Review of the past weeks
How the world has changed in the past 3 months. At the beginning of 2020 we were discussing the rebound of economic momentum in the new year, as the world was looking brighter after a strong return of risk assets in 2019. A trade agreement between the US and China had been reached and the Fed had lowered rates to ensure a recovery. Today, 3 months later, we are in the middle of a pandemic, a global recession is discounted for 2020, equities are in a bear market, and we have a monetary and fiscal response that seems unimaginable. The most important characteristic of this crisis has been the speed and volatility, as well as the new information, policy announcements and data available continously. The price action in March has been characterized by scramble for cash, a month where bonds, gold and other safe assets were sold indiscriminately alongside riskier assets.
Since the last IC on February 25th, the world has turned upside down, as a result of the Coronavirus pandemic. The number of affected people around the world is close to 800,000 and the number of deaths is also exceeding 30,000. The most affected countries have been Italy (more than 10,000 deaths), China, Spain and the US – now has the most confirmed cases. And more important, most countries around the world are in total lockdown and the result has been a collapse of global economic activity.
The most affected sectors have been the Airlines and Transportation in general. Most countries have banned flights from overseas and airlines have grounded most of their fleets. Another sector affected is the Hospitality sector – includes hotels, cruise ships, restaurants, etc. Most companies in this sector are closed. The Energy sector has been affected by two events. On March 8th, 2020, Saudi Arabia decided to increase production, as well as the coronavirus produced a slump in demand. This has sent benchmark crude below $30/barrel.
In Retail – with stores closing down, there are questions over which ones will reopen. In theory, retailers with large online operations can stay in business. Food retailers have experienced a boom time as panicked consumers stockpile goods. Technology has had mixed results; communications tools have benefitted, such as messaging tools, video chat sites, online medical consultations, etc. Surge in traffic is benefitting certain companies but decline in advertising will hamper others. Vast logistic networks are being disrupted, and unicorns that are burning cash cannot continue burning it forever.
Media and Entertainment is also a case of two worlds – cinemas, casinos and sport stadiums are shut. However for media companies speciliasing in home entertainment there has never been such a captive audience. Thus, many diversified media groups are doing ok in one part of their business while struggling in others.
Cable companies relying on live sports are suffering, as well as those relying on advertising. Industrials – the automotive industry has had to suspend production across most of the world – cars are not being sold and are not being driven. Steel and most Industrial companies are also shut.
Finally, Banks are in a better position that they were in the past crisis (2008-2009), however as yield curves are flat or negative, prospects of positive net interest income are nil. Volatility rising has been positive for trading revenues of certain banks.
As governments are using banks to transfer cash to consumers and businesses, they will not be allowed to fail.
- For all of the issues the world is facing, it was a relief to see global markets rally last week and yesterday, March 30th. 7 of the 11 worst days for the market in the past decade have come in the last two weeks. Stepping back, we did just have the biggest 3 day run since 1932 and the SPX did manage to book back-to-back-to-back gains (+17.55% in 3 days Tues-Thurs)—a first in 28 long trading days.
- Markets are discounting mechanisms, and the 2020 recession will kick off a new economic cycle, and over time the economy and asset markets will recover from the shock.Policymakers have responded more extensively than in any previous crisis. Just as easy monetary policy defined the last cycle, we believe the extensive use of fiscal policy will define the next one. Thus we believe that fiscal stimulus will run alongside monetary stimulus well into the next expansionary phase. This potentially will lead to a misallocation of resources in the future.
- Unfortunately, as the S&P and MSCI World gained in the past days, the VIX continued to be stubborn in showing any sign of relief. The focus in the near term is still “flattening the curve” and “dampening the volatility.”
- In the meantime, the road looks bumpy ahead. Certain measures remain stubbornly high, such as the VIX (still hovering over 55 after touching a historical level exceeding 80, earlier this month), Corporate Credit: IG spreads are at ~300bp and HY at ~1000, and there is very little liquidity in the credit markets. In Merger Arbitrage spreads fell to 9% last week after averaging +25% at last Wednesday’s close. Lastly, moves within the S&P 500, reached their highest level of correlation the week of the selloff. This had made it very difficult for active managers to manage risk while generating alpha when moves have been so correlated and driven by the most cyclical and bottomed out names over the last few days.
