Market Pulse
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March 23, 2020
Coronavirus Update: The Outlook for Global Credit
 

Market Pulse

Coronavirus Update: The Outlook for Global Credit

Coronavirus Update: The Outlook for Global Credit

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March 23, 2020

 
 

Overview

I will always value the advice I was given at the start of my career─limit defaults and take advantage of price volatility─and look to the valuation of the largest U.S. banks, buy when the spread exceeds +150 and sell below +100 (mean reversion is a feature of fixed income markets with monetary/fiscal policy support a necessary condition).

To put the latest moves in context, the large banks were below +100 in January, 10 days ago we saw spreads in the +210 to +180 range, this week we saw issuance in excess of +300. These are significantly important institutions, they are regulated, they have lots of capital but also take credit risk to the broad economy. We are confident the spread in 12 months will be lower, but short term we are a prisoner of fortune to the next headline and market flow.

Strategy

Markets are offering value but given the uncertainty in the outlook one can’t be confident better opportunities will not occur. We increased our credit exposure by a small amount in the second half of the week taking advantage of the new issue supply discount in high quality issuers, but continue to keep powder dry recognising more issuers will likely take a prudent approach and issue debt at attractive levels.

For the market to consolidate we are looking at 3 key indicators to give confidence to investors

  • A vaccine for the coronavirus
  • A slowdown in new cases (including consideration of re-infection)
  • The market stabilising and finding a clearing level for risk


Market Levels (credit spreads)

  3/20/2020 3/13/2020 2/28/2020 1/31/2020 12/30/2019 12/31/2008
U.S. IG +363 +216 +122 +102 +94 +555
EURO IG +236 +182 +114 +94 +93 +461
GBP IG +273 +199 +139 +122 +127 +565
             
U.S. HY +1013 +727 +500 +390 +330 +1662
EURO HY +876 +657 +410 +329 +285 +1953

 

Macro Backdrop

The economy (and asset prices) have been hit by the containment measures necessary to halt the spread of the coronavirus and the related fall in oil prices following the breakdown of OPEC discussions. Markets are looking for clarity over (1) the length of time isolation policies will remain in force and (2) the time to identify a vaccine. Hopes of a “V” shaped rebound are no longer the base case as questions over the assumption that warm weather will reduce the impact of the virus and health experts warning that a vaccine is months and not weeks away are repricing markets. The reality is a base case no longer exists with the limited credible data.

Governments have responded to the crisis by prioritising health as the primary goal. The need to reduce overcrowding and limited medical facilities have required a policy of isolation across most developed countries at the cost of economic activity. In response to the economic impact central banks have eased  monetary policy with rate cuts and additional QE asset purchase programs. Across most developed markets, rates have been moved to the zero bound. Fiscal policy has been more limited but is expected to increase over the coming weeks. While monetary policy can provide liquidity and low rates, the economic cost is being borne by shareholders and workers to date. The next stage of support will be direct public payments to the private sector (like the UK announcement to pay 80% of wages for workers at risk of redundancy caused by the coronavirus shutdowns) whereby the cost is socialised.

Corporate Impact

Many companies across a range of sectors are being hit by a loss of revenue. Earnings will fall and management teams are withdrawing guidance given the lack of visibility over the outlook. Financial metrics will weaken as leverage increases and refinancing will be less certain as debt costs increase. On a positive note, low interest rates, recent extensions of maturities and Government liquidity facilities will all help. Looking at sectors specifically, questions are being asked on a broad range of topics including (1) how deeply will consumer demand and credit payments be impacted if unemployment increases  (2) how big are the banks non-performing loan portfolios if companies have no earnings (3) what is the value of asset portfolios (4) how sensitive is the business to an oil price below 30 dollars a barrel (5) what supply chain disruptions exist. . .in short, no industry seems immune to risks.

Rating agencies are challenged. Do they look through the crisis or do they respond to the (hopefully short term) weaker economic and financial data. We have started to see early downgrades in several sectors including Energy, Airlines, Gaming and other Leisure sectors, but as yet there is no clear pattern of response across the broad market.

In conclusion, management is justified in withdrawing guidance, investors are correct to demand a higher risk premium for uncertainty.

Technical

Over the past week we have seen significant selling of corporate credit as evidenced by the fund flow data. The reason for selling is a combination of risk reduction, need for liquidity and profit taking, high quality fixed income has outperformed many other assets. Demand has been limited, although supply from high quality issuers towards the end of the week in both USD and Euro at discounted spreads suggests at a price there is demand.

Valuation

Spreads spent the first half of the week widening on a lack of demand and finished the week widening as supply repriced the market. Key to the coming weeks will be whether the corporate market has demonstrated market efficiency, have we found the clearing price for risk (see table above).

Looking to history, IG credit spreads would seem to be pricing a recession but not a severe recession accompanied by high defaults (a scenario not seen in modern times).
 

This communication is only intended for Professional Clients and not to be forwarded for onward distribution.

 
richard.ford
Managing Director
Global Fixed Income Team
 
 
 
 

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