Once the fire is doused comes damage assessment

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A fire hose at full blast will eventually extinguish the fire. Then comes the task of assessing the damage and evaluating how long the restoration will take.

In terms of central bank support and fiscal spending promises, this has been some week. Central banks in India and Canada cut their borrowing rates further on Friday. Such support works up to a point, helping to support a big three-day bounce in global equities that retreated on Friday.

But volatility remained elevated, suggesting this week’s big rebound falls into the category of a “bear market bounce”. Until implied volatility for the S&P 500, as measured by Vix, sustains a drop below 50 (it was at 65 on Friday), keep your tin hat handy.

Still, some think the “whatever it takes” measures from the Federal Reserve and the US Congress signal that the worst is behind us. Indeed, the Fed’s balance sheet has surged by a fifth — beyond $5tn — in the past two weeks. And, as the Bank of America plots in this chart, its analysts expect a doubling in the size of the central bank’s balance sheet in 2020.

Ian Lyngen at BMO Capital Markets says:

“The unprecedented amount of liquidity provided by global central banks has largely restored ‘normal’ functionality to financial markets in very short order — and impressively without the closure of the equity markets.”

Over in Europe, the European Central Bank has also upped its game, although bickering among EU leaders over the terms of a joint response had hardly been received well by the region’s share markets on Friday. The continent-wide Stoxx 600 closed down more than 3 per cent.

Looking at the damage inflicted across markets over the past month or so, and underlined by the vast outflows from bond funds of late, fixed income has borne the brunt of the pain. The latest update from Lipper shows a second straight weekly outflow record of $62bn after $55.9bn the preceding week. 

Credit markets tell a conflicted tale at the moment, which reflects deep reservations over the coming wave of bankruptcies and restructurings, alongside a new era of open-ended quantitative easing from the Federal Reserve, or QE infinity.

Money continues fleeing US bond funds and ratings downgrades are surging, but all the while high-quality companies are selling plenty of debt (record investment-grade sales beyond $100bn this week alone). Thanks to the big drop in Treasury yields (that offsets wider credit risk premiums), blue-chip companies can sell debt at interest rates near levels seen a year ago.

The big driver is the Fed’s new policy of backstopping investment-grade credit, with the central bank clearly wanting to make sure companies can refinance and raise cash. 

Fred Cleary at Pegasus Capital says:

“The entire credit system globally is on life support, the majority of that support is being delivered in unlimited US dollar liquidity.”

He adds:

“The longer the immediate health crisis lasts, there will be a ratcheting effect on the amount of time needed (12 months or longer) to repair balance sheets in the aftermath as payment holidays on loans, leases and mortgages are either recovered or ultimately foreclosed.”

With the Fed now a buyer of corporate debt, and its balance sheet seen doubling in size this year towards $9tn at least, there is a window for top-quality companies to sell debt. But, as Marc Ostwald at ADM Investor Services, notes:

“This owes as much or more to issuers needing to refinance and top up cash reserves along with the Fed pump priming, rather than demand.”

But not all companies can refinance and the wave of rating downgrades is gathering momentum. The longer-term consequences of Covid-19 is one of winners and losers in credit and equities.

As shown here by Bank of America, the pace of credit-rating downgrades is running at a record clip since 2002.

Here’s Moody’s with its latest take on corporate default rates:

“In a scenario where the downturn was very sharp but shortlived, the global speculative-grade default rate would climb to 6.8 per cent in a year. Under recessionary conditions mirroring those of the global financial crisis, the default rate would climb to 16.1 per cent in a year, and in an extremely severe recession, worse than 2008, the rate would jump to 20.8 per cent in a year.”

Trailing 12-month speculative-grade default rate forecasts under three different scenarios

At this juncture, it all hangs in the balance. In the coming weeks, as the pace of infections starts abating, market sentiment will remain a hostage to the longer-term hit to companies and what that entails for corporate earnings and debt servicing.

Chris Iggo at Axa Investment Managers says the sharp rise in subinvestment yields in the US (now above 10 per cent) and in Europe (above 8 per cent) reflects investors’ need for . . .

“ . . . that kind of yield for taking the significantly increased risk of default” and he adds: “Buying at these levels has historically been rewarding, subject to the marked-to-market volatility.”

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Quick Hits — What’s on the markets radar

One important market development this week has been a weaker US dollar. It appears the Fed’s fire hose is working. Brown Brothers Harriman highlights “cross currency basis swaps (a proxy for demand for dollar funding by foreign entities) has normalised for euro and sterling and continues to improve for yen”.

But, as these charts reveal, with FRA-OIS spreads having steadied, they remain at wide levels, and need to narrow a lot further. 

Aggressive central bank support and fiscal measures helped spur a rebalancing across portfolios between risk assets such as equities and credit versus the ballast of government bonds, as the end of the month and the first quarter approached. This entails buying equities and credit against trimming holdings of sovereign paper, and such rebalancing flows should fade by next Tuesday. 

That makes assessing this week’s rebound in risk appetite a little cloudy. A better sense of market sentiment should dawn once April arrives next week.

Your feedback

I’d love to hear from you. You can email me on [email protected] and follow me on Twitter at @michaellachlan.



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