- The question now is will global stimulus and central bank coordination be enough to rally higher or will we retest the lows?
- One of the strategists we follow closely, MS US Chief Equity Strategist Mike Wilson believes we have made the bottom and that on a 6 to 12 month time horizon, this will prove to be a buying opportunity even as we are in recession. He believes the speed and intensity of this recession is worse than their expected original bear case/recession outcome. With that he has lowered his 2020 base case S&P 500 EPS to $142 (-13%) and bear case to $130 (-20%). Year-end bear/base/bull targets are now 2400/2700/3000 (currently we are at 2626), and in an extreme bear case they see downside to 2000. Keep in mind Mike was already at the low end of consensus going into 2020. Mike believes a recession is ultimately the end of one cycle, but the beginning of another, meaning leadership change as markets bottom and rebound.
- From an asset allocation perspective 1) equity valuations have improved, 2) unprecedented central bank action has eased USD funding stress, 3) there are signs that volatility and negative market technical pressure may have peaked, and 4) the severe US recession economists are forecasting will shift from 'downturn' and into early-cycle 'repair', which is historically better for risk assets, especially credit. 2Q20 may be the worst quarter for growth in US history, but markets usually lead the economy.
- Using historical lead times it would be typical for a market bottom to be forming 'now'. From a risk/reward perspective credit begins to recover earlier than global equities. But for the time being liquidity in credit is still very low, and higher corporate leverage was a known issue before this crisis began. The Fed’s backstop of investment grade (IG) credit offers powerful support for higher quality companies with stable cash flows. However the Fed mandate does not extend to high yield.
- Stepping back, it’s worth revisiting where we stand on the “three pillars” that are leading the markets – the virus, global fiscal policy, and global monetary policy.
- Regarding the virus, we are currently bombarded with information every day, and we cannot add much to what the health experts are forecasting.
- With global and US growth likely to be close to a 74 year low in 2020, policy makers have embarked on an aggressive fiscal and monetary stimulus over the past couple weeks. It would be unfair to say that the reaction functions haven’t been immediate and aggressive. Many economists now expects that in the G4 plus China, the combined primary fiscal balance will rise by 440bps (~US$2.8 trillion) in 2020. As a percentage of GDP, the G4+China cyclically-adjusted primary deficit will rise, reaching 8.5% of GDP in 2020, significantly higher than 6.5% in 2009, immediately post GFC (Great Financial Crisis).
- In the US alone, the cyclically-adjusted primary fiscal deficit is expected to rise to 13% of GDP in 2020 (assuming a stimulus of US$2 trillion) compared with 7.0% of GDP in 2009. Further out, fiscal stimulus together with low policy rates may ultimately have a bigger inflationary effect than monetary policy alone, resulting in steeper yield curves. Steeper yield curves and greater fiscal intervention could also redefine the leadership of equity markets over the next cycle: returns being driven more by nominal earnings growth than multiple expansion, dividends preferred over buybacks, less financial leverage and value closing the gap on growth.
- From a monetary policy standpoint, since mid-January, around 22 of the 30 major central banks have eased. The global weighted average policy rate has declined to below post-GFC lows – rates have fallen by 55bp since December 2019 and 167bp since December 2018. G4 central banks have announced aggressive quantitative easing programs. Economists estimate that the Fed, the ECB and the BoE will make asset purchases of ~US$6.5 trillion in this easing cycle, with the Fed alone making cumulative asset purchases of US$4 to 5 trillion. By the end of 2Q20, it is expected that 25 central banks will ease further, implying larger monetary support than we saw in the aftermath of the GFC.
