BlueBay AM: Lockdown to end late April, before we all go to the dogs?

April 3, 2020

Growth estimates vary widely, but it seems sensible to think that output may fall by as much as 30% during the period that such measures are in place.

A rebound may then be expected to occur once restrictions are eased. However, there remains much debate as to how quickly life can return to ‘normal’, given worries that there may be a subsequent acceleration in infection rates.

Consequently, growth forecasts for 2020 as a whole seem to be in the ballpark of -5% year-on-year, but the reality is that we continue to deal with a fast-moving and unpredictable sequence of events.

In our view, if the policy objective is containment / eradication of the coronavirus at a national level until a vaccine is widely available, then the need to maintain social distancing and various restrictions on movement for many months to come may well mean that there could be an extended economic downturn every bit as severe, or worse than, we saw following the Global Financial Crisis in 2008. However, we believe that this is unlikely to be the case.

Lockdown lows

We believe it unlikely that many countries will choose to maintain lockdown policies for such an extended period. In our estimation, these policies may be successful in slowing the spread of the virus in the short term, but any hope of eliminating Covid-19 appears unrealistic given the global nature of the pandemic.

Rather, we believe that the current period is, and should be, used to ramp-up capacity in healthcare and to accelerate research into vaccines and antibody tests and treatments, which may help lower death rates amongst the sickest of those infected.

With lockdowns placing enormous strain on economies and societies, we are inclined to believe that these will have been terminated by the end of this month, allowing those who have developed immunity, as well as the young and the healthy, to return to work by the beginning of May.

Self-isolation for the vulnerable in society may be extended by several months, but it is possible that as herd immunity starts to increase, a more complete return to ‘normality’ could occur at some point over the summer.

Anticipating stabilisation in April

Based on this view, we believe that the point of maximum economic stress is likely to be during April, before the outlook starts to steadily improve.

From a financial market perspective, we have written in recent weeks that a credible policy response was the first requirement needed to stabilise financial markets, but that for confidence to improve it would be necessary to project to a time when the impact of Covid-19 had begun to pass.

In this context, although we would not be surprised to see another low in equity prices following bleak newsflow yet to come (especially with the US more broadly still lagging behind Europe in the onset of the pandemic), we are growing more confident that with respect to those assets, which most closely benefit from policy support, we have already seen the worst levels in this cycle.

We would suggest that this is the case with respect to sovereign issues in the Euro periphery, as well as high-quality investment grade (IG) bonds benefitting from central bank purchase programmes.

Within IG credit, we believe there is a compelling reason to adopt a more bullish view based on valuations. In the short term, cash corporate bonds have not rallied very much, lagging behind moves in synthetic CDS indices, as heavy new issuance re-prices existing paper in the secondary market. However, as new issue flow dries up into the reporting season, we are expecting spreads to tighten and have been increasing our exposure across strategies.

We also maintain a constructive view on Euro financials. Moves to suspend bank dividends strengthens the capital position of European banks and, based on our interactions with policymakers, we do not believe that coupon payments on AT1 instruments will be broadly impacted by these moves.

The funding conundrum

One challenge, which is pertinent to the financial sector, is trying to deliver government support to SMEs where it is most needed. We are yet to see examples of UK companies which have successfully raised government-backed borrowing to-date.

Although the policy measures that have been announced to-date have sounded constructive in principal – in practice, getting money to where it is most needed is proving much more difficult. Again, we believe that this speaks to a need to end lockdown policies relatively soon, as the longer these last for the greater the risk of a more profound economic collapse.

Elsewhere in Europe, we have been somewhat disappointed that moves towards corona bonds or common debt issuance have been eschewed by the northern Eurozone countries, including Germany and the Netherlands. It may have been hoped that, at a time of crisis, we would see an increase in solidarity, but this has not been the case, leading citizens in Italy (and elsewhere) to justifiably feel let down by the EU.

If policymakers in Berlin and elsewhere do not wake up to this, we are concerned that this could sow the seeds of renewed Euroscepticism across the continent. For now, we can be glad that we have the ECB purchase programmes, which should be able to contain moves in yields and spreads as long as they are effectively deployed.

Further afield, we would also observe that while countries in developed markets have been able to use their balance sheets to apply aggressive stimulus with respect to monetary and policy stimulus to deliver de-facto yield curve control, in many emerging markets (EM) the room to maneuver is much more limited.

