Lovers & haters

June 05, 2020

As the world faces enormous challenges, financial markets put ugly recession thoughts aside and enjoy some love.

The melt-up in risk asset prices continued over the past week, fuelled by abundant liquidity. As fears relating to Covid-19 recede, it seems that, such has been the magnitude of intervention by global policymakers, so we are in a world where there is now ‘too much money chasing too few assets’ (to paraphrase the monetarist Milton Friedman).

Central banks purchases are fuelling asset price inflation as market technicals dominate. Yet this rally is coming against a backdrop in which the macroeconomy remains in a pretty dark place. Simple evidence of the extent of the economic malaise is highlighted by more than 21 million continuing US jobless claimants over the past week – a total which is more than three times the peak seen during the last recession in 2009.

There are signs that demand and output are rebounding, as lockdowns are eased. This may lead to some eye-catching month-over-month gains in certain data series in the weeks ahead. However, the reality seems that year-over-year numbers are set to remain depressed, with falling incomes and rising savings rates weighing on consumer demand and investment spending hitting the buffers.

If a second wave of infections can be averted then the economic outlook could continue to brighten, but it still seems likely that it will be months (at best) before activity in certain key sectors can return towards levels seen late last year.

Glossing over the obvious

Consequently, when looking at equity indices such as the S&P, which are essentially unchanged on a year-to-date basis, it is sometimes necessary to remind oneself that we are in the midst of a deep and ugly recession.

Arguably, when the risk-free rate on long-dated bonds is driven towards zero by a central bank determined to anchor rates in the name of yield curve control, it makes it difficult to model the fair value of all other assets. For example, who is to say that an earnings multiple of 20 or 30 times is not attractive when dividend yields still dwarf long-dated bond yields?

Certainly, it is easy to understand how many asset allocators are pushed towards favouring stocks and risky assets, as it is hard to extrapolate any material returns from US Treasuries, with yields close to zero and the Federal Reserve deeply sceptical of taking rates into negative territory.

In speaking with policymakers, there is some growing unease at this risk-seeking behaviour at a time when underlying fundamentals appear deeply challenged. Nevertheless, this seems outweighed by the acknowledgement that the use of asset purchases and the financial repression it encourages, undoubtedly helps to limit economic downside risks by promoting accommodative financial conditions.

A growing divide

On the other hand, these same central bank policies may appear to be designed to make the asset-rich even richer, at a time when those less fortunate have become considerably worse off. In this way, monetary policies appear to be exacerbating income inequality across society.

At a time when the US has lurched straight from lockdown to curfews on the back of civil unrest, it could be possible that the understandable horror and outrage at the killing of George Floyd and persistence of racism in elements of Western society morphs into a wider protest movement against the ruling elite.

There are stark and growing divisions between the ‘haves’ and the ‘have-nots’ and the old and the young, who represent a generation bearing the brunt of the job losses and income shocks who will find themselves saddled with the burden of debt and taxes for many years to come.

Italy takes favour over Greece

In the Eurozone, the ECB’s decision to add an additional EUR600bn to its PEPP asset purchase programme exceeded market expectations. The total PEPP size of EUR1.35tn now accounts for approximately 10% of the region’s GDP and, given the flexibility to target these purchases towards markets where it is needed the most, it means there is more than sufficient fire power to absorb all of the excess issuance, as a result of elevated fiscal deficits coming from countries in the Eurozone periphery in the months ahead.

It would seem that since the German Constitutional Court ruling in contradiction of asset purchases, the ECB has been prepared to double down on its support and belatedly, Madame Lagarde is now more inclined to ‘manage the spread’, in order to ensure that monetary policy is adequately transmitted across the Eurozone. In the wake of this, we retain a constructive view with respect to the periphery.

Valuations may be less attractive than one month ago, but we believe it is realistic to look for spreads to return to levels prior to the onset of the Covid-19 crisis.

On a relative-value basis, we now see somewhat more value in Italian BTPs than Greek government bonds. Valuations have come a long way in Greece and with Greek government bonds now yielding materially less than their Italian counterparts, we have thought that it makes sense to switch between markets – especially as we believe that the macro backdrop will make it more challenging for Greece to return to an investment-grade credit rating in the year ahead, notwithstanding ongoing positive developments on the policy side.

Meanwhile, in the past several days, long-dated Treasury and Bund yields have started to move higher and the US dollar has begun to trade weaker versus most other currencies. This would suggest increased investor participation in reflation trades, yet we are sceptical that these trends can run very far for the time being.

Although the risk-asset rally could eventually encourage central banks to ‘take their foot off the gas’, it seems clear that interest rates won’t rise for at least a couple of years and for the foreseeable future we expect central banks to act as an anchor to the yield curve as they seek to do all they can to resuscitate economic activity.

Consequently, we believe that core bond yields should remain rangebound for some time and don’t see an attractive risk/reward payoff from adopting a material long or short duration position.

Value in the dollar despite the headlines

In FX markets, the US dollar has traded with a healthy bias on relative US economic outperformance over the past couple of years. This may be more difficult to discern right now, but leadership in the technology sector may well continue to favour the US economy and continue to make it a more attractive destination for capital than its peers.

In this way, it would seem premature to write-off the greenback – even if newsflow around the protest, US politics and the country’s handling of the virus do not inspire confidence in the dollar for the time being.

Elsewhere, emerging market assets have also continued to positively perform. In fixed income, all credit asset classes have now recouped around 75% of the losses sustained in March and in the case of some assets, a fading of concerns over supply, which held back performance in April and the first half of May, has helped spreads move tighter.

Indeed, some analysis suggests that the credit market in Euro IG could actually shrink this year, after allowing for ECB purchases, fallen angels exiting the index and growth in lending from banks which are eager to tap generous ECB liquidity facilities.

Looking ahead

It may seem for now that in the absence of a catalyst to push markets lower, the liquidity fuelled melt-up can continue a little longer. The obvious risks would be evidence of a second wave of Covid-19 infections, a larger US-China conflagration or signals from central banks that they are happy to slow asset purchases.

Consequently, where we had been in a mode where we were inclined to sell into strength, it now seems appropriate to maintain a moderately long risk bias – notably in the assets which central banks remain committed to buy in size.

Valuations are much less attractive than early April, but spreads remain materially wider than where they started the year and have not reached a point where they would appear to be rich, in our view – particularly if abundant liquidity and low levels of debt servicing costs keep default rates at historically low levels relative to the difficult fundamental backdrop.

In the battle between the lovers and the haters in financial markets, it seems that for now, love is winning. This won’t always be the case, but at a time of enormous challenges and difficulties around the world, a bit more love wouldn’t seem to go a miss.

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