BlueBay AM: Recovery will be a gradual process

April 17, 2020

Further moves by the Federal Reserve to support credit markets, announced just before Easter, have helped to support the recovery in risk assets over the past week. At an index level, US cash corporate investment-grade spreads are currently around 235bp, having retraced approximately half of the sell-off between the start of the year and the wide print on 23 March.

Plans to expand asset purchases to include ‘fallen angels’, which have been downgraded since the onset of the Covid-19 crisis, have also supported sentiment in high yield bonds, though the failure of oil prices to rally materially from their lows following the recent OPEC production cuts remains an ongoing concern in the energy sector.

We would, however, note that forward oil prices are materially above current spot levels, which have been driven lower as storage capacity is rapidly depleted.

G3 government bond yields have been largely rangebound during the past week, with investors broadly immune to economic data releases, which continue to highlight the magnitude of the economic hit coming from the virus.

As we move towards lockdowns being eased, we believe that GDP will have been adversely impacted at an approximate 35% run rate for around six weeks from mid-March to the end of April, before lessening to a 25% impact during May and a 15% impact in June.

Cumulatively, this will represent a total subtraction of around 6.5% from GDP over this period. Thereafter, we believe that growth in the third quarter is also likely to be subdued before a somewhat stronger end to the year.

In this way, we see US GDP over the calendar year at approximately -4.5%, with growth in the Eurozone and UK around -6.5% and the worst affected economies, including Italy and Spain, lower by -8%. 

The role of central banks

Given this challenging growth backdrop, we believe that central banks will want to support growth as much as possible by keeping financial conditions as easy as they can.

In this context, we believe that we will witness de facto yield curve control at a time of heavy public bond issuance, in order to anchor the yield curve close to current levels.

There may be relatively few clear investment opportunities in G3 rates for a number of months. However, as the economic backdrop does start to improve, we believe that central banks may eventually be in a position to loosen their grip on rates – particularly if inflationary pressure is starting to build to the upside.

However, such speculation can wait until later in the year. For the time being, we continue to live with a very high degree of uncertainty, in which there remain many unknowns with respect to the trajectory of the virus and the likely success at exiting lockdown.

Coping with the unknown

At the moment, it is still unknown whether – and for how long – those infected with Covid-19 have immunity. We also remain very uncertain as to how many individuals have had the disease given the low percentage of the population being tested in many countries. We are also in the dark with respect to the success of antibody tests and vaccines, making timelines hard to predict.

What we can conclude is that the period of lockdown has been very well observed in most countries, with individual behaviour actually surpassing what most models had assumed. In the UK, compliance rates appear above 90%, versus a model projection of closer to 70%. This is leading some to question whether a message of fear has been taken to heart so strongly that it will even be difficult to persuade many to return to work and more normal life as restrictions are eased.

In the interim, it is also clear that business failure rates are set to accelerate and lasting economic damage is now being done.

It is to be hoped that pent-up demand may lift the economy out of recession in the months ahead, yet despite the best intentions of policymakers, it seems inevitable that default rates will rise, unemployment rates will climb and it will take some time before output returns to the level seen at the start of the year.

Corporate impacts

It strikes us that corporate earnings are likely to shoulder much of the impact of the economic slowdown, in that profits are geared to overall economic growth.

As such, earnings multiples in stock markets are set to shoot higher, making further equity market gains increasingly challenging to sustain, in our view, once it becomes clear that the shadow of the Covid-19 crisis is likely to be felt over the course of the next two years.

Consequently, whereas we see further upside for those assets benefitting from direct policy support in the form of central bank purchases, we believe that the rebound for many other assets, in the wake of the sugar-rush associated with policy easing in the past several weeks, may now have run its course.

This is true of equity markets, while in credit markets we expect to see further credit decompression with lower-quality names underperforming the higher-quality segment of the market on a beta-adjusted basis.

Subordinated financials remain an exception to this rule, in our opinion, since we believe that bank balance sheets are very well capitalised and prudently managed. With respect to sovereigns, we continue to rely on support from policymakers within the Eurozone, though fear the backdrop in many emerging markets is likely to be more challenging, given a relative lack of balance-sheet flexibility in many such countries.

European paranoia

In the Eurozone, we still await further evidence of solidarity within the bloc.

It is striking that the Federal Reserve has been much more decisive and successful in its market intervention than the ECB. It seems that operational staff at the ECB are paranoid about distorting the market and are conservative in their bond-buying approach – which is ironic, as this policy is directly aimed at providing market direction and so they should not fear being able to demonstrate leadership.

For example, if the ECB were more robust in its actions, this could quickly dissuade those who actively seek to short bonds in the periphery, on a hope that EU break-up risks will re-emerge at a time of policy indecision.

A clear message of solidarity is needed with firm action to back-up this intent and we believe that this will eventually come, albeit we hope that we won’t need to see an intensification in stress for such an agreement to be reached.

After all, countries like Italy and Spain can ill afford for the situation facing their economies to be made even worse as a function of poor fiscal and monetary policy leadership at a Eurozone level.

Focussing on the UK, it has been interesting to see comments that the UK won’t apply for a Brexit extension in June. However, we are still inclined to expect that a deal will be struck such that there is an extension – albeit under a different name (such as a technical ratification period). Such an agreement is needed by 4 June, but with attention much more on Covid-19 and Prime Minister Johnson only just recovering from a life-threatening illness, it is hard to see this receiving too much attention for the time being.

Elsewhere, FX markets were rangebound over the past week and volatility indicators have been moving lower. However, it appears to us that the recovery in risk appetite remains fragile and in certain quarters there remains some inertia in letting go of a world view, based on an understanding that may have applied a few months ago but which is now very much out of date.

Looking ahead

We will be focussing on how the end of lockdown is seen to work in countries which have already eased restrictions, in order to see whether first steps lead to further easing measures, or signs that restrictions need to be re-imposed as rates of infection rise – as has been the example in Singapore.

Without wanting to sound callous at a time of widespread tragedy, we are also looking at how public opinion may become somewhat de-sensitised and accustomed to somewhat higher death rates than we have witnessed in the past, at a time when concerns with respect to the economic toll continue to mount. Indeed, daily death totals already seem to be attracting less attention, now that these figures seem to be on a downward or flat trajectory and are not spiralling higher.

This may be significant, as it seems that we will need to learn to cope with the presence of Covid-19 as it seems unrealistic that a vaccine will be widely available and deployed for at least another 12 months.

Uncertainty continues to reign

The truth is that we are living in unprecedented times and, from an economic and an investment point of view, are sailing in unchartered waters. In economic terms, policy delivery appears to have been about as rapid and responsive as one might have hoped.

However, it would be wrong to forget that real economic damage is being done and the scars of this crisis will last for quarters to come – and quite likely many years in some sectors such as air travel or hospitality.

National security protocols are likely to see production brought home, leading FDI flows to dry up and to an acceleration in trends towards reversing globalisation, which were already underway before this crisis hit.

Moreover, uncertainty will continue to drive volatility and with investors in financial markets only too prone to herd-following behaviour, it will be very important to know when it is time to go against the flow.

It is tempting to believe that in a few days from now the Prime Minister will be telling us that now that he is back on his feet, it is time to get the economy back on its feet as well. However, as the Prime Minister probably knows only too well, with this virus, the whole process of recovery isn’t necessarily something that can be controlled or rushed.