26 May 2020
By: Loomis Sayles Alpha Strategies Team
A tactical approach across the credit spectrum should offer attractive opportunities for insurers. Learn why we think focusing on higher-quality credits and shifting to pockets of dislocation makes sense now.
Q: What has happened in the credit markets since the beginning of the year?
Spread levels at the beginning of the year reflected market optimism and an improved global growth outlook. The thirst for yield continued in the first few weeks of January, but fears related to COVID-19 began to materialize in February. The global virus pandemic caused a significant exogenous macroeconomic shock which led to a dramatic reversal in risk assets and unprecedented fiscal and monetary response from global governments and central banks. As an example of the magnitude and speed of the shock, high yield spreads widened from 359 basis points to 838 basis points from the middle of February to the middle of March. March 9 and 16 were the two largest one-day spread moves in high yield since the tech bubble in 1997.Significant actions taken by large central banks globally have helped reduce systemic stress. The Federal Reserve's balance sheet has expanded by over $2 trillion since the end of February and will likely continue to increase with more lending announced. These programs, which are broader than what the Fed introduced during the global financial crisis (2008/09), have targeted various parts of the economy, including corporate credit, small businesses, municipal liquidity, commercial paper, money markets, and dollar liquidity. This has supported investment grade and crossover credits, allowing corporate issuers to issue more debt in a declining growth environment. While liquidity has improved generally, we expect that strain will continue in certain parts of the market.
Q: We have entered the downturn phase. How long do we expect this to last?
At this point in time, it seems that the impact on economic output is going to be quite large. GDP growth estimates for the second quarter of 2020 call for -10% to -30% or lower. The bigger question is how the recovery from this virus-induced shock takes place and whether the chart of the recovery will take on a "V," "U," or "L" shape. We believe that it will take form somewhere in the "U" to "L" category and that the longer it takes to contain the spread of the virus, the larger the negative economic hit may be. The length and severity of this downturn will likely depend on the time until the virus has peaked and the effectiveness of delivering fiscal stimulus. Every day not spent in lockdown to contain the virus has a multiplier effect on the length and severity of this downturn. Our estimates indicate anywhere from five to nine quarters to fully recover to previous GDP peak levels. As a consumer-led economy, it will be a challenging 2020 for the US. However, we believe markets will likely stabilize and improve well before the economic data starts to recover.
Q: Looking across the credit spectrum, where do you see opportunities over the next 9-12 months?
We believe there will be significant opportunities in many areas of the fixed income market over the next 9-12 months. We have already seen new issue markets re-open in investment grade, high yield and the higher-quality parts of emerging markets, signaling an appetite for risk reemerging. Many top investment grade issuers recently came to market to raise liquidity with deep discounts to outstanding paper. If markets normalize within the next 12 months, we could potentially see returns of 10%-15% or more on this new investment grade issuance. We believe there are also attractive entry points across high yield issuers and we continue to add risk to portfolios. We currently favor the high yield return outlook over bank loans. Emerging markets (both sovereign and corporate markets) have priced in severe global growth downgrades for the second quarter and an extremely negative outlook for oil.Given that repricing, we believe as the case count flattens in developed markets and economies start to reengage, emerging markets could offer significant upside, particularly in non-cyclicals. Demographically, emerging markets have younger populations. This, along with other positive factors, may mitigate some of the negative outcomes associated with the virus. We will be watching for emerging market FX volatility to fall back to normalized levels, further easing in US dollar funding pressure and oil to bottom before stepping back into cyclicals and lower-quality sovereigns.
There are also potential opportunities in securitized credit that should be less sensitive to a downturn and, as a result, seem cheap at current valuations. RMBS is interesting as the housing market is still thin and the consumer is not as levered as in the global financial crisis. We believe spreads in single A and BBB CLOs look cheap relative to bank loans for clients who have a higher risk tolerance. Whole business loans with a focus on credits that are solid and can adapt to a new social-distanced world can help provide upside. In our view, student loans, both fixed and floating, with long spread duration also look interesting. Overall, we believe staying senior (with some exceptions) with longer duration appears to be attractive area within securitized markets. Patience is warranted in more leveraged classes that are exposed to consumer credits and transportation or travel-related assets.
Q: What areas are you more cautious about?
We expect default rates, downgrades and unemployment to surge over the next 12 months. We believe that the energy industry is going to witness a large spike in defaults and restructurings, as well as significant impairments and a large number of downgrades. We also expect to see significant impacts in airlines, lodging, gaming, cruise lines and leisure, among others. We believe these industries will experience severe disruptions, although potential government programs may affect the eventual outcome for individual participants in those sectors.
Q: What are the long-term implications for growth?
There are still many unknowns in the length and magnitude of the path to economic recovery. Consumer behavior and spending trends may take longer than expected to recover. The labor market may be impacted with a higher unemployment rate, but we believe younger and productive workers will continue to support future potential growth. However, we think real GDP growth will likely be lower than pre-virus trend for the next few years. Time will tell if changing behavior has a material impact on longer term growth trends. Disinflationary effects of weaker demand are likely to outweigh any short-term inflation boost from supply shortages. Weak demand could keep commodity prices depressed. The negative shock of lower oil prices may also have lasting effects on growth in the Gulf economies.
Q: How should insurers approach credit investments in this environment?
Fixed income has historically served as the reserve component of the balance sheet for insurers. In our view, the first step is to get a strong understanding for existing risk exposures, and any potential liquidity challenges from liabilities. To the extent that insurers have preserved dry powder, we believe that a tactical approach to investing across the spectrum of available sectors in the credit markets should offer potentially attractive income and total return opportunities. We initially believe a cautious approach that focuses on higher quality credits, shifting to pockets of dislocation as we move through the downturn stage to recovery.
This material is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the team only, and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Investment recommendations may be inconsistent with these opinions. There is no assurance that developments will transpire as forecasted and actual results will be different. This information is subject to change at any time without notice.
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