History in the Making

• In 2010, the high yield market was even more robust than equities at the outset of the economic recovery.

This might be explained by both caution and growth. On the one hand, high yield bonds are debt instruments which sit higher up in the capital structure, and they pay healthy coupons that offset price declines when considering total return. A cautiously optimistic investor who wants to take advantage of the high correlation between all asset classes in a dislocation could potentially find more attractive risk/reward in the bond markets. But within the bond markets, high yield bonds tend to perform better than investment grade bonds after the economy has been beaten down and rates are low. This is because economic improvement tends to compress credit spreads and raise interest rates. Since the high yield market tends to have, on average, shorter maturities and wider credit spreads than the investment grade market, both of these factors work in favor of high yield as the country looks to recover from the economic downturn, whether in 2010 or 2020.

• The 2010 market recovery wasn’t without corrections along the way.

Most notable after the Great Recession was the market reset that took place in 2011. There was another smaller decline in mid-2010, which may be compared to the wobble in the markets in June/July this past summer. In our view, the risk of corrections is directly tied to the mismatch between market strength and fundamental uncertainty. Valuations in the marketplace tend to reflect projections built on top of fundamentals, either current or prospective. It is safe to say that in the current environment, the expectations built into the market are projections built on top of prospective fundamentals.¹ So if results during an earnings season collectively disappoint versus the prospective fundamentals that underlie a projection, the risk of a correction increases. And if the results or market sentiments cast doubt on the assumptions that underlie the projections themselves, then the risk of a correction increases further. Collectively, we may find that at least some of the observed market gains are spurred not just by hope but by hope squared.

• The markets in 2009 took nearly a full year to get close to recovering to pre-dislocation levels. In 2020, it took less than six months.

This observation is notable because the timeline of seemingly parallel events in two different periods is never the same. Why? Because, despite some evidence to the contrary, market participants do tend to learn from the past; or maybe more accurately, they tend to adjust future behavior based on their past experiences. In 2020, the markets recovered much more quickly than they did during the 2008/2009 decline. We believe this is because investors have learned over the last decade not to be skeptical of support from the Federal Reserve. But investors have let their good fortune cloud the risk that the entire timeline might be compressed. That includes the potential for further corrections. We believe, for many reasons, that we are likely to see more frequent corrections than we did during the Great Recession and that many market participants are much too complacent about the timeframe.

It’s 2012 All Over Again

Interest rates are low as the Federal Reserve reacted swiftly to attempt to head off an even deeper economic crisis. They have indicated that rates will stay low for some time, but eventually, they will raise rates when they see sustained inflation. But it’s unclear when the effects of the recession will be in the rear-view mirror as economic reports continue to be mixed. In the meantime, capital will likely remain cheap for both companies and investors.

The parallels between now and 2012 are interesting because the snapshots of circumstances aren’t as similar. Most notably, 2012 was several years after the crisis that unfolded in 2008 and 2009, and the market had just experienced its first meaningful correction in the fall of 2011. Today, we haven’t yet seen a correction, and we’re only six months past the worst of the recent market dislocation. But the Fed was also several years away from raising interest rates then, as they are again now. This alone warrants a closer look to see if we can glean any insights from that time period, also illustrated in the charts below:

• In 2012, the Federal Reserve was 3 years away from raising rates. But we didn’t know it at the time.

The market is pricing in low interest rates and virtually no expectations of a rate hike for the next few years. For this reason, it’s not unreasonable to look at how the markets responded to the three years before the 2015 target Fed Funds rate increase. However, there is a big difference between now and then. This time, the Fed has more or less broadcast to the markets that they will not raise rates, whereas in the 2012 to 2015 period, there was always a guessing game year-in and year-out as to when the Fed might act. Even so, the “taper tantrum” in 2013 gave us some indication that the markets were assuming an accommodative policy for longer than the Fed might have had in mind, and that event also gave us some indication of what would happen if the Fed surprised the market. With almost every investor expecting rates to stay low for years, the surprise would be even bigger if the Federal Reserve did something different. The impact could be substantially more dramatic than what we saw in 2013.

• The Fed’s inflation policy is different this time around.

This is one of the main reasons investors are willing to make such a big bet on the Fed keeping rates low. To recap, the Federal Reserve’s previous inflation policy was to target 2% inflation. But, if inflation ran at a lower rate and then picked up, they would still aim to act in a way that didn’t let inflation get much past 2%. This, the logic went, would prevent the economy from overheating through a recovery, especially given that the Fed tends to have a loose monetary policy during times of economic recovery that is hard to stop on a dime. In August, the Fed changed their policy to target an average of 2% inflation over time. Practically, this means they will let inflation run above a 2% level “for some time,” which basically leaves rates lower longer and risks getting closer to the edge of overheating the economy. So it’s not unreasonable that the financial markets are acting like free money will not go away anytime soon. Given the Federal Reserve’s growing attention to the bond and stock markets, which stand to fall if they abruptly change course, this seems only logical.²

• Interest rate policy isn’t everything.