- Chinese PMIs this week will be very important as investors look to model how Europe and the United States will emerge from this pandemic, using China as a leading indicator. It is important to remember that economic data levels now are not permanent, EU PMIs diving to all-time lows of 31.4, and 3.28mm jobless claims in the US is striking, but when the world recovers from the virus, factories are going to reopen, bars are going to need bartenders, and hopefully there will be a hiring spree offsetting the loss of jobs. The market needs to weather through the poor economic data until we can get there. The human (and economic) spirit cannot be broken.
Turning to Europe, valuations are low, investors have de-risked, and according to several analysts, we are likely nearing peak uncertainty, from a market perspective at least. For longer-term investors the risk-reward is beginning to look attractive, a message that is also reinforced by their market timing indicators that remain deep in buy territory. Cyclical value stocks will likely lead the market up in the immediate aftermath of a final trough. However, with uncertainty still high and with valuations now low across the board many investors are likely to maintain their quality bias and re-engage with ‘good companies at a better price’.
Another theme worth revisiting in Europe is that of High & Secure Dividend yielders. Covid-19 will have a significant impact on GDP and EPS but will also entail a severe hit to dividends as companies move to preserve cash. While the current risk to dividends is indeed high, many believe that a lot of dividend cuts already appear to be priced in to markets. Specifically, they note that it would take a 26% payout cut for Europe's current dividend yield of 4.9% to fall to its long-run average of 3.6%.
Looking over to Asia, there is a notable divergence between the economic recovery in China and the more muted equity outlook. Many find it constructive that China is easing restrictions on Hubei province, the epicenter of the outbreak, two months after it was first put in place. They believe China will put even more emphasis on "new infrastructure" projects to mitigate the economic impacts of COVID-19 and tackle its big city problems, estimating that annual average investment in new infrastructure will reach US$180bn in 2020-30 (2x the last 3-year average).
Equity markets globally have been in a free fall in the month of March 2020, but also showing important intra month volatility:
US 10-year Treasury bonds have also moved erratically during the month of March. After beginning the year of 2020 levels of 1.92%, the rate at the close of March 27th was 0.675% (currently 0.63%). During the month of March we have seen big swings in rates. We began the month of March at the level of 1.15%. On March 3rd we touched a low of 0.54% and on March 18th a high of 1.19%.
Interest rates were already low at the start of the coronavirus crisis. The decision of the Fed to cut rates on March 3rd and then cut rates again, on March 15th, was unprecedented. Then the Fed rapidly announced a plan for $700 billion in quantitative easing — $500 billion worth of US government bonds and $200 billion worth of bonds issued by Fannie Mae and Freddie Mac (“agency-backed securities”).
The Federal Reserve has acted twice in the month of March 2020, cutting rates:
- On March 3rd, it lowered rates from 1.75% to 1.25%
The Federal Reserve lowered the target range for its federal funds rate by 50bps to 1-1.25% during an emergency move on March 3rd, saying the coronavirus posed evolving risks to economic activity. The Fed reiterated that it was closely monitoring developments and their implications for the economic outlook and would use its tools and act as appropriate to support the economy. It was the first emergency rate cut since the 2008 financial crisis although markets were already pricing in a cut of 50bps or 75bps in the next planned FOMC meeting on March 18th. The move followed a G7 announcement made earlier in the day in which policymakers reaffirmed their commitment to use all appropriate policy tools to achieve strong and sustainable growth, although failing to provide specific actions.
- On March 15th (yes, on a Sunday) it cut rates from 1.25% to 0.25%
The Federal Reserve lowered the target range for its federal funds rate by 100bps to 0-0.25% and launched a massive $700 billion quantitative easing program during an emergency move in order to protect the US economy from the effects of the coronavirus. "The coronavirus outbreak has harmed communities and disrupted economic activity in many countries, including the United States. Global financial conditions have also been significantly affected. Available economic data show that the U.S. economy came into this challenging period on a strong footing. To support the smooth functioning of markets for Treasury securities and agency mortgage-backed securities that are central to the flow of credit to households and businesses, over coming months the Committee will increase its holdings of Treasury securities by at least $500 billion and its holdings of agency mortgage-backed securities by at least $200 billion", the Fed said.
