, economic pain sets in.
5. Governments rush to consider stimulus options to ease the economic impact.

Policy response

Different than previous market shocks, the effects of COVID-19 will be rolling forward over a period of time. It is unclear how long this will last; it will depend largely on the policy response.

• First and foremost, global pandemic policy needs to be swift and coordinated. The longer it takes to implement mitigation and containment measures, the longer the outbreak will wreak havoc through communities and financial markets. Right now, much of the globe is playing catch-up—we believe the US is playing catch-up.
• Monetary policy is something we’ve all gotten used to over the past 10 years. We know it can be done swiftly and we’re seeing it at work now with cuts from the Fed and added liquidity pumped into the system. Central banks are pulling their levers. We’re seeing coordinated global monetary policy now. That should keep this from becoming a financial crisis.
• Fiscal policy is another story and it’s been woefully underused in this cycle. Fiscal policy is going to have to be targeted and sweeping. We know that there are going to be businesses and sectors where policy will not reach, and we expect to see losses in the credit markets. In our view, the sooner governments act, the better.

What we can say is that we feel a lot better today about policy response in the US than we did last week. It seems like we’re now moving in the right direction as the US government has shifted from denial to containment. Policy response is on its way. 

(Post-call update: on Friday, March 13, President Trump announced $50 billion in federal aid related to COVID-19. This is a good step as the US government shifts its focus to containment.)

Credit: diving in, cautiously

The market is in price discovery mode right now. The current challenge is that Treasury yields, the reference rate, have come down quite a bit. So while spreads are wider, you're actually paying up in dollar prices in many cases, especially in the investment grade space. That doesn't sit well with us as value investors.

But opportunities are starting to bubble up, particularly in the BBB market where there’s potential for a shakeout and fallen angels may emerge. We believe we're well-positioned because we’ve been holding reserves in our portfolios. We’re liquid and we can act opportunistically.

When we think about high yield, we think the CDX market is very informative. It's a very liquid derivative that gives us an idea of where high yield spreads may go. Right now, it’s a little wider than it was in the fourth quarter of 2018, just below where it was at the peak of the European debt crisis in 2011, and still below 2008-2009 levels. We don't expect spreads to reach levels from the financial crisis because this is not a systematic banking crisis.

So, this is starting to look like a buying opportunity. Could spreads go wider? Yes, but we think yield levels are going to offer compensation for actual realized potential losses with a potential for some price action.

Trading challenges can create opportunity

We’d like to talk a little bit about the fact that many of the dealers (the intermediaries) trying to work within these markets are in brand-new territory. There are different players in the market today—much different than in 2008, and we’re seeing the impact. Take, for example, the US Treasury market, which is now functioning at about 10% of normal liquidity. Why? Because most of the trading within the Treasury market over the last few years has been from high-frequency trading. No human hands touching it, all electronic. In 2008, most dealers would have had 10 to 12 Treasury traders; now that number is closer to two. So now, a minimal number of Treasury traders, many who may have never experienced an environment like this before, are trying to figure out how to trade this market from home. And that's just one small example. Within each major market, the electronic trading many have come to rely on is contributing to the disruption and volatility. Buyers and sellers have also changed in other ways. Bonds are now held more broadly and globally; for example, emerging market bonds that used to be held tightly in Asia and Latin America may now be held almost everywhere. And intermediaries do not have the same capacity given risk controls and their shrinking size compared to the investment community.

Importance of research

These are really tough, challenging markets, but this is what we are positioned for. Market prices are moving a lot, but keep in mind the fundamentals have changed and investors need deep research to help understand what they’re buying. It takes work to recognize opportunities with true value.

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