The first half of 2020 was a tale of two markets. Initial reactions to the global outbreak of COVID-19 brought about massive risk-off flows and extreme market volatility, which were followed by asset prices stabilizing and rallying as global central bank intervention renewed investor confidence that liquidity would improve and asset prices would be supported. As a result, the second quarter saw a strong recovery in risk assets worldwide.
Despite pandemic-related shutdowns and unemployment taking a massive and continuing toll on many businesses and the health of the consumer, dual-pronged monetary and fiscal support sent public equity markets soaring. The S&P 500 posted a 20.5% return during the second quarter, its best since 1998, while the Euro Stoxx 600 posted a 12.6% return, a five-year high. In corporate credit, high yield and leveraged loan markets had their strongest quarters in over a decade – posting 9.5% and 9.8% gains, respectively – and the energy market saw a solid recovery.
The Fed’s liquidity backstops also reversed liquidity tightening across capital markets, reopening primary markets. Corporate issuers came to the capital markets en masse to secure their liquidity runways, with both U.S. investment grade and high yield bond markets posting record quarterly issuance of $900 billion and $146 billion, respectively. Meanwhile, quarterly global convertible bond issuance totaled $71 billion, bringing first half 2020 issuance to $92 billion – on track to reach the highest annual level since the global financial crisis. Structured credit markets lagged, as almost $40 billion in ABS and over $10 billion in RMBS new issue priced in the quarter. While structured credit markets sequentially improved over the course of the quarter, a slower primary market resulted in muted secondary trading volumes and stubbornly wide bid-ask levels relative to pre-pandemic levels. Data on U.S. consumers has thus far been better than expected, with mortgage and credit card payment remittance data stronger than anticipated.
However, market uncertainty is far from behind us, and we believe that several pandemic-related and geopolitical factors on the horizon portend heightened risk and support a cautious approach to credit selection. Yet many credit markets are trading close to pre-COVID-19 levels, and we believe investors across markets have been shunning fundamentals in favor of following the rising tide. We expect this dynamic will lead to future price volatility and a transition to an environment in which credit selection, guided by detailed fundamental analysis, will be key to identifying value opportunities and downside protection.
The effects of the pandemic have also begun to take shape in the global real estate market, though government support and accommodating lenders have delayed the onset of widespread distress. Transaction volume is down significantly across all regions, as both buyers and sellers have had difficulty assessing the global economic slowdown’s true impact on asset values, with notable uncertainty around rent collections, rental rates, and growth prospects. As challenges to fundamentals flow through to rent and interest payments, we expect increasing distress to lead to loan sales and asset recapitalizations in varying degrees. However, interest rates are at spectacularly low levels, and impaired income streams may still support annual debt burdens. As global rates appear destined to remain at these ultra-low levels, yields are likely to decrease for assets with cash flows that are deemed stable, thereby bolstering asset values.
The U.S. public REIT market rebounded substantially in the second quarter, though significant corrections in private market valuations are expected once transaction volumes normalize. Shrinking economic activity has weakened property fundamentals broadly, and the trajectory of the recovery in hard hit sectors – such as retail and hospitality – remains uncertain, as does the long-term impact on the office sector.
In Europe, the economic slowdown caused a 25% decrease in GDP, though government subsidy programs have allowed unemployment levels to remain stable. However, the expiration of these programs – most of which are set to expire before the end of 2020 – coupled with an undecided UK-EU Brexit deal could lead to a prolonged recovery for the region. Public real estate indices in continental Europe have declined over 20% year-to-date, and evidence of increased vacancy and ongoing rent defaults have driven further uncertainty in private market valuations.
Turning to Asia, while logistics real estate predominantly remained strong, economies contracted across the region and office fundamentals softened in several geographies. The Japanese REIT Index saw a recovery similar to that of the U.S. and Europe, but expectations of further economic contraction spurred the government to approve a record stimulus package. China and Hong Kong experienced significant economic contractions, and office fundamentals generally weakened, as office vacancy remained flat or increased and rents declined year-over-year. In South Korea, accommodative economic policies provided economic support, but a decrease in private consumption and exports led to a decline in growth, and a slowdown in leasing activity is expected given current market uncertainty.
Through these unprecedented times, we hope that you, your families, and your colleagues are remaining safe and healthy.