The Fed’s announcement expanded the QE program in two ways.
First, it uncapped the quantity of quantitative easing, saying simply that the Fed “will purchase Treasury securities and agency mortgage-backed securities in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions and the economy.”
Second, it expanded the scope of what can be purchased to include commercial real estate (things like offices and stores) backed by Fannie and Freddie to ensure low interest rates throughout the sector. It stated that QE exists as an alternative means of influencing long-term rates without trying to make short-term rates go below zero (which runs the risk that people will resort to storing physical cash in vaults rather than suffering negative rates). However, the Fed was also worried that there is so much fear in financial markets that the economic impact will not propagate naturally. Therefore, they decided to launch a huge “alphabet soup” of credit facilities:
The Primary Market Corporate Credit Facility (PMCCF) will buy newly issued corporate bonds, typically from large employers.
The Secondary Market Corporate Credit Facility (SMCCF) will buy existing corporate bonds to give people confidence that this remains a “liquid” market and thus they do not need to panic-sell corporate debt they already own, or fear buying new debt from credit-worthy companies.
The Term Asset-Backed Securities Loan Facility will buy asset-backed securities (basically packages of loans) composed of student loans, auto loans, credit card loans, and other forms of consumer debt plus some Small Business Administration loans.
The Money Market Mutual Fund Liquidity Facility will expand the range of things it buys to include a kind of municipal bond called a “municipal variable rate demand note” as well as bank certificates of deposit, which are medium-term loans consumers make to retail banks.
The Commercial Paper Funding Facility is going to expand to include “high-quality, tax-exempt commercial paper,” which is a kind of business debt that allows state and local governments to create tax subsidies for businesses.
The U.S. Congress passed a $2 trillion emergency relief bill (March 25th) that will expand unemployment insurance, provide $1,200 stimulus checks in emergency financial relief to most American adults and provide life preservers to distressed businesses impacted by the COVID-19 epidemic.
The $2 trillion economic stabilization package is the largest of its kind in modern American history, providing direct payments and jobless benefits for individuals, money for states and a huge bailout fund for businesses.
This government aid plan is unprecedented in its sheer scope and size, and will touch on every facet of American life with the goal of salvaging and ultimately reviving a battered economy. Its cost is hundreds of billions of dollars more than Congress provides for the entire United States federal budget for a single year, outside of social safety net programs. Administration officials said they hoped that its effect on a battered economy would be exponentially greater, as much as $4 trillion.
The legislation would send direct payments of $1,200 to millions of Americans, including those earning up to $75,000, and an additional $500 per child. It would substantially expand jobless aid, providing an additional 13 weeks and a four-month enhancement of benefits, and would extend the payments for the first time to freelancers and independents.
The measure would also offer $377 billion in federally guaranteed loans to small businesses and establish a $500 billion government lending program for distressed companies reeling from the impact of the crisis, including allowing the administration the ability to take equity stakes in airlines that received aid to help compensate taxpayers. It would also send $100 billion to hospitals on the front lines of the pandemic.
The bill is more than double the size of the roughly $800 billion stimulus package that Congress passed in 2009 to ease the Great Recession.
European Monetary Policy
Measures taken on 12 March 2020
On 12 March 2020, the European Governing Council decided on a comprehensive package of monetary policy measures to support liquidity and funding conditions for households, businesses and banks and help preserve the smooth provision of credit to the real economy. This package involved temporarily conducting additional longer-term refinancing operations (LTROs), applying more favorable terms during the period from June 2020 to June 2021 to all TLTRO III operations outstanding during that same time, and adding a temporary envelope of additional net asset purchases of €120 billion until the end of 2020.
European government bonds from Italy to Greece surged after the European Central Bank launched a 750 billion euro ($810 billion) debt-buying program to keep borrowing costs in check as countries prepare to increase spending to counter the impact of the coronavirus.
