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PEPP(a) PIGS

ECB announcements give Portugal, Italy, Greece and Spain something to smile about during a challenging week.

Risk sentiment has bounced during the past week, on hopes that global policymakers are now doing enough to position themselves ‘ahead of the curve’ as they battle to deal with the economic fallout from the Covid-19 pandemic.

Data expectations

A record 3.3 million weekly US jobless claims (which represents an eye-watering 217 standard deviation event) and plunging PMI surveys appear to offer only a foretaste of the economic downturn resulting from lockdown measures, aimed at slowing the spread of the virus.

Over the coming weeks, we are looking for data in a number of countries to show annualised rates of GDP contraction of close to 20% – effectively lowering growth over 2020 as a whole by as much as 5%.

However, it appears that fiscal and monetary authorities are now figuratively throwing the kitchen sink at the problem with respect to aggressive fiscal and monetary easing.

In this context, were life to be able to return to normal after the next three months, it is conceivable that the impact of stimulus could coincide with pent-up demand leading to a healthy rebound in the second half of the year. 

However, this will only be possible if it proves achievable to bring the coronavirus under control – either resulting from the rapid development of effective treatments for the sickest patients, the development of an effective vaccine, or from containment measures causing the spread of Covid-19 to be arrested.

Controlling the curve

Notwithstanding this uncertainty with respect to corona and the length of time which it will prove necessary to maintain lockdowns and social containment measures for, what is clear is that monetary authorities seem to understand that they would be ill advised to allow financial conditions to tighten against this economic backdrop.

Keeping rates low along the curve has strong echoes of yield curve control, as practised by the Bank of Japan for a number of years. Although neither the Federal Reserve (Fed) nor European Central Bank (ECB) have yet been explicit in this regard, it is well understood that central banks need to be able to effectively monetise the additional debt issuance resulting from the current economic shutdown. 

For example, where governments underwrite basic income, this can be thought of in the context of fiscal ‘helicopter money’. Although this approach may ultimately lead to longer-term inflation risks, it seems understood that for the time being, the job of central banks is to provide liquidity and underwrite stability in financial markets by keeping rates low. 

Complexities of flexibilities

At a time when investors have sought to de-risk portfolios, the new powers for the Fed to purchase corporate bonds in common with the ECB means that central banks can be a buyer of last resort, with the public sector intrinsically standing ready to shoulder the potential losses that could occur across the economy.

By contrast, many emerging markets are dependent on external capital and do not have such policy flexibility.

Without sufficient domestic savings or robust balance sheets, it is interesting to observe some countries engaging with the IMF on the topic of a temporary debt moratorium.

In part, this is understandable, given that the economic and social costs from Covid-19 may be every bit as large in these developing countries as we’re already seeing in more developed markets.

However, if such an approach is applied too broadly, then this creates a real risk that overseas investors will look to disengage with these markets.

At a time when investment grade and high yield corporate bond spreads have widened materially, this may reduce the impetus for US or European investors to chase returns in far-flung jurisdictions when there is plenty of opportunity closer to home.

Yet we believe it would be wrong to tar all countries with the same brush. There are likely to be success stories as well as disasters in emerging markets, though it seems to us as if those with deeper domestic savings and lower debt on sovereign balance sheets will be in a much better place to weather this particular storm.

Observing price action

It is not too surprising that those assets which most directly benefit from policy intervention have been among the best performers in the past week.

In the EU periphery, the commencement of the ECB PEPP programme has seen Greece spreads normalise below 200bp – less than half of their level during the height of the sell-off in the middle of March.

In investment grade corporate credit, CDS indices such as iTraxx Main have also recouped 50% of the widening they had seen in the past several weeks.

Yet it has been notable that cash corporate bonds have lagged this move quite materially – in part with a steady flow of new issuance coming to the market, being priced at a material concession to existing deals.

However, with new issues greatly over-subscribed, we look for corporate bonds in the secondary market to play catch up in the days ahead as investors seek to participate in the recent bounce in assets, which they know that the ECB and the Fed will now be buying.

We sense that liquidity on the offered side is just as bad as the bid side, with screen prices gapping in both directions in very limited trading volumes.

Government bond yields have moved lower in the past week, as fears with respect to a tsunami of debt issuance have been met by equally strong commitments from central banks to buy bonds and stabilise markets.

Meanwhile, actions to alleviate stress associated with the lack of dollar liquidity in the system have seen pressures in money markets ease, mitigating a scramble for dollars, which had also been responsible for driving the USD upward in FX markets in recent weeks.

This has seen the euro and yen rates versus the dollar move back towards their prior ranges, yet commodity currencies have remained under some pressure, notwithstanding a bounce from their lows.

Looking ahead

We would note that we may have seen something of a turning point in (some) markets during the past week, in line with some of the comments we have made our last few commentaries.

Where asset prices are targeted by policymakers, such as the euro periphery, we believe that we have already seen the wides for this particular move.

However, this is much more questionable with respect to those assets further removed from policy support. In this respect, price performance may depend heavily on how quickly (or not) the virus is brought under control in specific countries. Over the next few weeks we may see conflicting evidence in that regard.

Financial market volatility is likely to remain elevated during this period. We are somewhat worried that complacency may still exist in the US – as demonstrated by mixed messages coming from the White House.

We also wonder whether policies locking down the economy and imposing self-isolation will prove enduring in some nations not accustomed to freedom being curtailed in such a manner.

Furthermore, with restrictions being lifted in cities like Wuhan, it will also be interesting to observe how quickly demand bounces back and whether there is a renewed pick-up in rates of infection.

We believe uncertainty will be considerable over the next few weeks. In this regard, it seems unrealistic to expect markets to simply rally in a straight line and recoup all of their losses, given the extreme nature of the changes in the environment now around us.

Nevertheless, adding risk for now in those assets that can benefit from the policy response seems to be warranted, as unlike in 2008, central banks provide a much more robust backstop in the form of QE.

Agreement on corona bonds and a European stability mechanism (ESM) backstop for all of the Eurozone may be yet to reach consensus – yet this step towards debt mutualisation, which could transform the Eurozone by taking monetary union to the next level, suddenly doesn’t seem that far away.

Meanwhile, with Portugal, Italy, Greece and Spain all rallying in the wake of the ECB last announcements, it seems that the PEPP(a) PIGS at least have something to smile about during these difficult times.