In particular, those countries which already had stretched balance sheets, limited domestic savings and a dependence on overseas capital appear highly vulnerable. In this context, calls for a suspension in debt-servicing payments are potentially unsettling to investors, even if these are applied just to bilateral lenders in the official sector in the first instance.

Consequently, country and issuer selection appear critically important with restructurings set to escalate in the course of the year ahead. Divergent outcomes may make for attractive opportunities on the short side as well as on the long side, but more broadly speaking it seems difficult to be too bullish on EM in general at a time when global growth is challenged, FDI flow is likely to stall, commodity prices are challenged and when countries in developed markets seek to bring home some production to reduce their reliance on others.

Moreover, with valuations in domestic assets becoming much more attractive following a widening of spreads, an increase in ‘home bias’ may be a natural consequence of the events we are presently witnessing.

Oil’s pain point

In FX markets, an alleviation of stress in money markets following the announcement of US Federal Reserve swap lines has helped to reduce FX volatility. However, on a forward-looking basis, it seems hard to project future moves in major FX rates with a great degree of confidence. EM currencies have been under pressure following outflows from the local currency asset class, whereas oil-exporting countries have been heavily impacted by the ongoing spat between Russia and Saudi Arabia, which has seen new lows in the oil price.

With demand having collapsed and supply increasing, storage capacity is quickly being filled such that there is even a risk that the spot price of some forms of oil trades below a USD0.00 price point.

Clearly, this situation is unsustainable and with the US also eager to see some oil-price stabilisation, we are inclined to believe that a deal may be reached in the next week or two, which may well benefit Russia the most and lead to an easing of sanctions on the country. Otherwise, it would be our general assessment that there seems to be more obvious value and alpha opportunity investing in credit, at the current point in time, than is the case in either rates or FX where the opportunity set looks more symmetrical in terms of a prospective return profile.

Looking ahead

It seems that ‘searching for the peak’ in terms of infections, and subsequently death rates, will continue to dominate much attention and analysis over the coming week.

For now, economic data seems to merit scant attention, though from an economic viewpoint there will be a concern that sky-rocketing jobless rates could end up creating hysteresis if skills are lost and workers are away from jobs for too long.

Within many societies, it has been interesting to observe incumbent political leaders seeing a rise in popularity as the crisis has unfolded, yet it is far from clear that the mood may not darken if lockdowns draw on for too long.

Already, there is evidence of the young expressing their frustration at yet more ‘Boomer’-oriented policies, which they will have to foot the bill for. As the novelty of confinement quickly starts to wear off, it won’t be surprising if more groups start looking for someone to blame.

A whole new world awaits

What does seem clear already, is that the world we knew at the start of the year won’t ever quite be the same again. Patterns with respect to global travel may be permanently disrupted.

Conversely, trends towards working from home and relating to the increased use of technology for communication and social interaction are only likely to intensify given how quickly many have been forced to adapt in recent weeks.

We anticipate many countries will want to reduce their reliance on global supply chains with a focus on national economic security and elsewhere, it seems inevitable that an increasing share of GDP will be allocated towards the healthcare sector, such that the events we are currently witnessing never catch us unprepared in the same way again. Some changes may prove to be profound, others may be more subtle, but it is clear that we are living through one of the most defining watersheds in society that we will ever see in our lifetimes.

Perhaps it is too early (and insensitive) to be asking questions such as, ‘who will foot the bill for all of this?’ Yet intrinsically, understanding this can be at the heart of questions related to asset allocation.

Where countries socialise costs through the government balance sheet via fiscal deficits, QE and direct state intervention to support companies, then it is likely that this will infer costs principally on future generations – either via austerity in years to come, or quite probably from a period where savers will see returns lower than rates of inflation as a result of financial repression.

However, where these losses cannot be socialised in this way, it may be that debt issuers are reliant on a combination of charity and restructuring to lessen debt burdens to a manageable level. In this case, it is savers today who may be in line for a share of the losses.

Consequently, favouring those issuers who are most likely to benefit from policy support and avoiding those who are not, is currently at the heart of our thinking. Otherwise we continue to hope and pray all stay as healthy as possible and that it won’t be too long before these dog days are behind us.