Macroeconomic Update · Macroeconomic Update Second Quarter 2020 | DoubleLine Macro-Asset...

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Macroeconomic UpdateSecond Quarter 2020 | DoubleLine Macro-Asset Allocation Team

Second Quarter 2020 ReviewAfter suffering one of the worst quarters in over a decade during the first quarter of 2020, financial assets staged an impressive rebound in the second quarter. The recovery was all the more extraordinary coming despite COVID-19’s continued sweep across the globe. Global equities, as measured by the Morgan Stanley Capital International All Country World Index (MSCI ACWI), rose 19.4%. U.S. equities outperformed the broader market, with the S&P 500 Index up 20.5%. Large-cap technology firms led the rally, with the Nasdaq Composite Index up more than 30%. Structured credit rebounded sharply. Non-Agency residential mortgage-backed securities (non-Agency RMBS), as measured by the Markit iBoxx Non-Agency RMBS Broad Index, returned 15.2%. Non-Agency commercial mortgage-backed securities (CMBS), as measured by the Bloomberg Barclays Non-Agency CMBS Index, returned 3.8%. Collateralized loan obligations (CLOs) rated AAA, as measured by the J.P. Morgan CLO AAA Total Return Index, returned 4.3%, with CLOs rated BBB up 20.3%. U.S. investment grade (IG) and high yield (HY) corporate debt posted the best quarter since 2009, with IG returning 8.9% and HY 10.1%, as measured respectively by Bloomberg Barclays Corporate Total Return Index and Bloomberg Barclays High Yield Total Return Index. Commodities rallied 5.0%, led by a near doubling of West Texas Intermediate (WTI) spot prices. Gold surged to the highest level since 2012. (Figure 1)

The recovery in the prices of risk assets was driven to a large degree by central bank stimulus unprecedented in scale and scope. During the second quarter, the Federal Reserve’s balance sheet surpassed $7 trillion dollars, or one-third of U.S. gross domestic product. The Fed ventured into buying corporate bonds, including fallen angels, or IG corporates that have been downgraded to “junk” status by credit rating agencies.1 The central bank also engaged in a host of other credit and lending facilities to promote liquidity and support the flow of credit to households and businesses. The Federal Open Market Committee (FOMC), the Fed’s policy-making body, committed in its June meeting to increase its holdings of Treasury securities and Agency RMBS and CMBS at least at the current pace and signaled no interest rate hikes until at least 2022.

Sam GarzaPortfolio Manager

Ryan Kimmel Analyst

Fei He Quantitative Analyst

DoubleLine’s Macro-Asset Allocation Team

Figure 1Source: Bloomberg, DoubleLine

1 The Federal Reserve can purchase corporates that have been downgraded from investment grade to subinvestment grade on or after March 22, 2020. Source: Board of Governors of the Federal Reserve System. Policy Tools. July 10, 2020.

Performance of Asset Classes | Second Quarter 2020

First Half 2020Q2 2020

Macroeconomic UpdateSecond Quarter 2020

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To no one’s surprise, the National Bureau of Economic Research announced on June 9 that the U.S. officially entered recession back in February. The unemployment rate reached the highest level since the Great Depression at 14.7%, with continuing jobless claims reaching 24.9 million in early May, almost four times higher than the peak of the Global Financial Crisis (GFC). (Figure 2)

As lockdowns continued into April, personal consumption declined sharply. Disposable personal income rose an astonishing 14.0% in April and 8.2% in May year-over-year (YoY) thanks to increased unemployment insurance benefits as part of the federal Coronavirus Aid, Relief and Economic Security (CARES) Act. A $600-per-week bonus payment and other benefits more than offset the loss in compensation income for many unemployed. The combination of decreased spending and higher income led to a record-high savings rate. (Figure 3)

Continuing Jobless Claims versus Unemployment Rate | January 1990 through June 30, 2020


Personal Consumption versus Personal Income versus Savings Rate | January 1990 through June 30, 2020



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In the United States, as the daily rate of new COVID-19 cases started to decline in April and May, some states began the reopening process. As businesses began to reopen across the country and rehire employees, we saw better-than-expected economic data in the second half of the quarter. Unfortunately, the reopenings across the country coincided with a significant rise in new infections and hospitalizations, causing some states to pause and even reverse the reopening process. The recent setbacks reflect the challenges the United States is having in the attempt to foster an economic recovery while trying to contain COVID-19.

