A gloomy, dire atmosphere loomed over Wednesday’s (virtual) press conference at the Federal Reserve. Chairman Jay Powell warned about the likelihood of a long and difficult recovery phase, with the message for all those tuning in being clear as day: hoping for a quick rebound in economic activity is a fantasy. This message has been echoed by other Fed officials and, all in all, there were few positives to catch with warnings about pretty much everything from near-term solvency problems to long-term damage to the supply side of the economy:
“But the recovery may take some time to gather momentum, and the passage of time can turn liquidity problems into solvency problems. […] But the coronavirus crisis raises longer-term concerns as well. The record shows that deeper and longer recessions can leave behind lasting damage to the productive capacity of the economy.”J. Powell
Of course, the bazooka of interventionist action employed to this date, including rates slashed to zero, purchases of Treasuries, MBS, commercial paper and even junk bonds, is not enough. As pointed out by David Rosenberg, “the Fed is all about lending, not spending; and all about liquidity, not solvency”. Ratifying this, Powell threw the ball in Congress’ court, asking in short for more fiscal stimulus after acknowledging the “both timely and appropriately large” package of measures already employed.
There has been abundant market commentary about how, seemingly oblivious to the view shared by J. Powell and a plethora of other demigod investors, financial markets don’t seem to be pricing in the unavoidable hard period ahead. At first glance, it looks indeed as if the Fed has succeeded in boosting investor sentiment with some risk assets rebounding quickly after a violent sell-off in mid-March this year. US equities, highly concentrated in a handful of resilient big tech mega-caps, are now just 16% off the highs after experiencing a drawdown of almost 35%. This Wall-Street vs Main Street narrative remains dominant for now, but a closer inspection across all asset classes shows a different picture. The markets are, in the end, not all about US mega-caps.
Emerging Markets Debt
Starting off, a quick look at the JP Morgan Emerging Markets Bond Index (EMBI) shows a decent recovery from the levels preceding the violent March selloff that saw it drop more than 26%. The magnitude of this recovery is, however, limited when compared to other risk assets from developed markets. Despite rallies elsewhere, EM debt remains cheap. And all for good reason.
For one, the central banks in the developing world have limited ammunition at their disposal compared to their analogues in advanced economies. Bond purchases and interest rates cuts have been adopted in countries such as Chile, Colombia, Costa Rica, Croatia, Colombia, Croatia, Hungary, Poland, Romania, South Africa or Turkey. Many are, however, soon to reach their limits. Latin American economies are already starting to be affected:
“Peru and Chile have already lowered borrowing costs almost to zero, and are being forced to consider new tactics to rescue their crashing economies. Brazil and Colombia may soon be in the same boat.”Bloomberg
Moreover, while the dollar may fluctuate against other G10 currencies, the outlook for EM currencies looks more certain. With high unemployment on the horizon, limited fiscal stimulus capabilities and lower capacity for business to adapt to the new working environment, the stage seems to be set for broad weakness in EMFX going forward. Clearly not helpful for servicing their debt burden, a lot of which is in dollars.
Finally, debt relief looks more problematic than in previous sovereign debt crises. For one, governments are wary of restructuring or postponing repayment of their debt due to higher future borrowing costs – rating downgrades could prove costly and lengthen the recovery. Besides, structural changes may impede some of the traditional ways out of such a debt crisis, with private sector investors unlikely to fully co-ordinate into restructuring agreement and likely to play different cards than the likes of World Bank or IMF. Colby Smith reports:
“Rather than the banks and governments — the primary creditors in the mammoth debt crisis that racked the developing world in the 1980s and 1990s — creditors are nowadays largely a multitude of bond funds.”Financial times
High Yield Credit
In one of the most controversial moves in its 107-year history, the Fed announced more than a month ago it is tapping into the corporate bond market through a programme facilitated by BlackRock, the world’s largest asset manager. While the technicalities of the programme are themselves a subject for a separate article (or even book) and has been extensively discussed elsewhere, it is interesting to look at the market reaction that came along with the announcement.
An impressive reversal in both investment grade and high yield spreads followed the mere announcement (or shall we say commitment) of the purchases. Issuance in the IG space has skyrocketed to all-time highs before May 12th – and therefore before any intervention by the Federal Reserve through either direct purchases or ETF purchases. In fact, the high yield spreads only narrowed 5 basis points on the day the programme actually began.
This rebound, however, fails to show the full picture. From David Rosenberg:
“High yield spreads in mid-February were sitting pretty at 345 basis points. So at 732 basis points with Fed intervention, we’re still heading into a big recession? Spreads are at, or higher than, where they were heading into the 2001 and 2008 downturns, so the bottom line here is that the Fed, as powerful as it is, cannot really win over mother nature.”David rosenberg
So it seems smart money is pointing towards a different future compared to the FAANG stocks. Not good.
Italy (and Europe)
Moving to Europe, the recent developments involving Germany’s court ruling against the ECB are once again bringing the fragility of the eurozone and its institutions in the spotlight. After an initial drop at the end of March, the spread between Italian and German 10Y bond yields has widened through April and May and is almost back at the levels from March 17th. Already downgraded to “a single notch above junk” last month, Italian debt levels suspected to prove unsustainable for Rome in the long run.
“The coronavirus epidemic will now make Italy’s already bad debt situation worse by causing the Italian economy to contract by a projected 10 percent in 2020. That, in turn, will likely result in the Italian budget deficit ballooning to around 9 percent of GDP as tax revenues decline, while Italy’s public-debt-to-GDP ratio skyrockets to a staggering 160 percent of GDP by the end of 2020.”Desmond Lachman
The European Central Bank remains, of course, the saviour. Its government bonds purchases policy has been attacked by Frankfurt though a constitutional court ruling, setting the stage for an absurd and almost comical “Germany vs Germany” confrontation. What these recent events have shown, however, is that the thread Italy is hanging on is thin. It is true that the traditional rhetoric of “going beyond normal tools to use exceptional measures” coming from the ECB’s Christine Lagarde has somehow managed to calm the waters for now, but it is also true that central bank largesse will be seen though a different lens from across the continent going forward.
Every week seems to bring more and more weight on Italy’s shoulders. It is one of the pockets of the financial markets that is showing the disconnect between Main Street and Wall Street may not be that massive in the end. It’s all a matter of where one looks.
Matei Vlad is President of UCL Investment Society. He is also finishing his second year as student at the UCL School of Management.