But what we also learned from 2013 is that it doesn’t take a rate hike to spook the markets. Note that this correction wasn’t triggered by a signal that the Fed would sell the bonds it had purchased, nor even by a signal that it would stop buying bonds. The mere mention of the possibility that the Fed would consider paring back, or “tapering,” its bond purchases in the open market was enough to worry markets assuming the easy money party would last a while longer. Ultimately, rates stayed unchanged for another two years, and the “taper tantrum” appears as a blip on the price charts. But if one looks closer, one will find that where one was invested in the fixed income markets mattered significantly in capitalizing on the contrasting opportunities presented by an accommodative monetary policy and the risk of it ending. With the Federal Reserve in the middle of an even more audacious program of bond market purchasing, including an unprecedented intervention in the corporate bond markets including high yield, the Fed has several levers to act even if they choose to leave rates unchanged. This presents the face-saving opportunity Chairman Powell may need in order to find a consensus among both the dovish Fed governors who prefer to see the Fed hold true to its word to let the money flow longer and the hawkish Fed governors who will want to see some proactive action to address potential hyperinflation as the economy heats up.

It’s 2001 All Over Again

The population is scared. We’ve just gone through an experience that, for most of us, is new, unsettling and not over yet. For all of the economic damage that has occurred, the uncertainty has awoken an even more primal fear. Many people just don’t feel safe, and if there’s a light at the end of the tunnel, it’s faint at best. We’ve altered the way we go about our daily lives in ways that will likely be permanent, even after the current risk feels less acute. There is a foreboding feeling that life will never be the same.

In 2001, terrorism loomed large in the wake of the attacks on 9/11. The suddenness of the events that shattered the peace all across our nation left many worried that another attack could be imminent. There was much scrutiny trying to understand how we weren’t more prepared, just as there is today. And the uncertainty drove much of the population to react to their heightened fear, only letting up as that fear faded over time. In part, this is because the changes made to our national security were real, and most citizens are probably blissfully unaware of the threats that have been snuffed out by those changes. Meanwhile, the adjustments we have seen have made us feel safer, even if some of them seem like overreactions.³ Is the risk gone forever? We can hope, but unfortunately, probably not.

Today, as we write this, we still don’t yet know when we’ll have COVID-19 treatments or vaccines. Just as several promising treatments and vaccines appeared to be nearing the finish line, vaccine trials are being halted, and studies are being released with reports of questionable efficacy of drugs thought to combat the virus once contracted. Worse, politics has so tainted every aspect of the conversation around the pandemic that no one knows what to believe. But there are similarities with the country’s circumstances in 2001 that can give us hope, even as there are some clear differences we cannot ignore:

• COVID-19 is contagious; terrorism is not.

That alone makes the risk today different. A contagious virus can affect a much broader swath of the population at one time, as we have witnessed with the current pandemic. Even so, it can also theoretically be avoided, whereas acts of terrorism, due to their unpredictability, cannot be. So, the argument goes, the spread of a virus is more within our control, and the actions necessary to combat that spread are easier for individual citizens to take. When viewed through the lens of managing COVID-19 specifically, there is some truth to this. But this perception is exactly why the trajectory of this virus presents such a risk to the markets. There is an anxiety that accompanies a situation that feels controllable but isn’t yet under control. Wall Street doesn’t seem to feel this anxiety as viscerally as Main Street. By the behavior of the markets, investors might not be feeling it at all and, in our opinion, are lacking the caution we believe is warranted given the uncertainty.

• Neither fears nor recessions disappear overnight.

The tragic events of 9/11 happened in the aftermath of the 2000 dotcom bust and in the middle of a resulting recession. The mix of fear and economic malaise wasn’t just felt in September of 2001. The psyche of investors was impacted for some time, resulting in even more severe market volatility over the next two years as seen in the charts above. Today, we face the risk of an unexpected regression in our national battle with COVID-19, a stock market fueled by an indiscriminate demand for technology companies, and a recession with the potential for persistent unemployment rates not seen since peak unemployment during the Great Recession. The table is set for a national reckoning with pandemic risk that experiences even more dramatic ebbs and flows of fear and confidence than we saw with terrorism risk in the years after 9/11.

• In the aftermath of 2001, people had to learn how to manage risk. Markets today must also.