OutlookEconomic Growth

In the U.S., daily new cases of confirmed COVID-19 infections have more than doubled since mid-June. While new fatalities associated with complications stemming from COVID-19 have yet to rise to the same degree marked in April, the recent sharp increase in COVID-19-related hospitalizations in some hard-hit states such as Texas, California, Arizona and Florida is cause for concern as is a growing number of COVID-19 patients in intensive care unit (ICU) beds. Hopefully, the added five months of experience treating COVID-19 patients and new therapies will help reduce mortality rates in severe cases.

Many states have no choice but to pause or even reverse the reopening process in response to rising infection rates. Real-time economic activity measures have started to soften recently. Open Table, which tracks restaurant bookings across the country, is showing a recent decline in booking activity. The Johnson Redbook Index, which tracks same-store sales on a weekly frequency, remains at depressed levels. (Figures 4 and 5)

Open Table Restaurant Bookings YoY % February 18, 2020 through July 13, 2020

Redbook Retail Sales YoY % September 28, 1996 through July 11, 2020




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Hiring versus Firing

The health of the labor market is the foundation of a robust economy. Over the last couple of months, the labor market data have been mixed. On the positive side, nonfarm payrolls added 7.5 million jobs in May and June, and the unemployment rate declined to 11.1% in June from 14.7% in April. According to data from Homebase, which tracks hourly employee activity for more than 60,000 businesses across the country, employees’ hours worked improved from a 60% contraction in April to a 20% contraction in June.

In contrast, initial jobless claims remain stubbornly high, and when combined with initial jobless claims for Pandemic Unemployment Assistance (PUA), a federal program under the CARES Act that extends benefits to individuals not normally covered under unemployment insurance, initial claims reached well over 2 million per week as of June 30. (Figure 6) How can nonfarm payrolls show a 7.5 million increase in jobs added in May and June while initial jobless claims remain elevated?

May and June have seen a lot of employment turnover, with both elevated employment inflows and outflows. The June Current Population Survey reported 12.4 million employment inflows and 7.7 million employment outflows. (Figure 7) Nonfarm payroll numbers do a good job at measuring employment inflows and don’t necessarily include those claimants who are in the PUA program. Initial jobless claims on the other hand do a great job on tracking employment outflows but do not track employment inflows well. Many people that have been rehired might be on reduced hours, allowing them to continue receiving partial unemployment benefits, including the additional $600 per week from the CARES Act. So the jobless claim data might include some overcounting.

Initial Jobless Claims with Pandemic Unemployment Assistance January 3, 2020 through July 10, 2020

Employment Inflows and Outflows July 31, 2019 through June 30, 2020




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The Fiscal Cliff

Despite the large-scale decline in employment over the course of the pandemic, the hit to consumer confidence has been relatively muted compared to previous recessions. (Figure 8) Household incomes have been supported by stimulus checks and increased jobless benefits under the CARES Act to the tune of $18 billion per week. The emergency jobless benefits are scheduled to expire at the end of July if Congress does not extend them. While an extension to the fiscal stimulus package is possible, the size and scope of the potential programs are likely to be limited and more targeted. A less-accommodative fiscal policy could have an adverse impact on consumer confidence and spending, impeding a sustained rebound in economic activity.

U.S. Politics

With the 2020 U.S. presidential election looming, the potential outcome is beginning to come into focus in investors’ minds. The resurgence in COVID-19 infections and social unrest have weighed on President Trump’s approval ratings. (Figure 9) Prediction markets are showing a higher likelihood of a Joe Biden victory and Democrats taking control of both the House and Senate. A Democratic sweep could potentially lead to more tax reform and a reversal of Trump’s Tax Cuts and Jobs Act (TCJA). In that event, Washington would likely raise the federal corporate tax rate to 28% from 21% and increase personal income taxes on high earners.

Figure 9Source: Real Clear Politics, Bloomberg, DoubleLine

President Trump Approval Rating | June 1, 2017 through July 1, 2020

Conference Board Consumer Confidence | June 1, 1970 through July 1, 2020

Figure 8Source: Bloomberg, DoubleLine. Shading indicates recessionary periods.

Conference Board Consumer ConfidenceU.S. Recession


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U.S. Politics (cont’d)

While the markets appear to have priced in a V-shaped recovery, we still view the economic recovery path as highly uncertain. Without vaccines and effective treatments, we do not see the U.S. and global economies returning to normal. We have already witnessed the consequences of poorly handled reopening.

