Central banks have provided a guiding hand to markets as the crisis has unfolded, but it would be dangerous to assume they will play prop-up forever…
As economies emerge from lockdown, so financial markets have continued with a spring in their step as they reach the end of May.
During the past month, credit indices have posted upbeat returns with spreads rallying. Emerging market assets have outperformed over the past several weeks, having lagged the initial move at the end of March and during April on the back of support measures from the Fed and the ECB.
Notable price action in risk assets has been supported by increasing hope that therapeutics will materially lower forward-looking death rates from Covid-19 and that a vaccine will be available by the end of 2020.
Sentiment has also been buoyed by the notion that growth will rebound once restraints on everyday life are lifted. This has been underlined by the likelihood that fiscal and monetary policies will remain highly accommodative for some time to come.
Equities ride an upward wave
On the back of this optimistic thinking, US credit and equity markets have now retraced 70% of their peak year-to-date losses, which were witnessed in mid-March. However, dialogue with policymakers leads us to fear that financial markets may be taking a rather sanguine view of the world.
In speaking with officials, we feel a sense of concern that their actions won’t be able to prop up the economy indefinitely and that pain, as a result of recession, will be unavoidable. Unemployment certainly won’t fall as quickly as it has risen and this will represent a material drag on aggregate demand for some time to come. Activity in some sectors will take a long time to return to normal and defaults are likely to rise – notably in the ‘old economy’ segment.
For now, the question is more one of how high will default rates rise – and to what extent the provision of liquidity gifts struggling companies the market conditions to be able to refinance and thus defer a peak in corporate restructuring.
No pressure for June
In light of this, we find it is difficult to see how June could deliver a repeat of the returns generated over the past two months. At the same time, however, it remains difficult to see what will be the decisive catalyst to drive a material reversal in sentiment away from a renewed acceleration in infection rates, leading to fears of further lockdown in the second half of the year.
For the time being, it seems that escalating US-China tensions are being dismissed, even though it would seem that the threat of direct sanctions on China are becoming increasingly likely, following developments in Hong Kong.
Away from this, investor sentiment has been buoyed by EU Commission proposals with respect to the recovery fund and by comments from the ECB, which appear to suggest that an increase in the size of PEPP is firmly on the cards for next week’s Governing Council meeting.
Meanwhile, early evidence from countries which have left lockdown in the past several weeks appears to support the idea that there could be a sharp uptick in spending as pent-up demand is released over the next few weeks – even if it is questionable how sustainable this may prove to be, given the overarching macroeconomic backdrop.
New recession format
It is possible that an absence of bad news, in a landscape in which risk positioning remains relatively light, sees the price of risk assets continue to melt upwards.
The past economic cycle was very different to what had been witnessed in previous cycles and so it is possible that this recession may be very different to past recessions. Nevertheless, it is hard to escape the sense that there is a degree of complacency and wishful thinking supporting price action and the assumption that a ‘policymaker put’, ensuring that prices would not fall, could easily be tested.
For example, our sense has been that further stimulus from the Fed would be delivered should markets return to their March lows – but these levels are now a very long way from the prevailing status quo. Valuations in some part of the credit market may remain attractive, with investment-grade spreads still double where they were at the end of December.
Yet, we sense that the Fed and ECB have been more focused on ensuring that issuers have market access and in preventing further widening, rather than operating a mandate where they are assertively trying to push spreads tighter on an ongoing basis.
In light of this, our sense has been that the desire to intervene will increase if markets are notably weak, but may wane should they continue to rally.
Rates largely rangebound
Elsewhere, we continue to look for central banks to anchor yield curves in order to sustain accommodative financial conditions. Long-dated Bund and Treasury yields have risen in the past month but we believe that it is premature for rates to rise in a material way, especially with evidence that inflation continues to fall for the time being.
As written before, we see the G7 central banks adopting quasi ‘yield curve control’, mimicking the policy pursued by the Bank of Japan over the last few years. Although speculation with respect to negative interest rate policy continues to swirl, notably so in the UK, we believe that this is unlikely to be a favoured approach by The Bank of England or the Fed.
Consequently, we see major global rates as largely rangebound for the time being, so too it may seem to be the case for the major FX crosses.
Many of our investment convictions at an issuer and a relative value level have not materially changed in the past few weeks. Certainly, owning risk in good-quality sovereign and corporate credits seems to us much more appealing than extending loans to cruise-ship operators in the current environment.
However, we believe that we should reflect a more cautious overall stance coming into June and that we should continue to express a desire to reduce exposures on ongoing strength, selling into the rally whilst standing ready to buy on dips should we see renewed market weakness.
Arguably, it would seem surprising to us to think that markets could recover all of their February and March losses without a retracement at some point and it is interesting how a change in calendar month can sometimes mark a sea-change in sentiment.
At the same time, we are mindful not to become too pessimistic and in the investment-grade space believe that it is still appropriate to maintain a long-risk bias.
For now, the price action we have witnessed in the past two months in many markets would seem to be more characteristic of what one may expect to see were Covid-19 akin to a hurricane or some other major natural disaster.
Yet the coronavirus seems unlikely to prove a short-lived bad dream in our estimation. We can’t keep from thinking that this has been much bigger than that and the impact will be much longer lasting and likely permanent in certain respects.
Consequently, it would seem odd to see indices quickly back to start-of-the-year levels, acting as if nothing had really happened. At the moment, it may seem that the huge efforts to shield the global economy from the worst of the Covid crisis are propping up financial markets, but it is dangerous to assume that the ECB and the Fed can support markets forever.