Denial, panic, hope.
We are passing through stages of a global social and economic disaster. The denial of February quickly became the panic of March. Now markets are responding to the massive policy response. This has provided hope, hope that a true catastrophe can be avoided. Yet the news on the virus is yet to improve. This will keep investors cautious about the longer-term prospects and another leg-down in equity markets can’t be ruled out. In the wake of the massive fiscal and monetary stimulus it is key now that we do see declines in net infection rates in the next two weeks. That should happen first in Europe and then the challenge will be the US where the numbers are growing alarmingly.
Back from the brink
The health crisis continues. Yet markets are in better shape as I write than they were a week ago. The S&P500 is currently 20% above the low it made on the 23rd of March. The Stox50 is 20% above its 16th of March low and the FTSE-100 is 15% higher. In the bond markets, credit concerns have eased a little. The crossover CDS index has fallen from over 700bps to 535bps in the last week. Before the US Federal Reserve (Fed) announced its latest package of support, the US credit markets were in danger of completely seizing up. The spread on the 1-3-year sector of the investment grade US corporate bond market was trading at 53bps a month ago. It peaked at 443bps on the 23rd of March and is now back down to 350bps. Elsewhere in the credit markets, spreads remain elevated and are generally at recession levels. The encouragement, if any, comes from the fact that they have been brought back from the brink. Anecdotally, I observe that sentiment in the market has also improved with liquidity a little better, flows being more two-way and some companies able to issue bonds in both the US and European markets. However, things remain nervous and with many in the financial markets working remotely, risk taking, and liquidity levels will be challenged for some time to come.
End of orthodoxy
The improvement in sentiment that has been seen stems entirely from the policy initiatives announced by governments and central banks. Help has come in the form of liquidity through massive purchase programmes targeting credit and money markets, quantitative easing through the purchase of government bonds to create the fiscal headroom that governments need, and fiscal spending designed to support incomes, businesses and employment in the months ahead. Importantly a lot has also been done to address the very pressing public health needs. It should be welcomed that monetary and fiscal orthodoxy has been thrown out of the window to allow public authorities to quickly support health workers, to accelerate testing, to increase the supply of vital equipment and to underpin security for all key workers. The scale of the support is unprecedented and could amount to levels as high as 30% of gross domestic product in some economies, once the direct fiscal, conditional guarantees and monetary expansion is all taken into consideration. This reflects the scale of the damage done to economic activity. One just needs to see the US initial unemployment claims report this week to get a sense of that. It stood at a record 3.28mn people. Markets are reflecting the view that the economic shock is massive, but it should be reasonably short-lived, and policy has responded sufficiently to prevent a long-term economic problem. That maybe a little optimistic but essentially reflects what financial markets are saying.
Individual parts of the markets are behaving differently and will be impacted in varying ways by both the economic impact and the policy response. Money market funds saw massive outflows in the early part of March which put enormous pressure on the pricing of commercial paper and the ability of companies to raise short-term liquidity. This has been partly addressed by the Fed and the ECB but there remain tensions in the short-term funding markets as global borrower’s scramble to raise dollar funding. Again, this has been partly addressed by the Fed reaffirming international US dollar swap lines with other central banks. Yet things have not returned to normal here and are unlikely to as long as some companies face severe squeezes on cash-flow.
The corporate bond market is interesting. We are seeing remarkable levels of intervention by the authorities, including the direct purchase of corporate debt and the bankrolling of credit facilities aimed at preventing a financing disaster. This should limit the rise in the ultimate worst-case scenario for credit investors – massive defaults on debt that destroy investor wealth. In that respect, the widening of credit spreads should be seen as an attractive entry point as long as sentiment is driven by the belief that things will get better in months and not years. It won’t be an easy ride though. There will be a surge of downgrades and we have already seen a sharp increase in fallen angels (investment grade companies downgraded to high yield). For some time investors have been worried about the large share of BBB-rated companies in the investment grade indices and those concerns are now being realised with big borrowers at the lower end of the investment grade market getting junked. Some investors will be forced sellers of fallen angels. It is not clear how deep the pockets of dedicated high yield investors are such that they can absorb a big increase in paper in the high yield market. It will take time for this to settle to a new equilibrium. Meanwhile, traditional leveraged high yield companies will face financing issues as they tend to burn through cash pretty quickly when revenues decline. Access to credit markets should be there but it won’t be as easy for leveraged companies as it is for the better quality big-cap names. But this is why sub-investment grade now yields above 10% in the US and nearly 8% in Europe. Investors need that kind of yield for taking the significantly increased risk of default. But as I suggested last week, buying at these levels has historically been rewarding, subject to the marked-to-market volatility.
