As we reflect on the past year, 2020 has been anything but ordinary. The pandemic’s grip around the world has effectively caused immense devastation with loss of lives and a shutdown in many economies, leading to spikes in unemployment and business closures. Market moves have been extreme this past year, with wild swings from the among the worst quarter on record for credit excess returns in the first quarter, followed by the among the best. While we believe that this level of volatility will unlikely repeat in the near-term, we do expect sporadic jolts in spreads and market dislocation. Overall, economic conditions continued to stabilize during the period as central banks reiterated their unwavering support and the pace of U.S. Treasury and MBS purchases remained robust at $120 billion per month. On the employment front, following a spike in April to 14.7%, the U.S. unemployment rate has been steadily declining and edged down to 6.7% in November. However, nonfarm payroll remained below its February level by 9.8 million as COVID-19 infections rose and more states re-introduced restrictions, while a new stimulus bill which would provide support to millions of Americans was approved in the final days of the year. Despite an immense amount of volatility throughout the year, the OAS on the Bloomberg Barclays U.S. Aggregate Index closed the year at 41.9 after touching an intra-year wide of 126.5 and just three basis points wider than the end of 2019. Additionally, the Treasury curve steepened during the quarter with the 5-year yield rising from 0.28% to 0.36%, the 10-year yield rising from 0.69% to 0.93%, and the 30-year yield rising from 1.46% to 1.65%. However, yields across the curve remain substantially lower than the beginning of the year with the 30-year closing 2020 slightly lower than 5-year closed 2019.
While we would like to leave 2020 in the rearview mirror, the demarcation of the calendar year does not provide respite from challenges of last year; however, there is reason for optimism. We expect the first quarter to endure the challenges associated with post-holiday and seasonal surging virus activity, with the attendant pressures on economic activity and employment. The new administration, anxious to demonstrate a differentiated approach from the predecessor, will likely err for more restrictive measures. We anticipate the first weeks of the year to be amongst the most challenging since the onset of the pandemic. Market participants; however, are keen to look past the very immediate term and focus instead on the expected tailwinds as the weakness in the initial part of the quarter yields to the expected strength into the spring. We believe late first quarter economic data will appear very strong, in some cases records, as year-over-year rate of change data compares to the depression-like early pandemic numbers. If progress is incrementally achieved against COVID-19, we expect to see economic activity surge, especially on a comparative basis, as pent up demand and excess savings are deployed towards leisure, dining, travel, and other COVID-suppressed consumption. That said, much hinges on the roll-out of the vaccines and what path the U.S. takes to achieve herd immunity. Early indications are concerning, both in terms of vaccine administration and compliance. The initial roll-out has not been well organized, dramatically missing pre-announced milestones of production and vaccinations. Additionally, there is concern that health care workers have overwhelmingly declined to be inoculated, casting doubt on compliance among younger and healthier cohorts even once the vaccine is widely available. There is still a non-zero chance that herd immunity in the U.S. is achieved not by vaccinating 70+% of the population, but by excruciating exponential spread of the virus. This is a key risk we are monitoring.
Aside from COVID-19, we are also closely watching the sea change in the U.S. political landscape. Given the benefit of writing a few days into the new year after the Georgia run-offs, we now know Democrats control the executive and legislative branches of government, albeit by a small margin in the House and just the one tie breaking vote of the Vice President in the Senate. The initial market expectation is that vast stimulus spending is on the horizon which could lead to a strong reflationary environment driving both government yields and risk assets higher. We caution against this near ubiquitous outlook for a number of reasons. Firstly, the senate is only able to pass certain budgetary agenda items with a simple majority. The even party split amongst Senators has had the unexpected consequence of rapidly transferring significant power in Washington towards the center. Swing voting Senators Manchin(D), Collins (R), Murkowski (R) and Sinema (D) will wield significant power in a Senate that still requires 60 votes to pass major legislation, and are unlikely to give the administration the blank check that financial assets appear to be pricing in. Additionally, it is doubtful the power-dove couple Yellen & Powell would risk stifling the housing market and the broader economy by allowing rates to move significantly higher, instead opting to implement Japanese style yield curve control as opposed to negative rates.
Turning toward domestic fixed income markets, we see competing forces in the marketplace. We cannot argue that domestic bond markets are currently ‘cheap,’ but the pressures against higher yields and spreads are significant. Record Treasury issuance to support deficit spending and skyrocketing total debt to GDP are certainly trending in the wrong direction technically and fundamentally. That said, U.S. rates remain among the highest available, certainly among developed nations. At the time of publication, the tally of negative yielding debt topped $17.5 trillion, representing over 25% of global investment grade fixed income assets. The supportive global technical demand for U.S. yields cannot be understated. Furthermore, investors in U.S. fixed income assets are confident investing alongside a central bank that has demonstrated unlimited support in the event of market volatility. The U.S. Federal Reserve balance sheet is expected to eclipse $8 trillion by the middle of the year, up over 100% in just 18 months. With respect to spread assets, while the corporate bond buying programs expired at the end of 2020, it is widely assumed they would be quickly reinstated and implemented by the new congress at the first sign of market stress. The technical bid combined with the ultra-accommodative central bank will likely keep rates and spreads from rising significantly or persistently in the near to intermediate term.