Eye of the Storm
Real yields have stabilised, and unsurprisingly risk assets have rebounded and calmed. What now?
INTRODUCTION
The “Real Rates and Market Confidence” post on the 20th March highlighted the bond market concerns about fiscal debt financing, expressed by a violent move higher in government bond real yields. I suggested that Central Banks had to suppress this rise in real yields and that they were destined to announce much larger intervention, and “the 160bp round trip rise in real rates might have found a temporary respite. Further Fed purchase announcements could lower those rates, suppressing risk asset volatility (as private sector assets will not be diverted to fund the deficit). “
The subsequent Central Bank announcements on debt financing (debt monetisation, QE or whatever you want to call it) have succeeded in allaying those market fears and brought about a sharp decline in government bond real yields (left), almost back to the recent lows in the case of US Treasuries and UK Gilts (left). Unsurprisingly given asset price correlations (see Stressed Asset Price Correlations), that peak in real yields coincided with the bottom in equity indices (right). That rebound in equities has also been accompanied by relative stability in commodity and precious metal prices, levered DM currencies (SEK, NZD, AUD, CAD, KRW) as well as investment grade credit spreads. The outlier is EM, which I think is outside “the circle of trust”.
A PERIOD OF CONTEMPLATION IN AN UNCERTAIN ENVIRONMENT
It seems that the initial knee jerk market panic reaction over the public and private sector cost of the Covid19 pandemic is now over, which will now be followed by a period of reflection, number crunching and forecasting.
In the meantime, the underlying issue of global “overindebtedness” will remain and its consequences will continue to be a headwind to householders and corporates. Economic data will start giving an indication of just how deep the economic impact of the Covid19 shutdown will be, and judging by some of the data already released, economic forecasts of a “V- shaped” recovery are likely to be challenged. Market participants are therefore likely to keep focussing carefully on private sector solvency, as they did on government solvency (which caused the rise in real yields), and how fiscal policy might help.
As an example, Banks, Insurance Companies and Pension companies must contend with the profit limiting consequences of low and negative interest rates as well as low and flat yield curves. This set of circumstances is likely to remain in place for many years (see lower for longer). To add to the problems arising from the curve, each of these sectors has their own set of issues to confront, e.g. banks with upcoming NPLs and investment reinvestment risk, insurers with minimum guarantees on policies and Covid19 claims and pensions companies with higher NPVs of liabilities (see yesterday’s pension company note).
Central banks have so far rushed to address the liquidity issue in financial markets, as well as the sovereign “solvency” concern. The private sector solvency issue, however, is far more complex as it requires taxpayers’ money which is tremendously political. Central banks are already intervening with respect to bank dividend policies, whilst a storm is brewing over rescuing companies who have leveraged their balance sheets to fund buybacks or been seen to be tax avoiders.
To complicate matters, this economic slowdown will be very different to previous recessions and the GFC. Normally recessions are manufacturing sector led, and the GFC was all about the financial industry, household leverage and real estate bubbles. This will be a services led recession, truly global in nature, that will hit the self-employed, SMEs as much as large corporations, which suggests a longer return to where the global economy was before Covid struck.
If money or leveraged money cannot restart and grow back to the levels pre Covid, then its hard to see how equity or corporate bond “valuations” (and therefore prices) can return to those pre Covid19 levels (be it p/e or credit spreads). Post QE, Equity and corporate bond valuations are no longer a reflection of corporate profitability, cashflows or balance sheet strength, present or future. They are a “valuation” of those metrics, and that valuation is a function of how much money is available to buy those assets. The pre Covid environment saw a lot of QE money indirectly end up buying equity through the reach for corporate bond yields which permitted equity buy backs. What will the post bail out environment be? Will buy backs be allowed? Will dividend payments be curtailed? What will regulations and government intervention be?
CONTINUED HIGH RISK PREMIA AND EM DIFFICULTIES
To that end, I expect risk premia to remain on credit and equity markets until there is far more transparency on government intervention. I never had any doubt that governments would seriously increase their fiscal spending, financed by central banks – that was the GFC lesson. But it remains unclear whether corporates this time around will have it as easy with no strings attached. And that should be a concern for shareholders and bondholders, thus requiring a risk premium to hold those assets.
A final comment on EM. The quite brilliant Adam Tooze (his book “Crashed” is a must read) has written an excellent article highlighting the challenges facing some highly leveraged EM countries in a deleveraging DM environment. As mentioned in my previous posts, FX remains the pressure valve through which their imbalances will flow, especially as current low interest rates offer very small compensation against FX devaluations. In a world of fiscal expansion financed by central banks, EM countries really seem to be outside the “circle of trust” enjoyed by DM countries – EM will need more radical policies.
CONCLUSION
The stabilisation of government bond real rates did bring a stabilisation in equity, corporate bond, fx and commodity markets, albeit still at much lower valuations.
Although more stable, the over-riding state of over indebtedness will continue to provide a strong headwind to financial markets.
Market participants will now focus on how fiscal bailouts will repair GDP, addressing household and consumer insolvency.
The data will be very poor over the next few weeks and months. Investors will have many doubts about solvency issues in the household and corporate sector.
Until it is clear how GDP will recover, or the terms and conditions for government bail outs, risk premia should remain on corporate bond spreads and equity valuations.
In the meantime, the interest rate curve should continue to price a “low for much longer” scenario, bringing no respite to the financial sector.
FX will continue to be the pressure valve (Note today’s sell signals on daily charts of NZD, AUD and CAD – available on request).
EM debt monetisation remains outside the “circle of trust” enjoyed by DM countries. There are risks of more extreme policies.