If 2020 taught us anything, it was to pay attention to valuations… and perhaps stock up on paper products. For purposes of this outlook, we will turn our attention to the former.
A year ago at this time, no investment manager could have predicted that a global pandemic would disrupt our lives for the better part of 2020. But what they could have told you was that valuations across a variety of asset classes, particularly credit, were approaching multi-decade highs.
This was happening while many of the fundamental drivers had been deteriorating, therefore creating an unstable equilibrium and suggesting the risk/reward balance in many assets was less than ideal. If you took your cue from valuations, 2020 was a wild, but extraordinary ride. Now, with valuations having round-tripped in many parts of the market, we once again have to take a more disciplined approach to portfolio construction.
Current valuations will be set amongst the backdrop of a cyclically improving US economy, a supportive central bank, the swiftest and largest fiscal support in our generation, and the highest developed market yields on offer globally. This leaves us modestly constructive on corporate credit, but increasingly diversifying into other attractive sectors such as agency mortgage-backed securities and taxable municipal bonds.
Cyclical recovery could pose challenge to loose monetary policy
From an economic and policy perspective, we see 2021 as a year of cyclical recovery as vaccine rollout enables society to return to more normal consumption patterns. Inflation is likely to rise moderately, but remain contained given still large amounts of slack in the US economy. We expect interest rates to move gradually higher as markets begin to price a reduction in quantitative easing purchases in line with the cyclical recovery.
There may come a point in 2021 where markets begin to challenge the Federal Reserve’s (Fed) commitment to keep policy rates accommodative, even as they pull back on extraordinary stimulus measures, such as QE. In our view, however, the Fed will ultimately reaffirm its commitment to low policy rates which should cap any aggressive move higher in yields. This low-rate environment should set the tone for the global reach-for-yield to continue.
Corporate debt requires selective approach
While we expect corporate credit to be well supported in a global search-for-yield environment, the sector looks less appealing than it did earlier this year. With valuations having almost fully retraced to pre-pandemic levels, we believe that 2021 will be more about security selection and less about a broad allocation to the sector.
Looking at index level data explains this sentiment. Spreads on the investment-grade index once again stand on the more expensive side of their longer-term history. However, if one looks beneath the surface, there are still opportunities within the market. Issuers within the Covid-related sectors of travel, tourism, leisure and hospitality still offer compelling value (see chart below). Many of these companies issued significant amounts of debt in 2020 to shore up their liquidity position. It is our expectation that once we get past the worst of the virus, these issuers will focus on balance sheet management, which should result in stabilising leverage metrics.
Oddly the high yield market overall is higher quality, due to fallen angels (companies downgrade from investment grade to high yield) and a spike in BB issuance, than it was at the start of the year. It is this portion of the high yield market that offers attractive relative value as compared to lower quality investment grade bonds. Within the emerging market space we are seeing the same relative attractiveness of BB-rated to BBB-rated bonds.
Figure 1: Narrowing US investment grade corporate bond spreads
Source: Schroders and Bloomberg Barclays indices. December 2020
Diversity of municipal bonds is underappreciated
The taxable municipal market has played a larger role in portfolios over the last few months and will likely continue to feature well into 2021. The market saw a dramatic surge in issuance in 2020 as municipalities elected to tap the taxable market given the need for funding and the low-rate environment.
Despite repeated concerns expressed by market participants, additional aid to municipals has not yet materialized. Beyond the current political posturing, we continue to believe that additional aid is coming for states and localities, although the size allocated will not be enough to cover the budget holes across the country.
Any shortfalls will surely be met with lay-offs, furloughs, reduced services and higher taxes. However, there are some specific sub-sectors and issuers which offer attractive valuations in the current market. We see opportunities in the essential service issuers and revenue bonds such as airports, higher education and sales tax-backed bonds, though they will continue to be challenged by Covid in the near-term. It is important to note that many of the issuers within this space came into this crisis from a position of strength and have a variety of different tools to address the current challenges.
Despite coming challenges, the expectation of widespread distress across the entirety of the market is overly simplistic given that the municipal market is incredibly broad and diverse. Where some see volatility, we see buying opportunities.
Agency mortgage-backed securities well underpinned
With valuations in the corporate space becoming more ordinary once again, we are once again looking to agency mortgage-backed securities. This is another sector which has lagged the corporate credit rally and still trades at attractive valuations relative to its long-term history (see chart below). Given that the Fed is actively buying $40 billion of agency MBS per month, and policy rates will be anchored for the next few years, we believe the technical underpinnings of the market will remain well supported. We will look to this sector as a liquidity proxy, but with better income prospects than the US Treasury market.
Figure 2: US MBS valuations still attractive relative to history
Source: Bloomberg Barclays US MBS Index as of December 14th 2020.
Return to normal in 2021?
With the arrival of Covid vaccines, 2021 should be a much better year for the global economy and we could even see a return to more normal levels of activity. This and other factors should see supportive conditions for fixed income and financial markets broadly. But, given the starting point in valuations, a much more discerning approach is needed. Selectively choosing sectors and issuers that still have room to benefit from a “return to normalcy” should yield good rewards in our view. Beyond that, we must be prepared to rotate as new opportunities emerge as, if 2020 is any indication, there will be plenty of surprises.