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Walking an elephant through the corporate bond market

As the macro backdrop remains broadly unchanged, the influence of politics begins to loom large over markets.

Over the past week, equity markets and core government bonds have generally traded in a sideways fashion, digesting mixed newsflow with respect to economic data, the coronavirus, geopolitics and policy developments. US retail sales rose more strongly than expected in May, reversing a substantial portion of the prior month’s losses.

Nevertheless, GDP estimates for Q2 remain down around 30% and other economic data, such as weekly jobless claims, continue to underline the hit to activity which is being felt, with much of the economy still going through significant adjustment, even as lockdowns ease.

Meanwhile, accelerating rates of infection in California, Texas, Florida and Arizona have shown the ongoing risks, given the uncertain trajectory of Covid-19 in locations that have been trying to remove restrictions without having gained control over the spread of the virus.

That said, encouraging news with respect to therapeutic treatments, such as Dexamethasone, and hopes for a vaccine in the fourth quarter may help to subdue fears that a second wave will see a return to lockdowns in the manner they were imposed during the spring. Such a move seems increasingly unlikely given the increased concern pertaining to the social and economic fallout from such measures.

Broad-based buy-up provides a lift

Sentiment in credit markets was helped this week by a Federal Reserve (Fed) announcement that it would begin purchasing corporate bonds directly on a broad-market basis, in a manner akin to that followed by the ECB. Up to this point, purchases have been limited to ETFs or individual corporate bonds for those issuers which have made a specific application for assistance.

The stigma attached to this has meant that issuers have not wanted to come forward. Consequently, the volume of US corporate bond purchases has been operating at a much lower run-rate than had been inferred at the time that the Fed purchase plan was announced.

As a result, this change in operational modality was well received. However, we would strongly caution against the interpretation that, because this occurred on a day when the S&P had traded below the 3,000 level, this signifies that further policy support should be expected should equities trade below this level once again.

All too frequently we see attempts to fit a particular narrative to a certain pattern in price action. However, such explanations may have little basis in reality, based on comments from policymakers’ assessment of these events.

Core vs Southern Eurozone divide

In Europe, a healthy TLTRO take-up of EUR1.3 trillion was also seen as supportive for risk assets, with this representing a net addition of EUR550 billion of liquidity. We see this as particularly relevant with respect to government bonds in the Eurozone periphery.

Here banks are able to exploit the carry trade that the ECB has facilitated, borrowing money at an interest rate of -1%, in order to purchase securities yielding substantially in excess of this.

Previously, there has also been something of a stigma effect in being seen participating in these ‘free money’ trades. However, it seems that, as LTROs have become a more permanent feature of the financial landscape in Europe, so banks are dropping their prior inhibitions.

Nevertheless, it seems that banks in Southern Europe remain the keenest to participate and arguably an even bigger sum in the TLTRO could have been realised if some of the more conservative banks in the core Eurozone countries had shown the same level of enthusiasm.

Policy boost to mask Brexit woes

In the UK, the Bank of England (BoE) added GBP100bn to its QE purchase programme at its Monetary Policy Committee meeting this week. UK prospects appear to lag other developed-market economies, as the country continues to struggle with its response to the pandemic and as fears relating to a negative Brexit outcome exacerbate difficulties facing many UK businesses at a time of material stress. In this context, there may have been some disappointment that the BoE sounded more sanguine in its outlook than many would see as justified.

We continue to think that the pound may trend weaker and are inclined to believe that UK policymakers would be content with such an outcome, in order to cushion the economy as much as possible.

In search of robust fundamentals

In emerging markets, we continue to see a pattern of divergence between regions and countries. We expect existing proposals relating to the EU Recovery Fund to be largely ratified in July and this should offer policy support to a number of countries in Central and Eastern Europe.

We are also relatively constructive with respect to countries like Mexico (which should benefit from US companies switching away from China), as well as Israel, Malaysia and Peru, where fundamentals also remain in solid shape.

By contrast, we believe that in countries such as Colombia and South Africa there are clear signs of ongoing fiscal and current account deterioration. For South Africa, this could mean debt on a trajectory to hit 100% of GDP in the next few years, meaning that support from the IMF will become necessary, with potentially adverse implications for existing debt holders.

Looking ahead

We think that relatively little has changed and the market backdrop remains highly uncertain. It remains very difficult to predict the risk of a second wave of Covid infections and how this may impact the attempts to normalise economic activity as we move towards the second half of the year.

On the policy front, we retain a constructive stance ahead of discussions on the EU Recovery Fund, but elsewhere feel we may have reached a conclusion regarding the latest set of monetary policy easings from the major central banks. Further movement on fiscal policy remains possible, as highlighted in discussions with respect to a (long-overdue) package related to US infrastructure spending.

A USD1 trillion agreement would be seen in a constructive light. However, any money flowing from such an initiative is unlikely to start flowing for some months and so this may be more pertinent to the strength of economic recovery in 2021, rather than having much impact in the near term.

Moreover, with the Presidential elections looming just a few months away, we believe that politics are likely to come more to the fore in the coming days.

Broadly speaking, we continue to feel that some valuations have become detached from underlying fundamentals following the rally we have witnessed in Q2. This leads us to maintain risk at moderate levels. We are cautious with respect to low-rated credit and those issuers where we see a material risk of credit downgrades.

That said, we believe that IG credit will continue to be the part of the financial market complex that should stand to benefit most directly from central bank bond-buying plans. Although the Fed has articulated that it is keen not to ‘run an elephant through the corporate bond market’ as it conducts its purchases, its presence is nonetheless designed to be felt.

After all, elephants don’t need to be running to squash a few things. With policymakers eager to promote accommodative financial conditions, Trump will certainly be keen to ride that elephant, even if Powell, and for that matter, the GOP are uncomfortable with the thought of it.