Third Quarter 2020

During the journey through 2020, the shock and awe factor of events continues to surprise. Our outlook since March has focused on the crosscurrents of massive stimulus battling the unprecedented pandemic-driven shutdown of the economy. The flood of money into the economy and markets masks the devastation a level below the macro indicators. The fourth quarter should begin to provide more transparency on the myriad of challenges and pain points.
The Fed through its transparency, provides a level of confidence of a likely path forward. Their communications and actions reinforce our belief that short maturity rates will be anchored at the zero bound into 2023, as it will take time for inflation and employment levels to recover to pre-pandemic conditions. We align with the more pessimistic economic messaging of the Fed. The newly introduced average inflation targeting provides flexibility for the Fed to focus on supporting their other mandate of full employment. The Fed will be super accommodative, but their transmission mechanisms increase disparities. Small businesses and non-owners of financial assets get left behind.
Fiscal stimulus is a more effective method to smooth the uneven devastation of COVID and social distancing policies. The pandemic has exacerbated many of the pre-existing inequalities, and social distancing and health considerations introduced new penalties and burdens. Individuals and families that were most vulnerable have also been hardest hit. The debate over additional stimulus, its size, and who benefits will shape the path and trajectory of the recovery. The outlays associated with COVID, particularly with respect to the record levels of debt issued by both the public and private sectors, may dampen potential growth for many years.
Like any journey, there are many roads. It is likely that we are approaching some more treacherous terrain with upcoming elections and the possibility of a chaotic presidential transition. The pandemic, business dislocations, high unemployment, geopolitical jockeying, and social unrest add to the uncertainty and create an overhang for business investment and consumer spending. The resulting downside risks will lead to more volatile markets.
We maintain a modest overweight to the Corporate sector. This positioning is supported by a Fed policy that uplifts spread sectors, while also pushing investors to reach for yield. For most investors, the down-in-quality trade favors investment grade as it is a large liquid market and has attractive risk and return characteristics. We expect continued strong demand from a variety of investors, even as elevated volatility is likely given the higher near term risks. Valuations have tightened and represent only fair value. We expect a two directional trading environment for Corporate spreads. Security selection will remain paramount in creating value in the portfolios.
The MBS sector is negatively impacted by record low interest rates and by prepayment models used to value MBS that don’t reflect the elevated mortgage refinancing that is occurring. In addition, the Fed’s zero interest rate policy penalizes amortizing assets. We continue to evaluate MBS holdings using this lens. Our current cashflow preference favors bullet maturities, such as AAA-rated non-agency CMBS which offer attractive relative value. There are pockets of opportunity within ABS although strong demand has narrowed spreads considerably. Security selection and relative value will influence repositioning between MBS and other sectors, as they each have different risks.
As we consider monetary and fiscal policies and the economic environment at this early stage of the recovery, inflation should remain contained below the Fed’s two percent target. If inflation remains well behaved and the Fed anchors short term rates for multiple years, longer term rates will also remain near current levels. Our estimate of the trading range for the 10-year U.S. Treasury is 0.25%-1.00%.

Disclosure – As of September 30, 2020. Source: Pugh Capital, Bloomberg, and Bloomberg Barclays Indices. This market outlook and succeeding pages contains Pugh Capital’s opinions based on the information available at the time of the analysis. Opinions are subject to change without notice. Investors should evaluate their own risk tolerance, time horizon and other restrictions for their investment decisions. Statements concerning financial market trends are based on information available and current market conditions which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and investors should evaluate their ability to invest for the long-term, especially during periods of volatility in the market. Please do not redistribute. Refer to the Legal & Disclosures section for additional disclaimers, disclosures, forecast, outlook and other information.