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Related Insight

Quarterly Perspectives 2Q20

Second Quarter Highlights

  • The beginning of the second quarter saw a dramatic but widely anticipated deterioration in economic data, as COVID-19 mitigation efforts negatively impacted virtually all aspects of the economy.
  • As business activity slowly resumed in the second half of the quarter, many economic indicators recovered faster than expected.
  • Credit markets rallied signi cantly, with spreads having now retraced approximately 80% of the year-to-date widening seen from the peak in late March.
  • The beginning of the second quarter saw a dramatic but widely anticipated deterioration in economic data, as COVID-19 mitigation efforts negatively impacted virtually all aspects of the economy.
  • As business activity slowly resumed in the second half of the quarter, many economic indicators recovered faster than expected.
  • Credit markets rallied signi cantly, with spreads having now retraced approximately 80% of the year-to-date widening seen from the peak in late March.
  • Corporations capitalized on low US Treasury (UST) yields and strong investor demand by issuing debt at a record-setting pace.
  • The Federal Reserve (Fed) followed through with its plans to support the corporate bond market by initiating secondary market purchases; the Fed surprised investors by expanding its credit quality requirements to include segments of the high yield market and exchange traded funds (ETFs).
  • Volatility measures appeared to steadily subside by the end of the quarter due to the multitude of impactful scal and monetary responses, both domestically and globally.
  • The pace of downgrades from the rating agencies slowed in the later stages of the quarter. A wave of downgrades in March and early April led to some high-profile fallen angels and heightened scrutiny on marginal investment grade issuers.
  • Corporations capitalized on low US Treasury (UST) yields and strong investor demand by issuing debt at a record-setting pace.
  • The Federal Reserve (Fed) followed through with its plans to support the corporate bond market by initiating secondary market purchases; the Fed surprised investors by expanding its credit quality requirements to include segments of the high yield market and exchange traded funds (ETFs).

Second Quarter Highlights

  • The beginning of the second quarter saw a dramatic but widely anticipated deterioration in economic data, as COVID-19 mitigation efforts negatively impacted virtually all aspects of the economy.
  • As business activity slowly resumed in the second half of the quarter, many economic indicators recovered faster than expected.
  • Credit markets rallied significantly, with spreads having now retraced approximately 80% of the year-to-date widening seen from the peak in late March.
  • Corporations capitalized on low US Treasury (UST) yields and strong investor demand by issuing debt at a record-setting pace.
  • The Federal Reserve (Fed) followed through with its plans to support the corporate bond market by initiating secondary market purchases; the Fed surprised investors by expanding its credit quality requirements to include segments of the high yield market and exchange traded funds (ETFs).
  • Volatility measures appeared to steadily subside by the end of the quarter due to the multitude of impactful fiscal and monetary responses, both domestically and globally.
  • The pace of downgrades from the rating agencies slowed in the later stages of the quarter. A wave of downgrades in March and early April led to some high-profile fallen angels and heightened scrutiny on marginal investment grade issuers.

Second Quarter Sector Review

Financial markets continued to build on the recovery that began after the initiation of unprecedented monetary and fiscal policy actions in the final days of the first quarter.
This improvement occurred despite a historic deterioration in economic data resulting from

Second Quarter Sector Review

Financial markets continued to build on the recovery that began after the initiation of unprecedented monetary and fiscal policy actions in the final days of the first quarter. This improvement occurred despite a historic deterioration in economic data resulting from the drastic measures taken to contain the spread of COVID-19. Over the latter stages of the second quarter, markets continued to bene t from the powerful stimulus measures, as well as a stabilization of economic data that, while still poor, appears to show that worst case outcomes have been avoided.

Second Quarter Sector Review

Financial markets continued to build on the recovery that began after the initiation of unprecedented monetary and fiscal policy actions in the final days of the first quarter. This improvement occurred despite a historic deterioration in economic resulting from the drastic measures taken to contain the spread of COVID-19. Over the latter stages of the second quarter, markets continued to bene t from the powerful stimulus measures, as well as a stabilization of economic data that, while still poor, appears to show that worst case outcomes have been avoided.

Fixed income market returns for the quarter reflect this optimism, as the Bloomberg Barclays Aggregate Index produced a positive total return of 2.90% despite historically low interest rates that were little changed in the quarter. The returns were largely generated by spread compression across all sectors, resulting in an excess return of 2.46%. US Credit bounced back from the steep selloff in the previous quarter to generate a positive 7.71% excess return during the period, as the option-adjusted spread (OAS) of the Bloomberg Barclays US Aggregate Credit index tightened by 113 basis points (bps). Lower quality markets rallied as well, with the Bloomberg Barclays US Corporate High Yield Index generating a positive excess return of 9.66%. Excess returns on high-quality structured products were also positive during the quarter, as the Asset-Backed sector was able to fully retrace the losses of the first quarter. While the recovery in both investment grade and non-investment grade credit has been robust, year-to-date excess returns remain deeply negative at -5.32% and -8.67%, respectively.

the drastic measures taken to contain the spread of COVID-19. Over the latter stages of the second quarter, markets continued to benefit from the powerful stimulus measures, as well as a stabilization of economic data that, while still poor, appears to show that worst case outcomes have been avoided.

