It will be a long road to economic recovery

After the extreme shock to markets in March, asset prices reversed course in April, as investors hoped that unprecedented stimulus packages and medical research would ensure a reasonable return to normal. 

Central bank and government responses have been relatively swift and extensive compared with past crises such as the Global Financial Crisis. This has so far helped prevent an even greater economic decline, through interest rate cuts, bond buying, lending programmes and providing liquidity. 

We are now, arguably, entering a new phase in which markets will come to terms with the fact that the macroeconomic environment will be challenged for some time. It will take years, not quarters, to return to Q4 2019 levels of GDP. The US unemployment rate is also unlikely to reach 3.5% again for years. It seems more likely that the real economy will see something shallower than a V-shaped recovery.

As we enter this new reality, it becomes clear that the low interest rate environment that has prevailed in recent years is probably here to stay for a while. Central banks will likely err on the side of being conservative and accommodative for some time. For instance, the federal funds futures market, which represents market participants’ expectations, is pricing the federal funds rate at 0–25 basis points well into 2023¹. We can expect to see the balance sheets of the European Central Bank (ECB), Bank of Japan (BoJ) and US Federal Reserve (Fed) reaching a combined US$20–25 trillion². There will likely also be many more announcements of fiscal stimulus programmes and extensions of expiring programmes. 

The temporary shut-down of the global economy is a unique event and it will take time to recover.

 

The pivotal role central banks play in supporting markets 

The Fed’s announcements alone, rather than its actions per se, did much to support the markets. Corporate bond spreads narrowed significantly when the Fed announced it would expand its reach to the sector, despite the announcement coming well before any investments were actually made. Indeed, the Fed did not actually buy any corporate bonds until the week commencing 11 May, when it purchased corporate bond ETFs. It has yet to buy underlying securities in the secondary market, but its commitment alone helped calm the markets.

While the Fed’s expansion of potential purchases to include investment-grade corporate bonds and some fallen angels³ has provided much needed liquidity and helped stabilise markets, there will still be a significant number of downgrades. Indeed, BBB-rated bonds now account for approximately half of the investment grade market, whereas it was closer to 25%–30% 20 years ago⁴. 

While the central banks can support markets, they cannot prevent companies from becoming insolvent and their actions will not prevent default rates from rising. Some companies will undoubtedly go out of business, especially in the high-yield energy sector which was already under pressure prior to COVID-19. Our job as portfolio managers is to manage that risk and understand which companies have a better chance of survival. This is a time when deep fundamental research and an active approach are essential.

 

Improved liquidity, and record levels of new issuance

In March, illiquidity affected even US Treasuries, arguably the most liquid of bond markets. The Fed stepped in relatively quickly and helped restore the proper functioning of markets. While liquidity has since improved, we are not yet at pre-COVID-19 levels. US Treasury and currency markets are now functioning more or less normally, but liquidity hasn’t yet fully recovered in credit markets. Lower-rated issues have approximately half the liquidity that we saw pre-COVID-19, while the highest liquidity is in the new issue (primary) market.

March and April saw record corporate bond issuance in the US and Europe as issuers acted to shore up their balance sheets. This probably contributed to credit spreads levelling off after an initial period of spread tightening (when equity markets continued to rebound) because credit markets had to absorb a large volume of new supply. 

1. As at 30 April 2020. Projection based on pricing in the futures markets. Source: Bloomberg, Federal Reserve

2. As at 31 March 2020. Sources: Capital Group, Refinitiv Datastream

3. Bonds that have been downgraded from investment-grade to high yield.

4. As at 31 March 2020. Source: Bloomberg

FOR PROFESSIONAL / QUALIFIED INVESTORS ONLY

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• This material is not intended to provide investment advice or be considered a personal recommendation.
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