Friday, 27th of March 2020
“If a window of opportunity appears, don’t pull down the shade.”
– Tom Peters
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Have financial markets finally bottomed? This is the question that confronts investors after major equity indices rebounded for their third consecutive day on Thursday. Before the Friday market open, the S&P 500 Index was up +14.1% for the week (after its best 3-day performance since the 1930s), the STOXX 600 Index was up +9.7%, and the MSCI EM Index up was +6.0% (in dollar terms) in the first sustained rally for global equities since they peaked in late February. Whether this marks the beginning of the end of the sell-off – or merely the end of the beginning – matters enormously for those trying to navigate extreme market volatility, construct resilient portfolios against an uncertain economic backdrop, and ensure that books are primed for the inevitable rebound in oversold securities when it comes.
The impetus for the rebound was another massive Federal Reserve intervention on Monday, followed by the US Senate passing a $2tn fiscal stimulus package on Thursday. Having announced that it would purchase at least $500bn of Treasuries and $200bn of MBS last week, the US central bank upgraded its commitment to an open-ended pledge to buy these assets “in amounts needed to support smooth market functioning and effective transmission of monetary policy”. The Fed also added agency CMBS to its QE programme for the first time, introduced measures to lend directly to firms, and cut the interest rate on repo operations to zero. Although the totemic promise of QE infinity grabbed headlines, perhaps the most crucial (and interesting) announcement is the plan to work with the US Treasury to support $300bn of financing for firms and households. As part of the financing package, the Fed will establish an SPV which is able to buy investment grade (IG) corporate bonds with maturities of 5 years or less. This structure allows the bank to get around the Federal Reserve Act which prevents it from financing corporate America through direct bond purchases. In itself, this is a very significant and highly unusual intervention which shows how serious policymakers are about tackling the coronavirus-induced slump. However, it also represents a major shift in the focus of US monetary policy from financial plumbing and liquidity issues, such as the money market stresses that caused investors to panic last week and sent the dollar skyward, to supporting the real economy. This suggests that fears of an imminent liquidity crunch are overblown, and investors should look elsewhere to discern the future trajectory of asset prices.
From an investment perspective, the creation of this Fed SPV has also put a floor under US IG corporate bonds. Spreads have retraced somewhat as a result, but at ~300bps over treasuries (as of the Thursday close) they still imply corporate default rates far in excess of 2008. This is unrealistic given the nature of this crisis. IG corporate bonds are clearly an asset class with considerable promise – but they still face stiff competition in the current market context.
The other big US policy intervention that drove markets this week was fiscal in nature. Having rejected the first White House proposal last weekend, the Senate finally passed a $2tn fiscal stimulus package on Thursday, and by a margin of 96 to 0. A small group of hawkish Republican lawmakers objected to the expansion of unemployment benefits contained within the bill, but they failed to amend it and the measures passed by bipartisan consensus. The bill now moves to the House of Representatives, where it is expected to be shepherded through quickly, and then on to President Trump for signing into law. In addition to increasing unemployment benefits, the bill provides funding for direct cash transfers of $1200 to all Americans earning <$75k, $500bn for sectors caught in the coronavirus’ crosshairs, >$350bn in small business loans, and $150bn in aid for hospitals struggling under the increased burden of treating covid-19 patients. The stimulus measures come not a moment too soon. The US now has the highest number of confirmed cases of coronavirus globally, surpassing China (if you believe the official figures), and the WHO has warned that the country could become the next epicentre of infection when it is done ravaging Europe (as an aside, UK PM Boris Johnson has just tested positive for the virus). On Thursday, the same day that the US surpassed 1000 deaths from covid-19, new data showed that last week some 3.3 million Americans signed on to unemployment benefit for the first-time (smashing the all-time record of 695k in October 1982). Many of these newly jobless will have been let go on an initially temporary basis. However, depending on the duration and severity of the shutdown, these claims may become permanent. The Trump Administration is keen to minimise the economic damage from the healthcare crisis, and the President has suggested opening parts of the economy in the next few weeks. But how this can be done in practice (or at any meaningful scale) is unclear: many large states have implemented their own harsh quarantine measures which the Federal government cannot simply demand be lifted. More likely, the US follows the rest of the world into recession.
On the subject of economic growth, data released this week has all but confirmed that the world is now in the throes of a sharp contraction. The Eurozone composite flash PMI for March has fallen to a record-low of 31.4 (vs. 51.6 in February), dragged down by an unprecedented fall in the services PMI to just 28.4 (vs. 52.6). The flash reading for manufacturing has also fallen, but to a more manageable 44.8 (vs. 49.2 in February) as the sector is much less affected by quarantine measures than services. The US has also suffered a decline in its PMI data for March. However, the fall has been somewhat less marked than it has been for Europe where the outbreak is more advanced. The flash US services PMI for March stands at 39.1 (vs. 49.4 in February) and the manufacturing PMI beat estimates at 49.2 (vs. 50.7). This survey data is provisional and the extent of the damage to corporate profitability is unknown at this time. However, it was revealed this week that Chinese industrial profits have collapsed -38.3% this year (vs. last year and as of the end of February). This is a harbinger of things to come for Europe and the US when the Q1 earnings season kicks off in April.
Despite the challenges of the coronavirus outbreak and the severe economic impact of the response, one must always consider what is ‘in the price’ when assessing the investment landscape. It is clearly impossible to predict with any precision when the virus will pass and how large or lasting an impact on economic aggregates it will have. But pass it will, as sure as night follows day. Moreover, the uncertainty and confusion on display in the wild swings of recent weeks have led to such indiscriminate selling that it is impossible not to see opportunities amid the wreckage, even with the most cursory glance. There are now pockets of value across multiple markets that would have been unthinkable in the low volatility steady-as-she-goes environment that prevailed as recently as January. Determining when, not if, to strike is the principal goal of portfolio management today. As things stand, we feel that the best place to start allocating now is to IG corporate bonds given the remarkable spread widening since February – even in the highest quality issues – and the tendency for IG to lead the rally. Moreover, we now have an extremely aggressive IG bond buying programme from the Fed which puts a floor under the prices of these bonds and adds to the asymmetric risk-return profile we believe they exhibit.
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