The government bond market is interesting. The mechanics of the government bond market are now determined by how the global policy response to the crisis gets financed. Interest rates have been cut to what central banks believe to be the effective lower bound. Bond yields are lower than official rates on some parts of some yield curves but generally the level of official rates will set the floor for longer-term government bond yields. The surge in borrowing that will result from all the fiscal support is not going to be financed by pension funds and insurance companies but by central banks through quantitative easing and other programmes. I read an estimate that even with the massive increase in borrowing that the German government will do to finance its huge fiscal support for the economy, the “free-float” in the German government bond market could fall to as low as 30%-35%. Moreover, the “plan” is for central banks to create fiscal headroom and to keep borrowing costs low. With the effective lower bound on official interest rates creating an effective floor and massive bond purchases creating a ceiling, bond yields might find it hard to move much at all in the foreseeable future. For return seeking investors, this relegates the asset class somewhat and even in multi-asset portfolios, the hedging properties of bonds may well be curtailed for some time. The huge amount of QE being done is pushing yields lower at the moment, with curves flattening somewhat, but there may be a limit to have far this goes once the issuance kicks in. Away from the core, peripheral sovereign bonds in Europe have performed well over the last week in response to ECB policy announcements and particularly because the new PEPP (Pandemic Emergency Purchase Programme) will not be bound by the 33% limit on how much of a single issue the ECB can buy. This provides €750bn of firepower to prevent sovereign spreads from blowing out. It is working. Italian sovereign spreads are lower this week and remain at around a third of the peak levels reached during the 2012 Euro crisis. Yet more may need to be done. The discussion at the moment is whether to use the ESM to provide huge backstop financing to European countries. Will it take a disaster to finally move on the mutualisation of debt in the euro area?
The credit markets are focussed on whether companies have enough cash or access to new credit to meet any obligations falling during a period in which revenues have been slashed by the economic hard-stop. Equity markets also need to take this into account as well as trying to figure out how the trajectory of earnings look now. Economists have not yet concluded on the size of the hit to GDP, but it is clear from a range of micro-indicators (such as measures of traffic congestion in major cities) that current activity levels have plummeted. The latest data on earnings forecasts that I have seen reveals a surge in downward revisions to EPS forecasts. For the S&P500 this has been the second worst month of downward revisions since the series began and was only worse in the height of the 2008 crisis. The actual nominal EPS forecast level is probably going to be cut a lot further. Beyond the sentiment effect in place this week, it will be where these earnings numbers settle and how companies begin reporting that will determine how equities perform during the rest of the year. Macro trends, valuations and sentiment should all be positive, but the earnings picture will be critical.
The next two to three weeks will also be critical. During that time frame it should become evident whether the lock-down policies in place in Europe and elsewhere are starting to work. Modelling suggests that the peak of active infection rates should be reached in early April, but the actual path of reported cases depends on the ramping up of testing. The more people get tested the more reported cases there will be. This should produce more accurate estimates of the expected peak, but it may mean that the peak itself takes longer to reach. However, medical professionals argue that testing is vital as it helps isolate infected people and thus reduces the infection rate. But in the next couple of weeks the numbers are going to rise, especially in the United States which has already become the country with the largest number of active cases. The public health response has been more fragmented and delayed in the US than anywhere else. Thus, the disruption to the economy is going to be a real shock and this may still find its way into significantly lower stock prices. Let us all hope that Americans can get on top of the virus soon.
Needless to say, some good comes out of a bad situation. There are numerous stories of people doing extraordinary things to help each other and the vulnerable. We would all agree that the roles our frontline health professionals are playing are beyond compare. On a different level it is amazing how companies are adapting their operational set-ups. The side-effects of less travel and reduced pollution is great for the environment. Remote communication is coming into its own and will be much more of a feature of work once normality returns. It is frightening to think how this situation would have impacted if we didn’t have the internet, email and video-conferencing. We would be talking depression. The fact that we can all stay connected in the world of work surely has made the global economy more robust and will help when the recovery eventually comes.