The drama continues | Top Down

24 April 2020

Financial markets have continued to stabilise over the last month. World equities are up 14% in euro terms but are still down 15% year-to-date. The main positive that we have seen over this period has been the impact of aggressive central bank policy, especially from the US Federal Reserve. Governments have also put in place significant fiscal measures to try and limit the economic damage from lockdowns.

Yet the pathway for the global economy is probably no clearer than it was. We know there will be a recovery in the next couple of months, but we do not know the speed or the breadth of that recovery.

Central banks pushing again

The Fed has expanded the reach of its bond-buying programme into the corporate investment grade market and to those companies that were investment grade in February but might have been downgraded since then. Essentially the Fed has arrived in the high yield market. It has also opened an avenue for smaller corporates to access central bank lending from the Fed.

The ECB has also been acting. It has lifted its internal rules for country limits within its bond-buying programme, which will give support to the southern countries within the euro area and contain any widening of spreads. It has also allowed banks to draw down ECB funding using the debt of companies that have recently lost their credit rating (so-called ‘fallen angels’) as collateral. There seems to be a high probability that the ECB will add high yield to its buying programme, too, adding further support to the credit markets in the euro area.

Governments have been doing their bit

Fiscal measures continue to provide income support to individuals and to help maintain companies’ solvency. The US has just increased the size of its support package for smaller companies to preserve the economic infrastructure for when restrictions get lifted.

Individual countries in the euro area - with Germany leading - have set aside significant resources for income support measures and loan guarantees for companies. But the region still lacks a co-ordinated response. Each country still has to fund its own programmes. People are waiting to see if there will be burden sharing across all member states. Today’s meeting of the Euro Group should give some indication of whether this might occur.

Oil price woes

There is extreme dislocation in the oil market, but the implications are more limited than they would have been in the past. The sector only makes up about 3% of the world equity index - it would have been over 10% at its peak - and thus has a small impact on world indices. With central banks in the corporate credit market, the spill over from distressed energy debt to other lines of credit will be very limited. It is bad news for some emerging economies which are oil exporters (e.g. Russia and Mexico) but in developed countries its effect is smaller. Indeed, when we get back into recovery mode, we will have a tailwind of lower energy prices to aid the revival of consumption.

Meanwhile we are in the middle of the first quarter earnings report in the US and there are significant cuts to forecasts. We expected this and thought we could see forecasts reduced by 30% for 2020. Consensus is not delivering cuts that bad yet but, so far, we have not seen anything to suggest they will be greater than this. If that remains the case it will help confidence.

What have we been doing?

In equity markets we have been switching our exposure rather than adding to it. Indices have bounced from the extreme lows and the credit market looks like it is on a recovery path which important for equity markets. We are going to see a recovery in the economic figures in a month or so, but the speed and breadth of that recovery remains unknown.

China is the first coming out of the slump and production has increased rapidly. However, we have little indication of how the consumer is reacting and we need some clarity there. For the moment we have decreased our holdings in cyclical companies and moved to higher rated but more resilient ones. We have reduced our energy exposure as the share prices are not reflecting the commodity price at the moment

We have taken advantage of the increase in yields in the corporate credit market to increase our exposure and reduce our cash levels. The arrival of central banks in this market should push yields down and prices up. Given that we are likely to have negative interest for some time now the risk / reward looks attractive. 

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