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Complacency meets uncertainty
Andrew McCaffery, global CIO for asset management, said: “I think there was a high level of [market] complacency as we came into this, in terms of expectations around earnings, around the growth profile, and really the bar that had been set for those expectations.”
Central banks are responding to sharp market sell-offs with rate cuts, but conventional monetary policy has limited room for manoeuvre. Steve Ellis, global CIO for fixed income, said central banks “are making sure they provide lots of liquidity to lubricate the system,” amid emergency rate cuts of 50bps from both the US Federal Reserve and Bank of England.
“But I think they're running out of ammo here and they could go to helicopter money and go all in and do something very unconventional,” said Ellis.
Falling rates will intensify the search for yield, forcing it further into the equity markets. Romain Boscher, global CIO for equities, said: “Our conviction is that if people are hunting for yield, the only place to find a decent yield - now more than ever - is in the equity world. As long as you are investing in listed assets, in liquid assets.”
With major economies facing a combination of demand and supply shocks, markets are looking to governments to help companies and consumers weather the effects of the coronavirus.
Steve Ellis said: “The Fed is going to be cutting, the ECB potentially cutting as well. But it's going to be fairly impotent. I think there has to be a fiscal response here.”
So far, flows have been concentrated in synthetics and the hedging of exposures. Real money has moved far less, as long-term investors wait to see whether reallocations are necessary. Instead, much of the trading has been done by algorithmic programmes and ETFs, which have a greater share of volumes than they did in 2008 after broker-dealer inventory books shrank due to regulation.
If these players desert markets during sell-offs, they can bring liquidity to a standstill, as we have seen in the high yield market recently. Energy high yield bonds (a large proportion of the overall high yield market) in particular seem exposed, thanks to the oil price drop and greater short-term refinancing risk. Some new issues in credit markets have been postponed.
“The first thing is that when you're managing portfolios you have to make sure that you're running adequate levels of liquidity meaning cash, cash equivalents and so on,” said Ellis, “So as and when these markets do stabilise, we are in a position where we can take advantage of this dislocation.”
The investment grade market has been more robust. US IG yields have actually compressed despite widening spreads over US treasuries.
Winners and losers
Many companies are affected by the coronavirus outbreak, some more positively than others.
For consumer-led companies focused online shopping “most recent figures are pretty encouraging, let's say even higher than expected,” said Boscher. “This is why we are facing two types of companies. When they are dealing with a consumer offline it's a problem, when they are dealing with a consumer online, they are sharing with us pretty reassuring messages.”
Meanwhile the oil shock is particularly negative for high yield bonds issued by energy companies. Combined with a weaker outlook for the global economy, some companies may start to face difficulties refinancing their obligations.
“Obviously this is a concentrated profile around energy at the moment,” McCaffery said, adding: “A number of companies have been running on very tight margins in terms of cash flow management. The need for that refinancing is extraordinary through the course of the next two or three years, and much of that is in private markets as well, not just in the public markets. It's something we are very closely watching, in terms of how we see that refinancing profile for these companies develop.”
As well as affecting credit markets, the oil price fall is helping to transmit the economic impact of the coronavirus to the real economy, both in terms of currency (for importers and exporters of oil) but also as a positive boost for the consumer, even if they are travelling less.
McCaffery said: “We’re seeing a very interesting development even in the very short term between what's happening in Asia and in China, post the worst of the virus impact. Now getting a positive impact from oil are those [like China] who import it - a little bit of help at a very difficult time.”
The quarters to come
Complacency may have given way to uncertainty, but there is room for hope.
McCaffery said: “Until we start to see more evidence of what's playing out in the real economy and the direction of fiscal policy to really address the issues, then I think markets can recover on the expectation of fiscal policy but they'll be challenged through the next couple of quarters.”
Unorthodox policy measures carry risks, including inflation and a spiral downwards for the US dollar. But for now, they should extend the lower-for-longer rate environment, meaning yield will remain sought after in both equity and debt markets. Investors, meanwhile, will focus on quality companies with low leverage that can withstand tougher conditions.
“We are preserving a quality bias,” said Boscher. “It means that we are avoiding stocks with significant leverage because when you are late cycle, from a credit cycle perspective, it's not time to buy leveraged names.”