Fixed income market returns for the quarter reflect this optimism, as the Bloomberg Barclays Aggregate Index produced a positive total return of 2.90% despite historically low interest rates that were little changed in the quarter. The returns were largely generated by spread compression across all sectors, resulting in an excess return of 2.46%. US Credit bounced back from the steep selloff in the previous quarter to generate a positive 7.71% excess return during the period, as the option-adjusted spread (OAS) of the Bloomberg Barclays US Aggregate Credit index tightened by 113 basis points (bps). Lower quality markets rallied as well, with the Bloomberg Barclays US Corporate High Yield Index generating a positive excess return of 9.66%. Excess returns on high-quality structured products were also positive during the quarter, as the Asset-Backed sector was able to fully retrace the losses of the first quarter. While the recovery in both investment grade and non-investment grade credit has been robust, year-to-date excess returns remain deeply negative at -5.32% and -8.67%, respectively.

Monetary Policy: The Fed Opens its Wallet to Keep Markets Humming Along

The monumental monetary policy actions initiated in late March were reinforced several times during the second quarter, as the Fed continued to display its commitment to provide seemingly unlimited accommodation to offset the economic contraction caused by COVID-19. The Fed continued to expand its balance sheet holdings, primarily with the continued purchases of UST and agency-MBS, albeit at a declining pace as the quarter progressed. However, the biggest effect on the market came from the Fed’s initiation of its unprecedented involvement in the corporate bond market. Early in the second quarter, the Fed provided additional guidance on its previously announced primary and secondary corporate credit facilities (PMCCF and SMCCF). Surprisingly, the Fed expanded its purchases into the high yield market for fallen angels (issuers downgraded to high yield after March 22) and ETFs.

 

Although purchases didn’t immediately commence, spreads in investment grade and high yield markets responded dramatically, particularly in the most severely affected cyclical sectors. Fed purchases under the SMCCF were initiated through ETF purchases in mid-May at a relatively modest pace of approximately $300 million per day, reaching an aggregate amount of roughly $6 billion by mid- June. At that point, the Fed transitioned to individual bond purchases with maturities of five years or less constructed around an internally created Broad Market Index. Again, the initial pace of buying was relatively modest at slightly more than $200 million per day. To date, the size of the Fed’s corporate holdings is dwarfed by its UST and MBS positions, but the impact is considerable, as we believe these actions are helping foster continued confidence from investors. The PMCCF and the Term Asset-Backed Loan Facility (TALF), both created to assist issuers in placing new debt, remain dormant. Given the stabilization in primary markets and investors’ renewed risk appetites, we expect issuers will likely have less need to access these facilities.

 

Along with these non-traditional actions, the Fed affirmed its commitment to accommodative policy through conventional measures as well. At the Federal Open Market Committee’s most recent meeting in June, the committee laid forth its expectations for low inflation and high unemployment — along with a commitment to ZIRP (zero interest rate policy) – through 2022. During Chair Jerome Powell’s press conference, he struck a decidedly dovish tone, suggesting additional measures may be necessary should an improvement in economic fundamentals be slow to develop. As the Fed completes its comprehensive policy review, market participants are focused on the potential for forward guidance or even yield curve control as possible next steps. We expect increased communication from the Fed later in the third quarter. The Fed’s unprecedented market support has led to diminished interest rate volatility in Treasury markets, particularly in maturities under five years.

Although purchases didn’t immediately commence, spreads in investment grade and high yield markets responded dramatically, particularly in the most severely affected cyclical sectors. Fed purchases under the SMCCF were initiated through ETF purchases in mid-May at a relatively modest pace of approximately $300 million per day, reaching an aggregate amount of roughly $6 billion by mid- June. At that point, the Fed transitioned to individual bond purchases with maturities of five years or less constructed around an internally created Broad Market Index. Again, the initial pace of buying was relatively modest at slightly more than $200 million per day. To date, the size of the Fed’s corporate holdings is dwarfed by its UST and MBS positions, but the impact is considerable, as we believe these actions are helping foster continued confidence from investors. The PMCCF and the Term Asset-Backed Loan Facility (TALF), both created to assist issuers in placing new debt, remain dormant. Given the stabilization in primary markets and investors’ renewed risk appetites, we expect issuers will likely have less need to access these facilities.

