Waxing Moon

Price discovery, the mechanism by which competing buyers and sellers determine the price of a security, has been disrupted by the uncertainty surrounding the duration and severity of the coronavirus-induced economic shutdown. Jason Herried and Brian Schaefer discuss how equity and fixed-income markets have each processed this dislocation in their own way.

Equity Markets Act as Waxing Moon

Social distancing has meant that our investment team and most of the firm’s employees have transitioned to home offices. This means that at times I have shared a work space (a.k.a. kitchen table) with my children. In science recently, my son was studying the different phases of the moon. The month of March has resembled these phases:

Full Moon – the phase of maximum visibility. This is how investors viewed the world in mid-February. The economy was stable and seemed poised to experience faster growth in 2020. Markets made new all-time highs for the S&P 500 on Feb. 19.

Waning Moon – the phase that transitions toward darkness. While economies typically take months to slow toward a recession, the rapid transition to social distancing shut down the global economy in just weeks. Markets reflected the new outlook rapidly, with the S&P 500 declining 35% from its peak in just 21 trading days to the recent bottom on March 20.

New Moon – the phase when the moon is fully shadowed and hard to see. Markets experienced a new moon during the middle two weeks of March. Equity, fixed income, commodity and currency markets experienced significant dislocation in prices. When investors are in the dark, they search for light, which in a market context is liquidity – namely cash. Investors attempted to sell anything they could, pushing prices lower. Buyers were reluctant, with little cash available and an uncertain outlook to value assets.

The waxing moon is the phase when the moon begins to show as a crescent again. To continue our analogy, markets received some light last week through monetary and fiscal policy support. Equity markets rallied 18% in four trading days from the low to the recent high on March 25.

As a result of policy support, our outlook toward equities and credit markets improved last week. However, we expect volatility to remain high. We therefore expect opportunities in the coming weeks and perhaps months to deploy the above-average cash positions we had built. While aggressively adding equity exposure will take time, we have spotted opportunity within fixed income.

Fixed-Income Opportunities

It’s important to stress that what we have seen over the past several weeks in the bond market is a liquidity crisis – not a credit crisis like 2008. Investors are demanding cash out of fear and uncertainty, not fundamentals.

While the decline in bond prices has not been as deep as it was during the financial crisis, it has been the quickest, most indiscriminate move we have seen in decades.

Dash for Cash = Pricing Dislocations

The impact of this unprecedented dash for cash has been felt acutely by municipal bond funds and short-term corporate bond funds, which are typically among the most conservative fixed- income categories. Despite the fact that the credit profiles of the companies and municipal credits these funds own are solid, mutual fund companies must sell securities at a discount to meet investor redemptions.

As bond prices declined amid this forced selling, yields on tax-exempt municipal bonds rose above yields on similar quality taxable bonds even before accounting for their exemption from federal tax. The pickings were briefly so good that even investors not subject to tax began to “cross over” and buy tax-exempt bonds.

Short-term corporate bond funds were a victim of the phenomenon that as bonds move closer to maturity, they can be sold at a lower dollar discount than long-term bonds. Mutual fund companies sold their short-term bonds first to avoid the biggest price losses. This is why even ultrashort bond funds, with average maturities of one year or less, have seen their net asset values decline.

The good news is that the wave of selling in corporate and municipal bonds peaked from March 18 to March 20. In contrast, last week saw a steady return to normalcy, with corporate and municipal bonds rallying hard on news that the Federal Reserve would begin supporting these markets through both primary and secondary market purchases. The Fed is even buying the largest corporate bond ETFs, which has resulted in a much firmer market. At the end of last week, we saw these actions start to show up in rising rather than falling prices of our actively managed bond funds. We expect further price recovery as bonds begin to reflect the extraordinary fiscal and monetary measures being taken to ensure that credit markets are functioning for businesses that need access to capital.

The Cost of “Safety”

The demand for safety is such that investors have bid up cash equivalents to the point that short-term T-bill yields are now negative out to six months. Government money markets that invest in these securities will soon be yielding close to zero as their longer-term holdings mature and they reinvest the proceeds at today’s rates.

We believe the correct approach is not to join the dash for cash but to remain patient and buy high quality opportunistically as the market finds its footing. It remains a buying opportunity for clients with cash to put to work.

Credit Quality

We are continuously monitoring the securities in our portfolios, and we are stepping up these efforts even more during this unprecedented shock. The bonds in our individual bond portfolios have not been downgraded by the major ratings agencies, and we do not believe that the securities we own will be impaired over the short to intermediate term. We will continue to monitor developments diligently and make portfolio adjustments if a bond no longer meets our credit criteria.

The Next Phase

Unlike the phases of the moon, financial markets do not follow cycles perfectly. Markets appeared to move out of the bearish phase last week, but we don’t know if uncertainty will continue to wane or if darkness will return. Our advice is to brace for continued volatility and perhaps a longer period of social distancing than optimists expect. Volatility, however, can create opportunity for those who are prepared. While adding risk within equities should remain selective, adding exposure to fixed income with excess cash may be the first opportunity for investors to take advantage of.