All is not lost in today’s markets if investors position themselves for various risk/reward scenarios. The tendency to think of public behavior during the current pandemic as solely an exercise in risk avoidance is missing the point of the most applicable lesson we can learn from 9/11. In the wake of the attacks, an initial risk aversion quickly gave way to a culture of risk management by both investors and the public. What do we mean by risk management? Put simply, both investors in the markets and individuals in their day-to-day lives learned to live with the risk. This is different from taking risk indiscriminately, with no regard for the consequences, as we seem to be seeing in today’s markets. Rather, the post-9/11 world called for careful consideration of risk and reward and selective risk taking. The results in the charts above show a bias toward credit versus equity, a recognition that a senior position in the capital structure and the cushion of higher income can provide a more appropriate risk/reward balance than other asset classes. The same holds true today. Given the chances that we may find and broadly disseminate a vaccine for COVID-19 and given the chances that we may not, we believe investors are best served by selective exposures which aim to deliver regardless of what the future has in store. In this way, investors can reduce the anxiety and learn to live with prolonged pandemic risk rather than simply try to avoid or ignore it.

Are You Convinced? Neither Are We.

There is one common and flawed thread through all of these comparisons. What we are going through now isn’t 2001 or 2008. It’s 2020, with market factors which may have been influenced by the past but are decidedly different because of those very influences. But some actionable takeaways are clear to us:

• We believe the environment right now is ripe for anyone willing to invest in the credit markets.

The Fed has explicitly committed to maintaining a policy of low rates for years, probably even more aggressively than ever before due to the change in their inflation targeting policy. Jay Powell will likely lead the Fed to let the economy run hotter than usual when previous Fed chairs might have pumped the brakes a bit sooner. And I don’t believe Chairman Powell is going anywhere. He’s a respectable non-partisan who has played the cards he was dealt as well as could be expected, and regardless of who wins the election, I believe he is likely to keep his job, which reduces the risk of an abrupt policy change in the medium term.

• We believe caution is warranted.

For this very same reason, that the Fed will keep rates low for a prolonged period of time, the financial markets in all asset classes carry a risk of volatility unlike anything we have seen in some time. Free money is not a driver of responsible investing. We expect leverage to increase from even currently high levels. Meanwhile, the COVID-19 pandemic is far from being in the past, and there is substantial risk still that a vaccine will take longer than expected to produce and/or to administer broadly enough to be effective, both for logistical and politicized reasons. With the election upcoming and a potential constitutional crisis adding to the already frayed nerves of the country, there is a meaningful chance of a short-term de-risking in the markets, not unlike what we saw in 2011… but sooner. As we highlighted, 2020’s markets have had a compressed timeline compared to what we saw after 2008, so it may not take three years for a correction to take place. And there may be more than one.

• Not being invested is likely a mistake.

While we urge investors to be careful, we also recognize that risks, no matter how significant, may or may not manifest themselves. In our view, a responsible portfolio seeking to preserve capital and perform well in highly uncertain environments will seek out strategies which don’t aim to profit from just one direction of the markets. Should the optimistic outlooks come true, we don’t see a dramatic spike in the markets, but we would expect them to continue to grind higher. So while we see the asymmetry in potential market outcomes to the downside, there are upside scenarios to consider. In addition, the attractive yields found in the credit markets provide a level of income which mean investors don’t need price appreciation to get a reasonable return on capital. The cost of being uninvested may not be as high as the cost of being invested in indiscriminate risk, but it is a cost nonetheless, and one we feel investors do not need to incur.

What does all of this mean? After all, despite our preference for credit, every asset class is being influenced by the Fed’s rate policy, as well as a variety of other factors impacting supply/demand. As a result, too many bond managers have recently been trying to convince investors that an opportunity in a new asset class is the same type of risk as what they were originally hired to do because investing within their native asset class is harder. And often, it sounds like an attractive deviation from their core competency. Until it isn’t. This is unfortunately a common practice among risk-seeking managers. We saw it in the lead up to the 2008 market dislocation, and it didn’t end well. We believe the prudent investor should prefer a more cautious and disciplined approach without being so tactical as to have to time the markets.

Regular readers of our content will already recognize how one can aim to strike this balance. The goal should not be to avoid risk, nor should it be to take risk indiscriminately. The key to capitalizing on the opportunity is to avoid the game of musical chairs, because you only know the music has stopped after it’s happened. This means focusing on strategies that aren’t just positioned to benefit from the current environment. They should also be consistent, not too reliant on a manager’s tactical skills and focused on a clear and simple core competency that you understand. Today’s markets call for those investors aiming to be risk managers, focusing on differentiating themselves through careful security selection within a familiar asset class and a considered approach to the unique set of contradictory risks they face in the markets today. At Zeo, we have positioned our portfolios to aim to capitalize on the dueling potential outcomes that come from such complex circumstances, enabling us to partner with our clients, helping them through whatever comes next.

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By Venk Reddy

Originally published in Q3 2020 letter.