Along with these non-traditional actions, the Fed affirmed its commitment to accommodative policy through conventional measures as well. At the Federal Open Market Committee’s most recent meeting in June, the committee laid forth its expectations for low inflation and high unemployment — along with a commitment to ZIRP (zero interest rate policy) – through 2022. During Chair Jerome Powell’s press conference, he struck a decidedly dovish tone, suggesting additional measures may be necessary should an improvement in economic

fundamentals be slow to develop. As the Fed completes its comprehensive policy review, market participants are focused on the potential for forward guidance or even yield curve control as possible next steps. We expect increased communication from the Fed later in the third quarter. The Fed’s unprecedented market support has led to diminished interest rate volatility in Treasury markets, particularly in maturities under five years.

Outlook: Maintaining Risk Awareness Amid a Market of Masked Challenges

The proliferation of COVID-19 in the first quarter delivered an economic shock to global financial markets that made it incredibly difficult to price assets given the unknown impact of the virus. Paradoxically, the remarkable monetary and fiscal support that followed has made determining fair value for risky assets during the recovery challenging as well. The sudden evaporation of liquidity in March has now been replaced with a flood of support from central banks, which is affecting all asset classes

Companies have been capitalizing on improved risk sentiment by issuing tremendous amounts of new debt to build liquidity and extend their maturity profiles by refinancing shorter obligations. More than $1.2 trillion of new corporate debt has been issued in the first half of the year, which is close to double last year’s pace. Investor demand has returned in force, as inflows into investment grade products have been robust. This has led to valuations that appear stretched relative to fundamentals for companies in more challenged industries (e.g., leisure, hospitality, and travel).

Another factor benefiting markets is that the rating agencies have dramatically reduced the number of downgrades from the torrid pace seen during March and April. Ratings agencies appear to have developed a more patient attitude around some investment grade issuers that were quickly downgraded to low BBB in the early days of the downturn. While there have been several high-profile fallen angels among investment grade issuers and a growing list of defaults among high yield credits, they have generally been confined to the weakest players within the most affected sectors. We expect this trend will likely continue in the coming quarters, thereby making security selection a vitally important component of risk management.

With troubling infection rates in the US and an undoubtedly difficult second quarter earnings season ahead, we continue to maintain a vigilant stance in portfolio positioning. While the “Fed put” has mostly limited the potential for substantial spread widening, downside risks remain elevated based on the sustainability of the recovery. As we discussed in our first quarter commentary, we began the year with index-like allocations in credit, allowing us plenty of flexibility to make significant additions to high-quality credit across strategies when valuations were very attractive in March and April. We’ve maintained these defensive overweights, particularly in the Financials and Energy sectors, while taking some profits in select issuers where valuations have returned to pre-COVID levels. Compelling valuations persist in the banking sector, where it is important to note that the Fed will be abstaining from purchasing individual securities.

We believe our disciplined investment process was instrumental in delivering positive excess returns for clients across our composite strategies in the first half of 2020. Equally important was our effort to effectively manage volatility along the way by carefully monitoring sector exposures and individual risk positions. The speed at which markets have moved this year has been breathtaking and at times somewhat counterintuitive. Despite the likelihood of additional fiscal stimulus and more accommodation from central banks, we expect continued volatility from the risks we can see – COVID-19, the US political cycle, and an acceleration of the secular decline in certain businesses, to name a few – as well as risks that aren’t yet evident, but are likely to emerge in a world such as ours that is facing unique challenges.

Indicies

The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar- denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and nonagency).

The Bloomberg Barclays U.S. Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets.

The Bloomberg Barclays U.S. High Yield Index covers the universe of fixed rate, non-investment grade debt. Canadian and SEC-registered global bonds of issuers in non-emerging countries are included. The index includes both corporate and non-corporate sectors.

Important Disclosures

BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

This publication is for informational purposes only. Information contained herein is believed to be accurate, but has not been verified and cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice or a forecast or guarantee of future results. To the extent specific securities are referenced herein, they have been selected on an objective basis to illustrate the views expressed in the commentary. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. The securities identified do not represent all of the securities purchased, sold or recommended and it should not be assumed that any listed securities were or will prove to be pro table. Past performance is no guarantee of future results.

PNC Capital Advisors, LLC claims compliance with the Global Investment Performance Standards (GIPS®). A list of composite descriptions for PNC Capital Advisors, LLC and/or a presentation that complies with the GIPS® standards are available upon request.

PNC Capital Advisors, LLC is a wholly-owned subsidiary of PNC Bank N.A. and an indirect subsidiary of The PNC Financial Services Group, Inc. PNC Capital Advisors’ strategies and the investment risks and advisory fees associated with each strategy can be found within Part 2A of the firm’s Form ADV, which is available at https://pnccapitaladvisors.com.

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