Lessons from crises

Watching the epidemiological curves remains the most important short-term thing to do in financial markets. Better news on the health crisis is a pre-requisite for moving to the recovery phase. Visibility on the extent of the economic and corporate earnings damage won’t come before then. However, the central banks have given investors a huge reason to re-enter credit strategies. Short duration bonds are yielding the same or more than bonds with much longer maturities. With central bank rates so low this is a good opportunity to benefit from credit market normalisation. For the longer-term, the recovery trade needs to be built on quality equities, ideally with an exposure to high quality bond assets that both provide a hedge to risk and a source of liquidity if and when things go bad again.     

It's not 2008

The current COVID-19 period of economic distress and increased market volatility has inevitably drawn comparisons with the 2008 period, not because the causes of the crisis are similar, but because they both caused a bear market in risk assets and drew a significant amount of policy response. There will of course be similarities and investors can take some guidance from what happened back then. Yet there are so many differences as well ranging from what the source of the problem actually is, it’s much broader and indiscriminate impact and the size and speed of the policy response. People are legitimate in taking both a much more bearish and bullish view, because the level of uncertainty remains acute. It is worrying when one turns on Bloomberg in the morning and one of the first stories is about a potential re-activation of the virus in people that had previously tested clear. Yet at the same time it is encouraging when the US Federal Reserve announces even more support for business and households. 

Phased recovery

The framework I and many of my colleagues are using to help us see through the crisis is a recovery of three phases, as I mentioned last week. First, the news on the pandemic has to get better. This week saw more evidence of a slowdown in the rate of active cases in Italy and Spain with less new critically ill patients and more people recovering from the first waves of infection in early to mid-March. The slope of the infection curve also seems to be flattening in Germany, France and the UK and there are early signs of that from the US too. As long as there is no evidence of a second wave in China or renewed rates of infection in Europe then investors can be optimistic, we are on the way back to normality. The second phase is conditional on the first and concerns the pace which governments remove lock-downs (opening up of businesses, re-starting schooling, removing restrictions on travel and slowly allowing for an easing of social distancing). There is little clarity on that but once it starts businesses will have a better idea of how much damage has been done. The third phase is the long-road to recovery. We are in the “Nike-swoosh” shaped recovery camp and the precise slope of the upturn will be conditional on how quickly companies can deal with the legacy of the shut-down and start to return to normal business practice. In discussions with our equity fund managers today we focussed on advertising spend, an important source of revenue for media companies. It has been hit hard because no sporting or other events are taking place, so they can’t be televised, and media companies are not able to generate and launch new content. Who wants to pay for TV advertising space when all that is on is endless episodes of “The Hairy Bikers” or people broadcasting from their kitchens? There are lots of things that need to come back to normal and this will take time. Nowhere is this better illustrated than in the US labour market where this week saw another 6.6 million new claims for unemployment insurance. Yes, the Federal Government is generously topping up this benefit (the basic level of which is paid by the States) but not everyone who has been laid off will be re-employed straight away. 

Fed returns with more help

I think we know this though and markets are generally accepting that this is the road ahead. The speed at which markets have recovered is partly based on an acceptance of this roadmap and an acknowledgement that that a V-shaped economic recovery is impossible, but also because of the policy response. This has been bigger and quicker than in 2008. The Fed announced QE in late November 2008, some two months after Lehman collapsed. This time it acted quicker and simultaneously announced a much broader set of credit facilities. This week it added to and extended them, allowing the Fed to buy debt that has recently been downgraded to high yield and buying high-yield indirectly through purchases of ETFs that themselves are able to buy high yield bonds. This crisis is global and the policy response has been global. This crisis hits all parts of the economy and the policy response has been targeted at all parts of the economy. There has been cross-political spectrum agreement that this is the right response (no criticism equivalent to “bailing out the bankers” in a global health crisis). For these reasons it pays to be more optimistic.      

