Be ready for anything

To say it’s been an interesting year is an understatement—and we still have almost three months to go! Consensus appears to be a contested election, with the current tilt toward a Biden victory with control of the Senate less certain. It helps that the base case has been a disputed election, with the new dynamics of mail-in balloting fairly well understood. This would suggest less tail risk since it’s arguably priced in the market. But if there’s anything we learned this year, and really the last four years, it’s that caution on consensus is merited. Thus we enter this final stretch of 2020 roughly neutral on both credit and rates positioning because, quite simply, we want to be ready for anything.

To review how we got here, we entered 2020 in a somewhat defensive position with regard to credit, not because we foresaw the Covid-19 crisis but because we had such a strong run in 2019 that we felt it was time to take some bets off the table. Thus our shift to underweights on investment-grade and high yield for the first time in a decade proved beneficial in the first quarter when the virus’s arrival sparked a dramatic risk-off trade. Then as the second quarter got underway—and really, just before the first quarter was ending—we added exposure in much of the credit space and profited from the subsequent dramatic risk-on trade when unprecedented Fed and fiscal stimulus flooded the markets.

The third quarter vacillated between the two extremes. July saw somewhat of a renewed risk-off trade as a second wave of Covid cases raised concerns a budding recovery may stall.  This resulted in a bullish flattener as long rates fell faster than short rates (already anchored at historic lows by the Fed). August got a reversal—a bearish steepener with long rates rising on a consistent stream of positive economic surprises, particularly in housing and manufacturing, amid signs Covid cases were stabilizing/declining. September bounced between risk-on and risk-off, weighing the Fed’s pledge to keep benchmark rates near zero-bound for three years or until inflation hits and holds at 2% against election uncertainties and slowing labor-market improvement. In the end, the quarter ended roughly where it began, with the 2-year Treasury yield down 2 basis points and the 10-year Treasury yield up 2 points.

A neutral stance allows for flexibility

So where does that leave us as the fourth quarter gets underway? Neutral on most of our credit sectors, with a slight overweight on investment-grade corporate bonds offset by a slight underweight to high-yield corporates and commercial mortgage-backed securities, where social distancing and work-from-home orders tossed a monkey wrench into normal commercial real estate operations. A case can be made that, whoever wins the election, a relief risk rally may ensue because markets are going to get stimulus either way—fiscal if it’s Biden/Democrats, or tax cuts if it’s Trump/Republicans.

More than anything, once it’s all over, the markets will get some certainty against a backdrop of an improving economy still in the early stages of recovery. (This past week’s risk-on rally during widening election polling supports this view.) That favors equities over fixed income, and I wouldn’t be surprised if we start seeing that dynamic start to play out in fund flows, which in the second and third quarters were very strong for bonds. But because rates are at such low levels, duration of the benchmarks has been pushed out, heightening the potential of a sell-off on the longer-end of the curve in higher-quality credit assets, where spreads have narrowed back to normal levels.

Adding value in this ultra-dovish world is a challenge; we expect some opportunities will come on the rate front through tactical moves in duration and along the yield curve. For instance, we just shifted to a short position on duration on evidence longer rates seem to have made a technical breakout from range-bound summer levels. That said, we would envision taking off that short if the 10-year starts to near 1.00%. Think about that—100 basis points. This shows you just how little we are playing for and reminds us to scale these decisions with risk and return both firmly in mind. For similar reasons, we could make a tactical shift from neutral to a bearish steepener on the yield curve, with an eye toward picking up a little alpha. Finally, we will be looking at credit spreads and currency pairs carefully, again with the objective of adding small diversified sources of alpha. These days, we try to get it wherever we can.