Yields plummeted, led by a more than 200-basis-point drop for Greece’s five-year bonds, narrowing the gap between the debt of the euro-area’s strongest economies and the more stressed. The region’s corporate debt risk dropped the most since 2016 following the ECB decision, made in an unscheduled meeting Wednesday evening.
The Bank of England followed on March 19th, with its second emergency cut in borrowing costs this month, taking the benchmark rate to a record-low 0.1%. The BOE also announced a boost in its asset-purchase program target to 645 billion pounds ($752 billion), made up mainly of gilts.
The two decisions mark the latest in an escalating global response to an outbreak widely seen driving the economy into recession. ECB President Christine Lagarde reinforced the message that policy makers will do all they can, saying there are “no limits to our commitment to the euro.”
The ECB’s decision to pump more liquidity into the financial system include:
- Buying public and private-sector securities until at least the end of 2020
- Program will cover all assets eligible under current quantitative-easing program, and will be extended to commercial papers of sufficient credit quality
- Greek government debt will be included
- Collateral standards will be eased
- Program will continue until ECB judges the crisis phase of the pandemic to be over, but not before the end of this year
- The ECB will consider raising its self-imposed limits on QE holdings, and will increase the size of its programs if needed
- The initial jobless figures covering the period when the US shutdown began were the weekly jobless claims announced on March 25th. These jobless claims surged to 3.3 million (from 282,000 the previous week), and surprised many.
- On Friday, April 3rd, the employment figures for March will be released. Expectations have wide ranges here. Remember the last unemployment figures for February were 273,000 non farm employment and an unemployment rate of 3.5%.
- Corporate bond prices tumbled in early March but fixed income ETFs fell even further, resulting in extraordinary discrepancies between the price of the ETFs and their assets. An example is the price of LQD – a $35 billion investment grade fund ETF managed by BlackRock. Recently it slid to more than $6 below its NAV, the biggest discount since the 2008 financial crisis. Other ETFs that track high yield, municipal debt, bank loans and even US government bonds have also traded at extraordinary discounts.
- On Monday, March 27th, the Fed stepped in and announced it would begin to buy corporate debt to quell the crisis – including bond ETFs. It picked BlackRock, one of the biggest providers in the $1.1trillion market, to manage the purchases. The Fed will buy investment grade corporate bonds with a maturity of five years or less.
- US High Grade bonds are now yielding >300 bps over UST, US High Yield >1,000 bps over UST, US Leverage Loans >1,100 bps over 3 year UST, EM Sovereigns >600 bps and EM Corporates >540 bps.
We are in the middle of a very important economic crisis that is pushing the global economy into a recession. This is a time of extreme volatility and uncertainty. However if the virus is contained, we could see an economic recovery later this year.
The «$1.0 mm question» now is if we have seen the bottom of equities or not. Bear markets bring with them periods of short squeezes (we might be experiencing one now). The reality is that this recession will result in a large hit to earnings, and the extent of this hit, remains unknown.
This recession is unique as policymakers have responded more extensively and rapidly than in any previous crisis. Not only has monetary policy been used again, as in the GFC, but the extensive use of fiscal policy is unprecedent.
Our view now is to maintain the actual level of equities in our portfolios: T2 currently ~ 23%, T3 ~ 36% and T4 ~ 52%. These weightings already reflect a correction of the equity markets this year of around 25%.
Central bank intervention and fiscal policy will provide support to the markets, but we may have not seen the cycle lows in equities until the full extent of the blow to earnings is known, as well as the extent of potential recovery.
Our current fixed income positioning is very light. Holding mostly IG bonds of European banks, Latin American Corporate bonds and a Unconstrained bond fund that has a defensive posture.
We thus hold large cash holdings that can be deployed rapidly when we see the opportunity. Cash provides portfolio protection now, and in time will be dry powder to start adding risk in anticipation of the new cycle. However, for the time being our conviction is low and therefore we prefer to keep a cash buffer.
We expect equities to recover more quickly than credit. The Fed’s backstop of investment grade credit offers an important limit on spread widening.