A view from the markets – Looking for the turn
It is hard to be optimistic when the news is so bad. The virus spread is exponential and market declines are massive. Governments are having to impose emergency powers to deal with the health crisis and the financial and economic fallout. Looking through the issue to a time when things might be improving arguably seems churlish when fatalities are still rising in a growing number of countries. Life is not normal at the moment. Yet we have to look forward. The pandemic will come to an end at some point. Signs of that combined with a shift in focus from economic damage to policy driven recovery could turn sentiment around. Higher yields, steeper curves, a recovery in inflation break-evens, narrowing credit spreads and higher equity prices would be part of a recovery. I wouldn’t blame you for being sceptical but China is seeing hardly any new cases and its stock market has outperformed over the last week.
Is it all priced in?
Clearly there is no value in trying to predict market moves in the current environment. My guess is the evolution of the return curves of different asset classes from here will be different depending on how quickly and aggressively asset prices have already adjusted and on the duration and extent of the economic impact. Highly leveraged companies in the most distressed sectors will struggle to recover quickly and this will clearly be reflected in the price of their debt and equity. The question we can’t really answer is whether markets are fully pricing in the ultimate impact on the global economy. Interest rate expectations have been cut to suggest a prolonged period of deflation. Corporate bond spreads have widened to suggest a significant rise in defaults. Equity indices have fallen to bear market territory and a serious earnings recession. These fears and expectations will be confirmed by the data and company results in the weeks ahead. But it is not possible to say how markets will react once those fears are crystallised in hard numbers. Markets could fall a lot more. After all, the S&P500 only peaked 23 days ago. Bear markets generally last a lot longer and the ultimate drawdown is bigger than seen so far. However, this is not a situation that we have faced before. The “Lehman” crisis had long lasting implications because it destroyed balance sheets and led to a severe regulatory backlash. While there will be some long-term effects from the virus, it will more or less leave the global economy’s operating model in-tact. That was not the case after 2008.
What is needed for a turning point
As investors we need to consider the prospect of a turning point in sentiment and market reaction at some point. The macro-economic impact of the shock will last for a long time even though the big hit will come in Q1 and Q2. We are possibly talking about a significant and historical contraction in global GDP. Companies will struggle for a prolonged period and consumer behaviour might take many months to return to normal. Cash-flow and revenue expectations will compromised for months and some companies won’t survive that. However, I would argue that by the end of Q2 there is a scenario of market recovery and better investor sentiment. Key to this are two broad requirements even if the economic data continues to be very bad and second round effects work against a rapid economic recovery. The first is for the data on the spread of the virus to show signs of the infection rate slowing down. It will, and the China case shows how. New cases in China have approached zero in the last week or so. Of course, western Europe and the US are yet to see a peak but, depending on measures being put in place (containment or delay) the peak will be seen in the next few weeks.
The second requirement for a turning point is the need for investors to put more weight on the accumulated global policy response than they are putting on the negative economic impact that is happening right now. There is no question about it, the policy response is potentially reflationary and could provoke a stronger recovery when it comes. We’ve had major monetary policy initiatives from the Federal Reserve, the European Central Bank, the Bank of England, Reserve Bank of Australia, Bank of Canada, the People’s Bank of China, Sweden’s Riksbank, the Norges Bank and so on. Rates have been slashed were they can be and central banks are making available huge amounts of liquidity to help corporates and the proper working of the financial system. The sum is massive but markets are still thinking that it could be more effective and communicated better (M. Lagarde). Given the likely continued deterioration in credit markets in the weeks ahead, more asset purchases are likely to be announced. If original QE was put in place to save the system from the worst impact of its own doing, then surely the system needs to be saved form the worst impact of an entirely external shock. Things like evoking the ESM in Europe to prop up Italy could be seen.
Even in Europe the resistance to a comprehensive use of both extraordinary fiscal and monetary policies is crumbling. Germany announced today that it would provide any amount of cash to deal with the health crisis even if that means taking on more debt. The EU is going to allow deficits to widen irrespective of its fiscal rules. The UK government announced a £30bn fiscal stimulus. There is going to be more. We might even get to a place where central banks are effectively monetising debt and allowing governments to borrow more without a destabilising rise in borrowing costs. Lower rates, cheap and aggressively available credit and liquidity and fiscal stimulus will create the conditions for an economic recovery in due course.
As I write, global stock markets are up 5% on the day and bond yields are up 10 basis points. I don’t know whether those moves persist but if I take a 3-month view I would venture that core government bond yields will be higher, with a modest steepening of the curve from today’s levels. I would also expect to see equites building a strong base for recovery – not necessarily another bull market but certainly prices somewhere between the recent lows and the early February highs. Credit spreads would be a lot narrower as well, although the credit world is likely to face a rise in defaults for some time. Spikes in defaults always come after the peak in spreads and there is likely to be rising dispersion in the way credit trades. But at the market level, credit should outperform government bonds in a recovery period. It’s difficult to contemplate adjusting portfolios right now to be positioned for the recovery but it is probably the right thing to do over any sensible time horizon.
Bonds done mostly
Regular readers will know that I am a structural bond bull. But that is temporarily part suspended. As yield curves have flattened so much and as very long-term yields have converged on the level of official policy rates, the ability of government bond yields to fall further is reduced in my view. This also means that the utility of bonds to hedge any further erosion of value in credit and equity markets is significantly diminished. The 30-year German government bond is currently trading at -24bps compared to the ECB deposit rate at -0.5%. In the US, the 30-year yields has fallen below the level of the Fed Funds, but only at the peak of monetary tightening cycles when the policy rate has been much higher. The policy rate should act as a floor to very long-term bond yields. We are there in Europe and we are getting there in the US, but of course the Fed is likely to bring the policy rate down another 100bps. So the US is still in the game as far as lower bond yields goes and long-term yields could fall another 1% in extremis. For this to happen the Fed needs to move and then the bond hedge can work again – especially given that the Fed has also announced a massive increase in 3-month repo operations that will allow it to temporarily buy securities across the yield curve.
The last month has proved that investors should have diversified portfolios. The over 10-year sectors of the US, UK and European government bond markets have delivered returns since mid-February that will have alleviated some of the losses that have been generated by equity markets (by around 50% in the case of the US equity market). It’s just that the option value has diminished significantly since. It needs to reset. That means yields need to go higher. I think this is what will happen but not in a straight line and by a magnitude that will clearly be limited by central bank intervention and the lasting risk aversion that will inflict investors. Similarly, the recovery in equities and credit may be challenged by set-backs. We could see worse levels before the recovery sets in. But on a three to six month view there are grounds to be bullish. After all, 3-months ago, most of us had never heard of a coronavirus nor had been tempted to stockpile toilet rolls.
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