As dystopia becomes the new normal, further policy easing will be required

Mark Dowding 80 x 80.jpg
Mark Dowding
April 24, 2020

Investors settle in for a protracted fight against the virus and look to the ECB to increase its support measures in line with the US.

Developments in energy markets and EU politics have provided the focus for market attention over the past week. From a historical point of view, this will be remembered as the week when oil prices traded in negative territory with West Texas crude dropping as low as -USD40 per barrel into the contract expiry.

Oil shocks exceed expectations

We had flagged the risk of a negative oil price in our 3 April commentary as it had become apparent that any measures to curtail supply have been insufficient to correct for the drop in demand that has resulted from the economic lockdown in place across much of the globe.

A shortage of storage always suggested to us that negative oil prices were a risk in the short term, yet the magnitude of the collapse in the front contract still took us by surprise and constituted yet another ‘black swan’ event, of the type that seems to be occurring all too frequently these days.

Going forward, we believe that downward pressure on oil could continue and there may be further downside in the contracts expiring in the next few months, though as supply responds, prices above USD35 are likely during 2021, as long as the global economy is in recovery from the Covid-19 crisis at that point.

Meanwhile, the oil price rout may serve as a reminder that all is certainly not well in the global economy, notwithstanding the recent asset price recovery in financial markets. It also highlights the perils associated with products such as ETFs.

Whilst the oil price can trade negative, ETF prices cannot, hence, were there a renewed drop in oil prices, there is a risk that ETF losses could be left with arranger banks – calling their viability into question.

Movement in oil prices saw US equity prices dip during the middle of the week before recovering to settle close to the point marking the 50% retracement of the year-to-date sell-off. These moves saw other risk assets also trade somewhat softer in the past week with investment grade, high yield and emerging market (EM) credit spreads giving up some of their April gains.

Is ECB action enough?

Sentiment in Europe was overshadowed by weakness in periphery spreads in the run-up to the EU leaders’ summit. After the European Central Bank (ECB) announced the EUR700bn PEPP in March, spreads in the region initially reacted positively.

However, doubts have subsequently grown that this policy action was inadequate – especially in comparison to the much larger intervention coming from the US Federal Reserve (Fed). This has been compounded by a jump in new issuance volumes in the eurozone sovereign market and increasingly the market is concluding that the size of the PEPP is insufficient, as things stand.

We would argue that the ECB should be seeking to deliver de facto yield curve control, such that it is supporting accommodative financial conditions to help the eurozone economy at a time when fiscal policy should be as expansionary as needed.

However, yield curve control needs to be applied to all yield curves in the eurozone – not just German Bunds. If not, it will likely see a tightening of financial conditions in the periphery choke off any hope for economic recovery in those countries like Italy and Spain, which have been worst affected by the crisis.

In this context, it arguably is the job of the ECB to control spreads at this time – and so Christine Lagarde’s comments at the last press conference – that she did not think that this was her job – continue to damn her in the eyes of the market and offer encouragement to those wanting to take short positions in the periphery in the hope that an inadequate ECB response will encourage a break-up of the eurozone.

Consequently, the ECB will, in our view, need to spend many billions more correcting Lagarde’s mistake if it is to change perceptions among the eurosceptics. An announcement this week that the ECB would start accepting collateral from fallen angels, whose ratings drop below investment grade, was another positive incremental step.

However, in order to convince markets of their intent to deliver monetary stability, it may be necessary for the ECB to announce a doubling in the volume of the PEPP when it meets for its regular monetary policy meeting next week.

Recovery views yet to rationalise

In some parts of the eurozone, it may appear that policymakers are still somewhat naïve with respect to the gravity of the economic situation being faced. As it becomes apparent that life won’t be able to return to normal any time soon, with social distancing measures continuing to disrupt our lives for many months to come, it seems that some are too quick to assume that there will be a rapid bounce back with a ‘V’ shaped recovery.

However, as we have suggested over the past few weeks, it appears that GDP in the US and eurozone is unlikely to breach end-2019 output levels until the middle of 2022 at the earliest. It has also been somewhat disheartening to see too many political leaders pandering to domestic considerations, at a time when solidarity and leadership at a regional level is sorely needed.

From a fiscal standpoint, slow progress with respect to an EU Recovery Fund may yet make for an impressive headline number, but the details are likely to be more underwhelming, given this will probably assume 6x of leverage are applied to a much smaller number coming from the EU budget.

