July saw all major asset classes continue to climb higher. A 5.6% jump in U.S. large-cap stocks helped erase year-to-date losses. Similarly, a strong 4.7% gain in high-yield bonds helped push year-to-date returns into positive territory. High-yield spreads tightened by 128 basis points, ending the quarter at 5.16%. Gold was the top-performing asset for July, closing the month at $1,994/ounce. The yellow metal is up nearly 30% year-to-date through July.
Corporate Bond Frenzy
On August 10, aluminum packaging company Ball Corp. set an enviable record. Capitalizing on the Federal Reserve’s historic support of the corporate bond market and investors’ seemingly insatiable demand for yield, Ball sold $1.3 billion of junk-rated debt that matures in 10 years at the paltry yield of 2.875%1—the lowest ever for a below-investment-grade note (of a similar maturity). The deal, which raised $300 million more than Ball initially expected due to robust demand, underscores the remarkable reach for yield investors are engaged in around the world as central banks have doubled down on programs designed to keep rates low and asset prices high.
One such program is the Secondary Market Corporate Credit Facility (SMCCF), which is designed to “support market liquidity for corporate debt.”2 On the same day as Ball Corp’s historic capital raise, the Federal Reserve (“Fed”) disclosed the list of corporate bonds it purchased in July under this program. For the month, the Fed bought $1.8 billion of corporate bonds, of which $110 million were BB-rated junk bonds.3 The purchases were spread over 753 individual transactions. While the amounts are insignificant relative to the Fed’s almost $7 trillion balance sheet, the purchases signal the lengths they are prepared to go in order to inoculate the markets from the economic fallout of the pandemic. The list includes bonds issued by Microsoft, Berkshire Hathaway, Alphabet, Apple, Amazon, Ford, Oracle, Cisco, Pfizer and Bristol-Myers Squibb. Collectively, these companies held more than $732 billion in cash and other short-term investments at the end of June. With rock solid balance sheets and virtually unlimited access to cheap capital, these companies have no need for government support. Apple, for instance, has a 2.4% note outstanding that is due in May 2023 and sports a yield-to-maturity of 0.39%.4 The purchases themselves are, of course, too small to be having an impact on market liquidity, but that is not the point. The message sent by the Fed is clear—they will do whatever it takes to support markets.
Unprecedented Support, Unknown Consequences
While few market participants would bemoan higher asset prices, there are concerns with the behavior that such loose monetary policy encourages. According to SIFMA, for the year-to-date through July 31, there has been $1.524 trillion of corporate bond issuance, $224 billion of which has been below investment grade.5 This surge in new corporate debt represents a 79% jump relative to the same period last year.
Part of the reason that pandemic-related shutdowns were so devastating to the economy was due to the record-high corporate debt levels coming into the crisis, which served to magnify the impact of interruptions in revenues. The ratio of U.S. nonfinancial corporate debt to gross domestic product (GDP) was 45% at the end of last year.6 That was the highest reading in the post-War period. Today, that number is estimated to be 58%.7 The 12.4% six-month jump in the ratio is the largest increase since 1950 and is more than six-times greater than the second-largest six-month increase (set in the second quarter of 1970). Corporate debt generally contracts in the wake of recessions—it doesn't explode higher.
While presumably good-intentioned, the Fed’s unprecedented response to the crisis may also lead to unknown consequences. One potential risk that investors may start to pay more attention to is inflation. The higher-than-expected jump in core inflation for July—which came in at 0.62% month-over-month,7 the highest increase since January 1991—suggests that supply disruptions coupled with trillions of dollars of easy money can move the inflation needle.
As of August 13, inflation expectations implied by the U.S. Treasury market are 1.7% per year for the next 10 years and 1.6% for the next five8—both measures are higher than at any point since the Covid-19 crisis started and higher than the yield on the Bloomberg U.S. Aggregate Bond Index (1.13% as of August 13). An unintended consequence of Fed intervention may be negative real returns on corporate bonds for the foreseeable future.
While uncertainty grows about the potential for unintended consequences resulting from the large amounts of monetary policy and fiscal stimulus that followed coronavirus-related shutdowns, it also grows with the upcoming election in November and the wide range of outcomes for policy changes that may follow. On August 11, with the U.S. presidential election less than 90 days away, Joe Biden announced his running mate would be Kamala Harris, the senator from the State of California and former California Attorney General. In the coming weeks, investors’ attention will likely shift to a host of election-related issues, including dynamics around mail-in voting and further details on policy platforms. Market volatility may increase as the election approaches, potentially creating attractive investment opportunities for long-term investors. RMB believes this is a good time for investors to re-evaluate risks within portfolios as the possibility for a downside increases for risky assets. We still feel that investors who added to stocks when they were down should consider rebalancing and taking some profits. We will continue to look for additional opportunities to selectively increase risk, if further stock market pullbacks develop. In the meantime, we continue to focus on dislocations in various niche markets that present attractive risk/reward opportunities.
2New York Fed: https://www.newyorkfed.org/markets/primary-and-secondary-market-faq/corporate-credit-facility-faq
3Federal Reserve: https://www.federalreserve.gov/monetarypolicy/smccf.htm
4Bloomberg, data as of 8/11/2020
6U.S. Bureau of Economic Analysis, Board of Governors of the Federal Reserve System
7U.S. Bureau of Labor Statistics
All market pricing and performance data from Bloomberg, unless otherwise cited. Asset class and sector performance are gross of fees unless otherwise indicated.
The opinions and analyses expressed in this newsletter are based on RMB Capital Management, LLC’s (“RMB Capital”) research and professional experience, and are expressed as of the date of our mailing of this newsletter. Certain information expressed represents an assessment at a specific point in time and is not intended to be a forecast or guarantee of future results, nor is it intended to speak to any future time periods. RMB Capital makes no warranty or representation, express or implied, nor does RMB Capital accept any liability, with respect to the information and data set forth herein, and RMB Capital specifically disclaims any duty to update any of the information and data contained in this newsletter. The information and data in this newsletter does not constitute legal, tax, accounting, investment or other professional advice. Returns are presented net of fees. An investment cannot be made directly in an index. The index data assumes reinvestment of all income and does not bear fees, taxes, or transaction costs. The investment strategy and types of securities held by the comparison index may be substantially different from the investment strategy and types of securities held by your account. The S&P 500 Index is widely regarded as the best single gauge of the U.S equity market. It includes 500 leading companies in leading industries of the U.S economy. The S&P 500 focuses on the large cap segment of the market and covers 75% of U.S. equities.