A complex journey out of lockdown lies ahead

Mark Dowding 80 x 80.jpg
Mark Dowding
May 01, 2020

As the likelihood of a V-shaped recovery fades, social distancing measures complicate a world which has turned on its head as hand gel outprices oil.

Financial market volatility has continued to moderate over the past week, with hopes for an end to economic lockdown growing, as global Covid-19 death and infection rates continue to ease. For the time being, little attention seems to be given to economic data releases, even as many indicators plunge to historically weak levels.

In normal times, a 4.8% annualised contraction in US Q1 GDP would dominate headlines. However, given the prevailing backdrop, this decline appears to offer only a foretaste of a much larger contraction in Q2.

In this context, what seems to be much more open to debate is how quickly economies can stabilise and (hopefully) rebound in the second half of 2020 and thereafter in 2021. This question appears to be contingent on how rapidly lockdown measures are lifted and whether this, in turn, leads to a second spike in infections, requiring renewed restrictions, which will further limit economic activity.

Emerging from lockdown

The path out of lockdown consequently appears to be an uncertain one and a journey without historical precedent. Yet it already seems clear that restrictions are likely to be eased – if only on a gradual basis – and it would appear probable that economic activity in some areas may continue to be impaired until such a point that a vaccine is developed and widely deployed. As a result, it would seem to us that hopes for a ‘V’ shaped recovery in growth are likely to be dashed.

As we think through our own plans to implement a ‘back-to-office’ strategy, we see many hurdles and issues that represent a material challenge – assuming an obligation to ensure a two-metre rule under social distancing protocols.

For example, a requirement to ensure a duty of care will mean that desks need to be separated by four square metres and are located two metres away from communal areas, such as walkways. This is even before figuring out how elevators, toilets and other shared facilities can be organised in such a way, in order to satisfy statutory requirements and mitigate contingent risks of litigation, in a worst-case scenario.

In thinking this through, it seems inevitable that, in practice, large numbers of employees will likely need to continue to work from home for an extended period even as the lockdown eases, regardless of how eager many are to get back to the office. In many respects, the more one looks at this, the more you can foresee issues which resemble something of a Gordian knot – especially if one were an institution in the middle of a skyscraper in the centre of Manhattan, for example.

Anyway, if these are some of the practical challenges that may be faced by a firm in financial services, it can only be assumed that ongoing disruption may be more acute in many other sectors of the economy, where remote working and social distancing are even more challenging to adhere to.

A rocky path ahead

Meanwhile, it strikes us that supply chains are likely to be disrupted and demand impaired for months to come.

Additionally, in many countries, governments may have been responsible for spreading a message of fear within society, in order to promote adherence to the lockdown. It seems plausible to think that this sentiment may linger for months to come, even as official messaging starts to change.

Certainly, the strict adherence of lockdown has been a relative surprise to many policymakers and it is concerning to see surveys suggesting that many individuals are keen for lockdown to persist in the (unlikely) hope that the virus can be totally eradicated.

Against this backdrop, it feels that markets have been front-running the end of lockdown over the past several weeks, yet the path ahead is likely to be a lengthy and challenging one, from our perspective.

Another ECB miss-step

In Europe, we were rather disappointed at the outcome of the ECB meeting this week. Despite messaging that the volume and composition of asset purchases will be adjusted as necessary, Christine Lagarde (again) failed to take the opportunity to correct the gaffe she made at the last meeting, in which she told markets that it was not the job of the central bank to manage sovereign spreads.

We have thought that it is the job of the central bank to underpin financial stability and that it would be incumbent on the central bank to promote accommodative financial conditions across the countries that comprise the Eurozone (not just in the core) in these challenging times.

By failing to do more now, one could be forgiven to think that the ECB remains relatively relaxed with spreads at prevailing levels, notwithstanding the widening seen over the course of the past month as the magnitude of the economic crisis continues to hit home. In addition, there is a prevailing sense that the European response is underwhelming relative to measures taken by the US central bank.

To date, the Federal Reserve has increased the size of its balance sheet by 58% since the start of the year, whereas the ECB measures have thus far only delivered a modest 10% expansion.

There seems a growing risk that a lack of leadership and a desire for consensual decision making is delivering an outcome that achieves too little too late in Europe, leading many to lament that Mario Draghi is no longer at the helm.

Divide of the ‘haves’ & ‘have nots’

As we begin May, we would caution that the further recovery of asset prices are unlikely to proceed in a straight line. We continue to believe that those assets which benefit most directly from central bank purchases are those which are most likely to outperform over the medium term.

Conversely, we have a much more cautious outlook on those markets and sectors where balance sheets are stretched. For example, we would observe that most defaults and restructurings will come from those issuers who entered the current crisis with ‘B’ or ‘CCC’ credit ratings. In our view, defaults will typically occur when it is no longer possible to roll-over maturing liabilities and with credit metrics deteriorating for many such issuers, it is clear that not all will be in a position to weather this storm.

Arguably, central bank purchases of investment-grade bonds and fallen angels within high yield will largely benefit borrowers who already have reliable market access, yet issuers who are the most cash-starved are least likely to benefit.

Meanwhile, we suspect those companies that may be owned by private equity firms, or others who have chosen to domicile in tax havens, may also be disqualified from receiving support and this suggests that there is likely to be some decompression with respect to credit spreads as the market bifurcates between the ‘haves’ and the ‘have nots’.

Trading markets where hand gel outprices oil

If this is true in corporate credit, we see a similar pattern holding true with respect to sovereign issuers. High-quality issuers will have the balance sheet flexibility to increase their borrowing, albeit at elevated spreads, and we are eager to participate in new issues in this space, where deals are priced at an attractive premium to paper in the secondary market. Qatar and Israel have been two such recent examples of this.

Meanwhile, we are much more cautious with respect to weaker borrowers, where we see material signs of credit deterioration; here opportunities may lie on the short side via CDS.

Similarly, we believe that there is scope for a number of EM currencies to continue to underperform should policymakers seek to cut rates to support domestic economic activity, allowing some tacit devaluation to ease domestic pain. Also, with a barrel of oil worth less these days than a bottle of hand sanitiser, we retain a cautious view with respect to energy-related assets and FX.

Looking ahead

It is easy to see how trade tensions may resurface, as the recriminations around Covid-19 accelerate, just as the death toll starts to slow. In this context, we can continue to see many challenges in the economic landscape.

Having started April looking for assets to rebound, we believe that selling strength and reducing risk may now be appropriate, on the view that there may be opportunities to add exposure at more attractive levels, should markets suffer a renewed bout of volatility.

It strikes us that the journey out of lockdown is set to be a complicated one and as much as central banks have added liquidity and this is helping to inflate asset prices, it will be difficult for markets to overlook fundamentals for too long.

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