Treasury and Agency Securities

The U.S. fiscal response and massive deficit spending have led to unprecedented supply of Treasury securities. In the second quarter, there was a net treasury issuance of $2.75 trillion. The International Monetary Fund (IMF) projects the budget deficit will hit 25% of Gross Domestic Product (GDP) in 2020, 2.5 times the deficit following from the GFC. The increase in supply has been met with an increase in demand. The Fed increased its holdings of Treasuries by $1.7 trillion since mid-March through the end of June and will continue to purchase Treasuries at a pace of $80 billion per month. Commercial banks increased their holdings of Treasuries by $200 billion over the last two months to $1.1 trillion. (Figure 10) The Fed intends to keep official short-term rates near zero until at least 2022, a policy stance that should anchor the front end of the yield curve. Cyclical indicators like the copper-gold ratio are starting to drift higher, which could signal a higher 10-year Treasury yield. (Figure 11) Long-end breakeven inflation rates have recovered much of the decline marked during the depths of the March sell-off. Survey-based inflation expectations have also started to move higher. This dynamic has led to yield-curve steepening, which we believe will continue with anchored front-end rates and the potential for long-end yields to drift higher.

Commercial Bank Holdings of U.S. Treasury and Agency Non-Mortgage-Backed Securities

January 1, 2009 through July 1, 2020; $ Billions

Copper-Gold versus U.S. 10Y Yield July 1, 2010 through July 15, 2020




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Treasury and Agency Securities (cont’d)

We are constructive on Agency RMBS. Option-adjusted spreads (OAS) to Treasuries on Fannie Mae and Freddie Mac Agency RMBS have become more attractive relative to other spread products. (Figure 12) The Fed continues to buy Agency MBS at a pace of $20 billion per week, or roughly 30% of gross issuance. Record-low Treasury yields have increased incentives for mortgage borrowers to refinance at lower rates, leading to higher prepayment speeds. However, tighter lending standards and refinancing bottlenecks might lead to slower prepayments than market consensus.

Credit

In our last quarterly letter, we highlighted the value in structured products in more-senior tranches of the capital structure. Since the severe dislocations in mid-March, the senior tranches of CMBS and CLOs have retraced 75%-85% of the spread widening. Given many of these tranches are now back at par or near par after trading 10%-15% discounts in March, we shifted to a more-neutral stance. Mezzanine debt has not recovered nearly as much as the senior debt, with principal losses being discounted in some segments. We still see alpha opportunities in the space.

As we have noted in the past, we are less constructive on corporate credit, given the increase in leverage and decrease in quality of the overall corporate debt market. We have persistently warned of the rise of corporate defaults come the next cyclical downturn. Just as we predicted, defaults and bankruptcies have gone up over the past few months. (Figure 13) Fed purchases of corporate debt have ushered in record corporate issuance. At the same time, higher-quality IG spreads have retraced 85% of the widening seen in March. Given our relatively more-negative outlook, the risk-reward for investing in corporate credit is skewed to the downside. On a relative value basis, senior tranches of non-Agency RMBS, CMBS and CLOs look more attractive.

Fannie Mae Agency RMBS versus U.S. AA Corporate OAS

June 30, 2010 through July 15, 2020

Figure 12Source: Bloomberg, DoubleLine.

U.S. Corporate High Yield Default Rate September 1, 2004 through May 1, 2020

Figure 13Source: Bank of America, using the rolling 12-month default rate for HY corporates based on par value.


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Equities

Equities continued to rally after the March sell-off, with the S&P 500 less than 5% from the February all-time high. However, there was a great deal of dispersion, with much of the rally driven by a few tech and communication services stocks. While the S&P 500 is nearly flat YTD, the S&P 500 Equal Weight Index is -9.5%. We fear the resurgence in infections will lead to a pause in states reopening that will halt the economic recovery, resulting in potential downgrades to forward earnings. According to Goldman Sachs strategist David Kostin, Biden’s proposed tax reform would reduce S&P 500 2021 earnings per share by 12%. With valuations, based on forward price-to-earnings ratio, near the same level marked during the dotcom bubble, these risks do not seem to be in the price. (Figure 14) We still view the current rally in the context of a bear market and would look to fade the rally as the tailwinds of accommodative monetary and fiscal support are mostly behind us.