This said, policy easing is being delivered incrementally – even if it lacks the speed and scale of what has been announced across the Atlantic.

EU solidity is challenged

In observing the EU over recent years, the mechanics of decision-making can seem slow and cumbersome. At the same time, the EU has tended to manage to take the right steps in the end. Consequently, we are unlikely to have seen the end of the policy support that will eventually be extended and policy options certainly have not been exhausted.

Ultimately, we think that the biggest threat to eurozone stability will come from politics. At a time when economic hardship means that citizens will be looking for scapegoats to blame, the biggest risk is if voters in countries like Italy determine that the EU is culpable. This could encourage Salvini and La Lega to stand on a eurosceptic platform, yet that is more of a risk heading into 2022, rather than in the near term.

Aside from this, our belief that the EU will hold together and ‘do whatever it takes’ suggests that we should look for spreads in the region to tighten in the weeks ahead. Eurosceptics are wrong to worry about debt-to-GDP ratios, in our view (these are considerably high in a country like Japan than Italy), and Italy’s debt is absolutely sustainable as long as borrowing costs are not permitted to spiral higher.

In this context, we believe that sovereign credit ratings should continue to benefit from euro-area support and whilst a downgrade in Italy to low BBB may be likely later in the year, we cannot foresee Italy’s credit rating slipping below investment grade ahead of the next national election.

Therefore, we retain a constructive view on spreads and have been adding exposure in the past week following recent widening, on the belief that the playbook which has worked consistently in the eurozone government bond market over the past 10-years will continue to hold this time around – not least because Covid-19 is a common threat, rather than a development which any particular country should feel any blame for.

By comparison, newsflow in US markets has been relatively muted in the past week. Measures to supply liquidity have seen 3-month Libor rates decline to 1.04% (the lowest level since 17 March), yet unsecured cash rates continue to trade at a substantial premium versus secured cash rates when the effective Fed Funds rate is just 0.05%.

Crude impacts currencies

In FX, oil-related currencies have been under some pressure and with more EM central banks easing monetary policy, it seems that policymakers in a number of emerging markets seem content to allow currencies to adjust lower, if this is the price of delivering policy accommodation.

Otherwise, talks pushing for a widespread debt moratorium across the weaker EM countries appear to have hit some resistance, with many private-sector creditors unwilling to extend a helping hand and official sector creditors irked that they should be taking pain when others are allowed to be free-riders.

In a week when private-sector creditors are rejecting the terms of a proposed Argentine debt restructuring, holding out for a better offer, it seems that charity is in short supply. Ultimately, this may mean that we see an increased number of debt restructurings and defaults. It will be interesting to see whether issuers and official sector creditors end up taking a tougher line on private sector bond holders than has been the case to-date.

Generally speaking, we remain more inclined to take positions on the short side with respect to those issuers where restructuring risks are likely to rise, and where bonds still trade at prices close to par, whilst favouring those which have much stronger credit metrics and where we believe restructuring risks are likely to remain very remote.

Looking ahead

Newsflow around the virus will continue to be a focus of market attention over the next several weeks. As rates of death and infection moderate in Europe and the US, a lot of scrutiny will be attached to how these figures may re-accelerate as lockdown is eased.

In this context, a pick-up of cases in Japan and Singapore have recently been a cause for concern and the example of those countries in Asia which have been ‘ahead of the curve’ elsewhere will need to be monitored closely.

What seems increasingly clear to us is that the path back to normal is looking more like a marathon than a sprint. It is becoming clear that the fight against Covid-19 is likely to be a protracted one and one can recall how at the onset of the First World War, there was initially a belief that it would be ‘all over by Christmas’, only for the grim reality of trench warfare to drag on for years to follow.

This isn’t meant to be an overly bleak or pessimistic prognosis, just an admission that as we learn more, we need to accept and understand that it will be some time before life goes back to the way it was up until earlier in the year.

With widespread deployment of a vaccine possibly 12-months away (at best), hopes to contain a second wave may rest on drug treatments being able to improve the prospects for the sickest patients.

For the time being, notwithstanding doubts related to a Chinese trial, it seems that in this dystopian journey we find ourselves in, we are still pinning some hopes on Remdesivir, a drug from Gilead…blessed be the fruit.

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