In the third quarter of 2020, the recovery across credit asset classes continued. Pricing firmed though July and August amid continued capital inflows, positive COVID-19 vaccine headlines, a dovish Fed, progress on a new economic relief package, and better than expected corporate earnings. Additionally, risk-on sentiment was relatively broad-based despite rising COVID-19 cases in the U.S. and increasingly tense U.S.-China relations. This positive tone lasted until the beginning of September, when two weeks of mutual fund outflows gave pause to the market rally. In the last two weeks of the quarter, prices also turned negative amid spikes in COVID-19 cases in Europe, dimmer chances of a second round of U.S. fiscal support, and increasing concerns about a contentious U.S. presidential election.
The S&P 500 handily outperformed high yield and leveraged loan markets with an 8.93% return in the third quarter; however, credit and equity returns in Europe lagged, and the S&P 500 and Euro Stoxx 600 posted year-to-date returns of 5.57% and -13.24%, respectively.
Given the strong rebound of the primary new issuance market and return of investor appetite for credit, many issuers took advantage of the circumstances by enhancing their balance sheet liquidity or extending maturities. Although this proactive behavior will likely put off any day of reckoning for troubled issuers and decrease the probability of a near-term default rate spike, an extended period of economic stagnation could push both defaults and downgrades materially higher given the growth of leverage across corporate debt markets.
With the Fed’s liquidity programs and the CARES Act providing support to U.S. consumers, fundamental performance in the RMBS and ABS markets has been in-line with or above expectations—helping investors regain comfort with the asset class—and solid inflows have led to price recovery. CMBS also continued its price recovery during the quarter, albeit at a slower rate than other credit markets. Although the commercial real estate debt markets remain challenged, we believe they represent an interesting area of focus for investors that have the capacity to underwrite CMBS securities to a granular level.
Despite a solid ongoing recovery and many credit markets being at or near their pre-pandemic levels, there is increasing dispersion under the surface of a number of those markets. With this in mind, we believe solid credit selection and avoidance of the many remaining pockets of risk will support prudent investors’ efforts to identify opportunities to outperform going forward.
Turning to global real estate, in the face of ongoing pandemic-related uncertainty, operating fundamentals are challenged and sales activity has significantly declined. Given that real estate is an asset anchored in long-term cash flows, it is critical to have a good handle on operating fundamentals and a fairly clear view of the future, though current market dynamics have made that difficult. The path forward varies by property type, as hotels and retail assets have generally been most impacted by COVID-19, multifamily and industrial have been performing well, and the future of office remains a point of debate as companies re-evaluate the need for and size of their space. For all property types, however, there are nuances across quality levels and geographies, so a local view is paramount. Despite the uncertainty surrounding real assets, positives like near-record low interest rates, unprecedented government stimulus, and significant dry powder should support longer-term values.
In the U.S., commercial real estate transaction volume remains muted, and investor appetite has been suppressed, as underwriting is difficult at best. The shock to demand created a large bid-ask spread between buyers and sellers, and lenders are biased toward geographies and property types with more certain recovery profiles. On a positive note, vacancy rates are healthier than they were during the global financial crisis—due to limited new supply in the last cycle and conversions of excess space—and low interest rates have supported valuations.
Although government stimulus in Europe has provided support to GDP figures and employment levels, real estate activity has been slow, as evidenced in office, where transaction volume and leasing declined meaningfully year-over-year. Beyond office, European transaction activity is bifurcated, as there is high demand for multifamily and industrial properties but little to no activity in retail and hotel. In the UK, a similar dynamic exists; office investment activity decreased 40% year-over-year, while industrial activity increased 10% year-over-year.
Asia seems to be further along in its recovery than most of the world, though the recovery is uneven by country and real estate product type. For example, China’s economy grew 4.9% in the third quarter after a sharp decline in the first quarter, whereas Japan’s GDP declined 7.8% in the second quarter but is now showing signs of improvement. The logistics sector in Asia remained resilient through the pandemic, while the recovery of office varies by country and hospitality and retail are clearly suffering.
Through these unprecedented times, we hope that you, your families, and your colleagues are remaining safe and healthy.