SummaryThe economic data in the U.S. have generally come in better than consensus in June. This has led many market participants to extrapolate a V-shaped recovery. The resurgence in COVID-19 infections in the South and Southwest has caused many states to pause and even reverse the reopening process. This will ultimately weigh on economic activity and slow the pace of recovery. The risk of COVID-19 hot spots leading to pauses in states reopening will likely be an ongoing issue if there is no effective vaccine or viable therapy. We need a federal platform for increased testing and contact tracing to move forward. The approaching U.S. general election is also on top of mind. A Biden victory and Democratic control of both the House and Senate are looking more likely, but a lot can happen between now and early November. The risks of a further slowdown in the economy don’t seem to be in the price of risk assets, given the valuations of equities and corporate credit. The risk-reward for structured credit looks more attractive compared to corporate credit. We also prefer to allocate to Agency RMBS, which should outperform other spread products in a more-draconian scenario given the government guarantee. We maintain our view that the Treasury yield curve will continue to modestly steepen with anchored front-end rates and higher long-end rates. We continue to closely monitor the daily COVID-19 case, hospitalization and fatality data along with higher-frequency economic data. Stay healthy and good luck in the second half of 2020. n

S&P 500 Forward P/E Ratio | January 1, 1990 through June 1, 2020

Figure 14Source: Bloomberg, DoubleLine. Shading indicates recessionary periods.


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DefinitionsBloomberg Barclays US Treasury Index - The U.S. Treasury component of the U.S. Government index. This index includes public obligations of the U.S. Treasury with a remaining maturity of one year or more.

Bloomberg Barclays US Corporate High Yield Index - Composed of fixed-rate, publicly issued, non-investment grade debt.

Bloomberg Barclays US MBS Index - An index that measures the performance of investment grade fixed-rate mortgage-backed pass-through securities of the Government-Sponsored Enterprises (GSEs): Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).

Bloomberg Barclays Non-Agency CMBS Index - Measures the performance of investment-grade commercial mortgage-backed securities, which are classes of securities that represent interests in pools of commercial mortgages.

J.P. Morgan CLO Index - Tracks floating-rate CLO securities in 2004–present vintages. Additional sub-indices are divided by ratings AAA through BB, and further divided between pre- and post-crisis vintages.

Morgan Stanley Capital International All Country World (MSCI ACWI) Index - A market-capitalization-weighted index designed to provide a broad measure of stock performance throughout the world, including both developed and emerging markets but excluding the United States.

MSCI Emerging Markets Index - Measures equity market performance in global emerging markets. The index captures mid and large caps in 26 countries including China, India, Korea, Mexico, Taiwan, and the United Arab Emirates.

S&P 500 Index - A market-capitalization-weighted index of the 500 largest U.S. publicly traded companies by market value. The index is widely regarded s the best gauge of large cap U.S. equities.

An investment cannot be made directly in an index.

Important Information Regarding This MaterialIssue selection processes and tools illustrated throughout this presentation are samples and may be modified periodically. These are not the only tools used by the investment teams, are extremely sophisticated, may not always produce the intended results and are not intended for use by non-professionals.DoubleLine has no obligation to provide revised assessments in the event of changed circumstances. While we have gathered this information from sources believed to be reliable, DoubleLine cannot guarantee the accuracy of the information provided. Securities discussed are not recommendations and are presented as examples of issue selection or portfolio management processes. They have been picked for comparison or illustration purposes only. No security presented within is either offered for sale or purchase. DoubleLine reserves the right to change its investment perspective and outlook without notice as market conditions dictate or as additional information becomes available. This material may include statements that constitute “forward-looking statements” under the U.S. securities laws. Forward-looking statements include, among other things, projections, estimates, and information about possible or future results related to a client’s account, or market or regulatory developments.

Important Information Regarding Risk FactorsInvestment strategies may not achieve the desired results due to implementation lag, other timing factors, portfolio management decision-making, economic or market conditions or other unanticipated factors. The views and forecasts expressed in this material are as of the date indicated, are subject to change without notice, may not come to pass and do not represent a recommendation or offer of any particular security, strategy, or investment. All investments involve risks. Please request a copy of DoubleLine’s Form ADV Part 2A to review the material risks involved in DoubleLine’s strategies. Past performance is no guarantee of future results.

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For Investors in ChileIf any products are offered within Chile, they will be offered and sold only pursuant to General Rule 336 of the SVS, an exemption to the registration requirements, or in circumstances which do not constitute a public offer of securities in Chile within the meaning of Article 4 of the Chilean Law No. 18,045 on Securities Market.This communication is addressed only to “Qualified Investors” (as defined in SVS General Rule No. 216).Si algunos valores son ofrecidos dentro de Chile, serán ofrecidos y colocados sólo de acuerdo a la Norma de Carácter General 336 de la SVS, una excepción a la obligación de registro, o en circunstancias que no constituyan una oferta pública de valores en Chile según lo definido por el Artículo 4 de la Ley 18.045 de Mercado de Valores de Chile.Esta comunicación está dirigida a “Inversionistas Calificados” (según se define en la Norma de Carácter General N° 216 de la SVS).

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