Second Quarter 2020

Each economic cycle has aspects that define both the risks and the opportunities. This recession and the unfolding recovery are unique due to the massive fiscal and monetary stimulus at the early stages of the downturn, combined with pandemic risks, the dramatic shutdown of the economy, and the uneven resulting pain and safety concerns. There is high uncertainty about the path forward back to positive economic growth. It will be uneven and strewn with unknowns that can meaningfully change the comfort and longevity of the journey.

As the economy navigates through this recovery, the noise surrounding the timing and nature of the coming expansion, possible additional fiscal stimulus, and an anticipated second COVID wave make it tough to handicap the cross currents. The market believes the trough in growth occurred in the second quarter and we would concur. Our forward look is shrouded in extreme uncertainty that spans the pandemic, social unrest, extreme job dislocation, combative trade policy, weakening corporate fundamentals and presidential elections. These barriers and roadblocks to growth and functioning markets are offset by existing monetary and fiscal policy, expectations of more, and the belief that while we start from a distressed level, the recovery has begun.

As we progress forward, the recession’s impact will become more apparent, as will the winners and losers. At an individual level, those that have been most marginalized in our economy are also most at risk. While the George Floyd murder sparked protests, the BLM movement is about broad and systemic racism which has been magnified by COVID. On the business front, the small business community is more at risk than their larger counterparts. However, regardless of size, there will be industries and firms that feel the pain of the current economic and social challenges more powerfully than others. These nuances are difficult to handicap as they reside not at the macro level, but within communities and industries that are harmed or helped uniquely due to the circumstances.

We expect further corporate spread tightening as the primary trend, but with two-directional trading. Fed support is an important anchor to our viewpoint. Their broad facilities which target all sectors of the investment grade market are intended to push down borrowing costs and improve market liquidity. Their substantial and early support of risk assets, along with their willingness to do what it takes within their capabilities as we move forward, provides a strong technical tailwind and inspires broad demand from investors that has elevated the value of spread products.

While the technicals for Corporates are strong, fundamental challenges are many. Issuer differentiation will be important as we navigate forward through the recessionary and COVID fallout. Security selection will become a greater contributor to alpha, while downgrades and solvency screens will help manage downside risks. We remain overweight credit, but the easy money has been made.

For structured products, we prefer ABS and non-agency CMBS. We maintain an underweight to MBS because we believe prepayment expectations are not high enough to capture the actual speeds we expect, which increases the likelihood that spreads and returns will be lower. For non-agency CMBS, fundamental challenges persist but positive technicals, along with attractive relative value, create pockets of opportunities to add risk to portfolios in the senior tranches.

We expect short and long term rates will remain low with subdued expected inflation and elevated unemployment motivating the Fed to keep zero interest rate policy in place over the next few years. We maintain our estimate of the trading range for the 10-year U.S. Treasury at 0.25%-1.50% for the rest of 2020. Please give us a call if you would like to discuss.

Disclosure – As of June 30, 2021. 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.