Credit lows were in March

In 2008 the credit recovery came first. The investment grade market bottomed in mid-October 2008, the high yield market in December 2008 and the equity market in March 2009. I suggest that the investment grade credit market has bottomed in this crisis. March was one of the worst months ever for total returns and a similar drawdown is very unlikely to happen again any time soon. And investors are not too late to re-enter credit. Spreads remain elevated and the credit curve is very flat, reflecting the sharp rise in yields on shorter maturity bonds – those being the easiest to sell in March when investors needed to raise liquidity. A normalisation of the credit curve will see shorter maturity spreads fall more quickly than longer maturity spreads. Given that policy rates are close to zero, there is a very attractive opportunity in short-duration bond strategies in both investment grade and high yield. Here in the UK the yield-to-worst on the 1-5-year sector of the corporate bond market is the same as that on the over 15-year sector. That is not normal. Short term corporate bond yields are some 250bps above the Bank rate. This should translate into a decent return as spreads come down and bonds prices pull to par.  

Rates hedge 

Another observation I would make about the last few weeks is about the performance of government bonds. Yields fell sharply and, as I argued last week, this is a sector that remains the safest from a credit point of view (although the Fed is doing its best to level the playing field between Treasuries and corporate bonds). Importantly, core government bonds, particularly longer duration ones, did exactly what they are supposed to do during a risk-asset crisis – went up. The correlation of daily total returns between the S&P500 and the US Treasury index during February and March was -0.41. There were only 4 days on which both stocks and bond prices went down together – one of them was month/quarter end and the other three were the worst and most illiquid days of the crisis when investors were essentially selling what they could. A bond strategy with exposure to long duration government bonds would have performed better than a pure credit strategy and a multi-asset strategy with a bond bucket would have done better than a pure equity fund. Now, I am not saying that there is another risk blowout coming, but having something that naturally hedges corporate exposure is a good thing and I would argue that it should be a component of a medium-term investment plan.

And still can

Without venturing into bond-maths, it should also be noted that the duration of bonds goes up when market interest rates come down. The duration of the European government bond index has risen to 8.25 years today from 7.9 years this time last year and 7.7 years two years ago. For the US Treasury market the duration is more than 1 year longer today than it was two years ago and the UK government bond index is almost 2 years longer. This means the market as a whole is more sensitive to changes in yields and investors can take advantage of that by having a smaller capital allocation to fixed income but getting the same duration exposure. This should be particularly useful going forward, in a recovery trade. A higher allocation to high yield or equities can be achieved, with attractive entry points, while still having some exposure to long duration to provide the risk hedge. Government bonds by themselves aren’t likely to be the more rewarding asset class, with yields low, but even with narrower ranges in which they are likely to trade, they can still do a job.

Long-term recovery is about equities

So do we need to wait another 4 months for the equity market to bottom? That would be the 2008-2009 playbook and for many investors the likely evolution of the earnings cycle means there is still a downside risk. It remains to be seen but I don’t feel that calling that we’ve seen the bottom in stocks is a high conviction thing to do at the moment. The market does not look like it agrees with me but there were two 20% or more sized rallies after the credit market bottomed and before the S&P hit its March 2009 low. Equities clearly benefit from all the credit support but there are starting to be some very scary looking forecasts for earnings (someone mentioned a S&P EPS number for 2020 of $100 which would represent a 40% decline from the consensus that held prior to the crisis). What multiple would you put on that? Even at 20x that is a market level that is 800 points lower than what the market is trading at as I write. We will get a better idea when companies start releasing Q1 earnings statements soon but the risk is that some of those results will be much worse than anticipated and companies will not be able to offer much in the form of visibility for the next couple of quarters either. The best we can hope for is that equity investors remain forward looking and the 3-phase recovery stays on track. Not everything in the economy has come to a standstill and there will be some robustness in getting back to normal eventually. So accepting the bottom can’t be picked, a long-term investment strategy should be adding to equities now.