First Quarter 2020

In 1971, there was an iconic billboard that had received a lot of press then and seems appropriate now. It read, “Will the last person leaving Seattle – Turn out the lights.” The coronavirus has brought the economy to a virtual standstill and our downtown business area resembles a ghost town with very few people or cars on the streets. The initial coronavirus cases were identified in this community and we have had front row seats to the devastation that is taking hold as social distancing is being broadly implemented. We are at the beginning stages of a recession that is likely to be deeper than is currently being discounted by the markets.
In our prior outlook, we highlighted that the economy was late-cycle and that there were many challenges that were biased toward slower growth as the primary trend. We also referenced imbalances that have been building over many decades. In addition to health concerns, market worries are focusing on zombie companies, the growth in lower quality corporate debt and the ability to service it. As a result, we are seeing the early stages of liquidity and solvency concerns as profits and cash flows evaporate. Two of the big uncertainties are how long this policy of social distancing remains in place and are businesses and individuals positioned to weather this type of downturn. Our sense from Seattle’s experience is that it will be a deeper recession as safety nets are limited and national leadership is behind the curve. Much of the foregone activity will not be possible to recoup, many businesses will not survive and unemployment will rise.
In the U.S. and other countries around the world, monetary and fiscal responses were implemented in an attempt to offset some of the devastating effects on the economy and to maintain the orderly functioning of funding and securities markets. Monetary policy has alleviated the liquidity crisis. It is early in the downturn cycle and it will take time for this crisis to evolve and for fiscal stimulus to have an impact. Once we see a peak in the number of reported cases of coronavirus, we should see rapid reengagement from businesses that survive. As this plays out, the pronounced risk aversion that characterized financial markets during the first quarter should begin to subside, but this is not likely to occur until the third quarter.
The corporate sector is in the eye of the storm. In addition to coronavirus, the energy industry is dealing with a massive drop in crude prices, compounded by a collapse in global aggregate demand. Liquidity challenges will be ongoing through the second quarter and we expect a surge in downgrades and defaults as this recessionary environment plays out. One aspect of illiquidity is historically wide bid/offer spreads, which make the cost of repositioning high. Nonetheless, valuations have cheapened significantly and we believe that it is an opportune time to add credit.
Our outlook for MBS has shifted to an underweight position as Fed support repriced the sector tighter. With the decrease in interest rates, we expect volatility in prepayments over the next couple of quarters. Our analysis indicates that actual prepayments will initially come in higher than forecasts but virus impacts may cause a slowdown. The sector’s relative outperformance vs. credit provides a liquid source to reposition the portfolio as we look to add Corporates. The ABS and Agency CMBS sectors have widened out to attractive levels. We continue to see these sectors as anchor positions and are comfortable with their risk profiles. We are concerned about non-agency CMBS near term and look to be neutral to underweight. We will look to move out of Agency CMBS into non-agency AAA rated CMBS once the markets reprice collateral and occupancy risks.
We expect high uncertainty, negative economic growth, business destruction, declining inflation and zero-bound Fed policy to keep interest rates anchored at low levels. We have lowered our trading range for the 10-year U.S. Treasury to 0.25%-1.50% for the rest of 2020.

Disclosure – As of March 31, 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.