April 29, 2020
Investor sentiment remains fragile – although on balance, positive – as negative news on the economy and lack of visibility into corporate earnings forecasts are offset by a continued flow of fiscal and monetary accommodation.
While building the bridge to recovery using congressional- and Treasury-backed stimulus programs alongside bond-buying of all stripes by the Fed is critical to maintaining near-term market momentum, investors will soon begin to look toward the recovery phase to determine what it will look like. Will consumer behavior be forever altered or simply face short-term modifications? More importantly, as countries and states here in the U.S. develop and execute plans to ease lockdown measures, will there be a second wave of infection?
In addition to these broad-based and, unfortunately, currently unanswerable questions, investors have become more concerned about two distinct issues: the steep and sudden decline in the price of energy, and the municipal bond market.
First and most importantly, energy equities do not always follow the price of West Texas Intermediate (WTI), the U.S. benchmark, or Brent Crude, the international benchmark. Both of these benchmarks have reflected a steep downturn in global oil prices as demand shock related to the COVID-19 lockdown measures collides with an oversupply in the market. WTI and Brent prices have both fallen roughly 70% year-to-date.
The moves in global energy markets have certainly dominated headlines, with the price of the May contract for a barrel of oil falling last week into negative territory for the first time in U.S. history. Of note, and in addition to the demand destruction noted, this collapse was driven by two important and related issues. First, these futures contracts settle at expiration with the delivery of physical oil. If you own the contract, you own the oil. Many of these contracts are owned in energy-related Exchange-Traded Funds, which typically sell contracts near expiration and buy the next month’s contract. This systematic approach works during normal market environments. Second, given the supply/demand imbalance, storage capacity for physical oil is extremely limited, rendering the delivery of physical barrels difficult even for those who want it. With the “financial owners” of these contracts unable to roll them over – and as expiration neared – panic ensued, resulting in contract holders willing to pay someone to take the contract off their hands: hence the negative price.
So, where do we go from here? In terms of our outlook for the commodity, we believe that the supply/demand imbalance will persist throughout 2020. Demand will continue to be suppressed by the slow re-opening of regional and national economies, and supply will remain robust despite promised cuts from OPEC+. Longer term, we believe that current conditions will accelerate a trend that was under way before the COVID-19 crisis: restructuring, right-sizing and focusing on profitability. This will likely mean that fewer but stronger companies emerge from the crisis as the cost of capital and spending discipline needed to succeed continue to rise. In the interim, supply will have to fall, and wells will likely continue to be closed off. And as explored in analysis from our economists, energy-producing states in the U.S. and petroleum-revenue-dependent countries will likely come under financial pressure.
Recent market turmoil in the energy spot and futures market supports the approach we take to providing our clients with exposure to commodities. We prefer equity-based commodities to futures-based exposure, and energy stocks have not followed the commodity down: The XLE, a broad index of energy stocks in the S&P 500, has actually rallied over 50% from its March low, although it remains down nearly 40% year-to-date. The lesson here is that equities will anticipate these kinds of disruptions before we see them manifest in data, and similarly, will begin to price in recovery before it emerges.
We do not expect a wave of state or local defaults in the investment grade space for a few main reasons. First, revenue declines are expected to be burdensome but not unmanageable, with projected revenue losses in states ranging anywhere from 15-25% over the next year. Second, the municipal sector is generally positioned for financial resiliency, supported by rainy day reserves, federal stimulus, and the ability to implement cost cuts and/or tax increases. Third, the Fed has a strong track record of providing support in “force majeure” events, and we don’t expect that to change.
That said, there are a handful of investment grade municipal issuers – for example, Illinois – who entered this crisis in worse shape and are at greater risk of default. At a state level, this also includes Hawaii, Kentucky, New Jersey and Connecticut. However, we do not expect these issuers to default anytime in the near future. If they continued down their current paths, default could become a longer-term risk, but such an event would be well anticipated and already priced into bond prices.
At Northern Trust, we expect credit quality to be an important attribute to portfolio construction as the impacts of COVID-19 unfold, and we continue to maintain vigilance on that front. Our proprietary credit process and dedicated team of analysts look through rating agencies’ assessments and perform the necessary fundamental analysis at the issuer level. The municipal bond market is made up of an incredibly broad array of issuer types, and this kind of analysis is always criticat – but perhaps now more than ever.
In the high yield municipal space, a longer-term uptick in defaults is probable, but in the near term, many high yield issuers have been well supported by federal stimulus programs, particularly around transportation and higher education. Further, higher default risk has largely already been baked into bond prices and would be well anticipated by us and other active municipal bond managers.
For more detail on our outlook for credit conditions in the municipal bond market, read Municipal Bonds: Credit Update amid COVID-19.
Default risk has clearly risen in certain areas of the muni market. There has been a lot of news on this front recently, beginning with Senate Majority Leader Mitch McConnell’s suggestion that federal assistance to state and local governments would not be forthcoming and that perhaps bankruptcy would be a viable option for distressed budgets. Allowing – or encouraging – broad-based defaults is, of course, not a viable option, and we believe the comments represent typical politicking as we move to the next phase of fiscal stimulus. Republicans may use support to state and local governments as a bargaining chip to attain desired infrastructure spending, or even to garner support for the U.S. energy industry. We expect to hear much more on this issue over the next several weeks. In the meantime, the Fed has, once again, stepped into the breach and expanded a key support program for the muni market, adding smaller counties to the eligibility matrix and extending the maturity range of acceptable bonds from two to three years.
In thinking through liquidity risk, it is important to note that although liquidity is much improved from the dark days of March, conditions remain far from normal. In a post-global financial crisis regulatory regime, the traditional liquidity providers are simply not there: banks and primary dealers are more reluctant to extend their balance sheets to support market function. That is why the Fed had to step in, and Fed intervention has improved but not fully healed stressed liquidity conditions.
For investors with known cash needs, it is critical to work with your Northern Trust team to identify those needs now, and to plan accordingly under the assumption that liquidity conditions may not improve over the near term. Your relationship team will work closely with our municipal bond experts to explore ways to meet your liquidity needs with minimal market impact.
This is a great question, as with any kind of market stress comes potential opportunities. We believe that municipal bonds broadly represent an important asset class and a core component to a diversified Risk Control portfolio, particularly now given their yield premium relative to U.S. Treasuries: 10-year triple-A municipal bonds currently yield 1.45%, 0.83% more than the 0.62% offered by the 10-year Treasury note. Our interest rate outlook is “lower for even longer,” with Fed policy expected to remain extremely accommodative into the foreseeable future, so this premium offers a very attractive entry point for investors looking to initiate or add to municipal bond portfolios. This premium will also attract “crossover buyers,” investors who are agnostic to the tax benefits of municipal bonds but find the absolute yield advantage attractive. Pension funds and insurance companies are always looking to enhance yield, and municipal bonds offer the opportunity to accomplish that goal as well as enhance overall portfolio diversification.
We continue to prefer higher credit quality, with a focus on general obligation bonds or select revenue bonds with clear and consistent cash flows. And finally, we like pre-refunded bonds, which are municipal bonds pre-refunded with Treasury holdings – hence, providing a municipal yield in exchange for only Treasury risk. These can be hard to come by, but our managers are always on the lookout!
About Your Questions Answered: With volatility at historic levels amid the COVID-19 outbreak, investors continue to be challenged by a daily barrage of news and unprecedented economic uncertainty. To help them navigate this difficult period, each week we are featuring answers to some of the top questions we have received.
Most importantly, please know that our thoughts are with each one of our readers – our clients, colleagues, business partners and everyone else within our community – as we strive to overcome this health crisis.