We wanted to share with you our Research Team’s market analysis of the first quarter of 2020 which was provided to our wealth management clients as we thought you might find it interesting.
We would be remiss not to begin our usual quarterly correspondence by communicating the Vivaldi team’s sincere wishes for your good health and fortitude in the face of this global health crisis. This year will be one for the history books and likewise these market environments will be described alongside some of the biggest historical market corrections. The first quarter was an eventful one from an asset class and sector perspective. Without belaboring the various drawdowns, below is a select number of broad-based benchmarks.
Something the Vivaldi Investment Research team has been discussing a great deal internally (now on daily video conferences as opposed to in ad hoc conversations around our office) is the difficulty in extrapolating a useful analog to the current events in financial markets but also in the global economic system as a whole. While we would generally point to the collective historical experience of our team, which has witnessed several different market and economic contractions, it isn’t immediately evident that those prior events can be related to today’s range of risks that need to be taken into consideration. While the 1987 crash was epic in scale, it was relatively modest in duration and was largely a financial market event. In the subsequent 30 years, a non-exhaustive list
— including the savings & loan crisis, dot-com bubble, 2001 recession, and the 2008 global credit contraction
— have all had varying degrees of financial market versus real economic impact. Again, it isn’t perfectly clear to which of those prior events we should be looking to as the most akin to the current market and economic risks. The real economic, and direct societal impacts, of a health-related crisis are inherently harder to comprehend in the context of financial models and portfolio construction decisions, as the knock-on effects are, in our view, more numerous as well as more drastic in tail scenarios. Still, the team’s in-depth understanding of both fundamental and structural risks present within the broad set of financial markets has proven useful in ensuring that we are invested in a relatively protected position regardless of the cause, duration, and severity of economic distress.
One easy way to view this very disparate set of market events is through the lens of broad-based domestic equities. Below is a chart of the peak-to-trough drawdowns of the S&P 500, measured as a function of time, for the last four bear market environments:
This simplistic view, to date, has portrayed a less than average level of concern around the COVID-19 period, as financial markets attempt to handicap the negative fundamental impacts of putting a global economy into an induced coma against their expectations for monetary and fiscal stimulus as well as a dizzying array of opinions as to how to forecast when that coma may come to at least a partial end.
To spend a great deal of time in this note sharing our collective “best guess” of where our team’s consensus falls would almost certainly be a waste of your time, as we acknowledge that if our view ended up looking particularly prescient three months from now when we write our next letter that would owe itself to luck and serendipity more than our critical thinking skills. With that, we will highlight a few notable dislocations, bifurcations, and outright “strange stuff” that we have seen manifest in the current market environment.
The first major theme that we have been focused on as a team is the broad underperformance of credit markets relative to equity markets. Whether looking to leveraged loans, high yield bonds, investment grade corporates, various sectors of structured credit, or even municipal bond markets, the broader relative risk construct when compared to more subordinated equities simply broke down. As a simple visual of this, we would point to the performance of the first lien leveraged loan market versus equities in advance of the Federal Reserve announcing the unprecedented action of buying outright longer-duration corporate credit on April 9th. The loans, which have clearly established protections and seniority over equity holders in bankruptcies, traded down nearly as much as the broader equity markets.
Similarly, we have also seen these types of risk paradigm dislocations across credit sub-sectors. Notably, certain areas of less liquid credit have materially underperformed more liquid credit that we would expect to actually carry more economic sensitivity. This was particularly pronounced, relative to our expectations, in municipal bond credit markets where junk bonds outperformed investment grade municipals for a period of time.
This was especially shocking as broader interest rates experienced a large risk-off rally (lower rates), which has historically provided a large tailwind for the duration-sensitive municipal sector. We saw similar dynamics between first lien loans and junk bonds within structured credit loan products (CLOs) even just relative to the very underlying loans themselves.
For some time, we have maintained a focus on the market for Closed End Funds. While we have always highlighted that part of what generates the opportunity in that sector is that a closed end fund’s market price can dislocate from actual underlying portfolio Net Asset Value during periods of extreme volatility (as the fund trades at a “discount” to that NAV), the moves we saw in March were unmatched at any other point in history. Take, for example, the below Closed End Fund which invests in senior loans and traded down nearly 20% further than it did during the Great Financial Crisis.
While we could keep going, we would also highlight one area that is more esoteric but important in the context of these comments on credit markets. The below chart belongs to the mezzanine tranche of what is referred to as a “credit risk transfer” or “CRT” securitization which have been issued by Fannie Mae, Freddie Mac, and Ginnie Mae going back to 2016 or so. To make a complex-sounding security simple, this bond is exposed to the credit risk of a large pool of legacy agency mortgage borrowers. Those mortgages are guaranteed by the agencies which are themselves backed by the U.S. government, as we all saw play out in the last credit crisis.
This chart begs the question of what would have driven this agency MBS security to trade from $107 to $70 in the matter of three weeks, and then back to 95 in another two weeks. The short answer is liquidity (or lack thereof) of some of these more esoteric credit assets. The forced liquidation of various mortgage REITs, which ran with very high degree of leverage to squeeze more return out of that bond when it was trading at 107, required them to liquidate large portions of their portfolios all at once.
The Investment Research team here at Vivaldi has been busy generating as many touchpoints as possible with our underlying investment managers, particularly with those that are more directly impacted by these types of dislocations and non-economic pricing. With that said, we have recently been shifting our focus to areas of opportunity that will undoubtedly arise from these dislocations. While we believe we have been conservative in how aggressively we have moved to deploy capital in new investments out of respect for the incredibly complex nature of the current COVID-19 pandemic, we must think about areas where we would like to play offense once we are done playing defense.
*All Chart Sources: Bloomberg
As always, please do not hesitate to reach out to our team with any questions you may have. We appreciate our continued relationship in 2020.
MICHAEL PECK, CFA
President, Co-Chief Investment Officer
BRIAN R. MURPHY
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