Hanging in the Balance

Jeffrey Addis:

Welcome to our podcast. My name is Jeffrey Addis. I am the President and Chief Operating Officer of Merganser Capital Management.

Before we begin, a few important regulatory disclosures. This presentation is for informational purposes only and should not be considered as investment advice or a recommendation of any particular issuer, security, strategy or investment product. Now, onto our podcast. I am pleased to introduce David Fishman, our Deputy Chief Investment Officer.

David Fishman:

Today is August 10th. After we last got together, virus headlines started to improve, with cases beginning to slow in some large states, Arizona, California, Florida, and Texas, while the Midwest experiences a surge. 5 million cases and 160,000 US deaths is an embarrassment, but there are headlines on quicker-than-expected vaccine development.

We got confirmation of a record-breaking 32% annualized decline in Q2 GDP, the silver lining being it wasn’t as bad as some feared and a record drawdown in inventory should be a tailwind for Q3. Down 32% was three times larger than the previous record. Perhaps it doesn’t feel as bad given unprecedented 48% growth in M2 money supply keeping markets and the economy running. The peak-to-trough decline is better than Europe, where lockdowns were more complete. Now, questions are rising about the strength of the rebound in Q3. As the saying goes, the markets climb a wall of worry, evidenced this past week with rising risk asset prices, while Congress negotiated continuing aid, outweighing fears they disappoint, perhaps anticipating Trump’s executive action to bridge the gap between the two sides.

Since we last got together, rates have continued to come down, more on the long end, curves are flatter, credit spreads are tighter. Volatility also continues to decline. Year-to-date total returns to the Bloomberg Ag are up almost 8%, and high yield is now up 1%. The NASDAQ is up 23%. The Dow and S&P are plus or minus 4%.

Reports that new COVID infections had dropped in recent days helped the market start the month on the right footing. Risk asset prices continue to rise as the Fed continues to provide uninterrupted support. St. Louis Fed President Bullard said the apparent slowing of the recovery in July shows that there will be ups and downs along the way, but he still expects rapid growth in the third quarter. President Kaplan from Dallas also noted the slowing in July, but said the virus is something we have to adapt to and learn to live with. Despite the uncertainty we live with, high yield credit went into positive territory year to date ending July after Q2 defaults hit a record high. High yield spreads and ISM data are highly correlated.

Manufacturing-related businesses are learning to adapt. Strong car sales continue to surprise. ISM manufacturing survey increased from 52.6 in June to 54.2 in July, meeting expectations. Like many other recent manufacturing surveys, the ISM data have improved significantly in recent months after falling sharply earlier in the year once COVID started. The ISM surveys measure of employment, however, while higher in July, remains soft at 44.3.

At the most recent Fed meeting, Chairman Powell acknowledged the deceleration in the pace of recovery over the last month. The major news was an extension through year-end of their lending programs, with additional policy changes still under debate. The market expects additional debate about expanded asset purchases, yield curve control, and other unconventional policies in September, with potential changes announced in November, which is surprising given the Fed independence around election season. A dovish Fed continues to reinforce that it will do whatever it takes to protect the long-term health of the US economy. This includes allowing inflation to remain above its long-term target of 2% for a period of time if employment remains significantly dislocated from the non-accelerating inflation rate of unemployment.

While the Fed is thinking ahead to the possibility of inflation, we view this as unlikely to materialize in the near term given substantial declines in energy prices, and physical response remains a laggard in its speed and consistency. Trump’s actions on Saturday avoids the risk that Congress interrupted unemployment assistance as they debated a physical stimulus plan. To date, this has been key to limiting the fallout from historic shock by masking underlying stress. Trump’s action kicks the can down the road while Congress delays their summer recess. Continuing this aid is critical to consumer credit performance and avoiding the economy slipping back into recession.

Nine years after S&P first downgraded the country, Fitch put the US credit rating on outlook negative at the end of July, citing a deterioration in the US public finances in the absence of a creditable physical consolidation plan. The action from S&P in 2011 paradoxically led to lower borrowing costs, but the potential now to have two of the three most widely followed rating agencies rate the United States below AAA does raise risks to borrowing costs during a time of exceptional deficit spending.

US policymakers now face a delicate balance between the challenge and generating inflation at the same time Goldman cites real concerns around the longevity of the US dollar as a reserve currency. In the meantime, 10-year rates are near their lowest level since the start of the crisis, so it is a problem for another week, month, or quarter. These concerns are not new, but they are getting more widespread attention.

The European Union finally reached agreement on an $860 billion plan to finance their COVID recovery. It sounds like Europe is relatively well-positioned to continue economic reopening while keeping virus infection rates low. This would be a big change relative to the recovery post-global financial crisis, where the US outperformed for years.

Beyond Europe, readings of global manufacturing activity in July were generally in expansionary territory. The JP Morgan Global Manufacturing PMI is at a six-month high for July and above the neutral 50 for the first time since January.

On the labor front, initial jobless claims rose during the second half of July for the first time in almost four months, before returning to the downward trend for the week ending July 31st. Weekly claims remain stubbornly high at 1.2 million new filings. July’s jobs report beat expectations, up 1.8 million, the third month in a row of gains. The unemployment rate came down to 10.2%, but the labor force participation rate fell modestly, which will be something to watch. It is too early to celebrate, with over four million people leaving the labor force. As we know, certain industries have been especially hard hit. Year over year employment in air transportation is down 22%, food service down 20%, and hotels down nearly 40%. No sector has been more impacted than the motion picture and recording industries, down a staggering 52% year over year.

Earnings for Q2 largely beat expectations, even as retail bankruptcies continue. Lord & Taylor and Ascena, only the latest. CMBS triple B minus, which represent a levered bet on retail, remain one of the worst performing fixed income sectors year to date, down 7% versus triple B corporates, up almost 7%.

The investment team has been less active of late, a reflection of summer blues, a slowdown in issuance headed into earnings, and the rally we’ve had, leaving some credit sectors looking expensive again. Relative value is harder to find. We are again seeing better value in government guaranteed mortgage sectors. The opportunity set has narrowed with the recovery now going on four months, and we are seeing more spreads that are too tight. In both credit and structured, there are names we like, where we have expressed trades within structures and creditor CMBS we’re extending modestly. We’re also being more active in reducing names that have become overvalued, CMBS Conduit IO, numerous corporates, and selling where our thesis has been challenged, single asset mall exposure in Hawaii, for instance.

Thank you for joining us. We aim to produce timely and digestible information for our community of investors.

Jeffrey Addis:

This commentary contained or incorporated by reference certain forward-looking statements, which are based on various assumptions, some of which are beyond our control. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends which are based on current market conditions. No part of this presentation may be reproduced in any form or referred to in any other publication without the express written permission of Merganser Capital Management. For more information, please visit our website at www.merganser.com. Thank you.