The ultimate public health costs and economic impact of Covid-19
are at this time unknown. Public health responses have weighed the
human cost of intensive care units being overwhelmed and the
number of preventable deaths exploding against the jump higher in
unemployment, collapse in investment and demand destruction
attached to social distancing. Governments have, understandably,
chosen life over wealth.
But policymakers have also sought to use their government and central bank balance sheets to cryogenically preserve the structure of their economies over a three to six month period – variously guaranteeing subsidised business loans, providing grants to SMEs and households, underwriting the private sector wage bill, and implementing a range of regulatory and accounting forbearance measures.
Perfect cryogenics appropriately discounted with perfect foresight would leave financial markets
relatively unmoved – deferring or missing the first six months of a perpetual stream of earnings is
something that might warrant fairly minor market movements. Imperfect cryogenics would see
cash flow problems within the affected economies and their trade partners become widespread
solvency problems: firm failures abound and the recent weakness in financial markets is just a
prelude to a more meaningful collapse that accompanies a synchronised global depression.
While the future is unknown we do know some things about the present.
The first thing we know pertains to valuation. The additional yield above government bonds
offered by investment grade corporate bonds has tripled this year from around +100 basis points
to around +300 basis points. Fixed income markets at times last week ceased to function and
large dislocations attached to bid-less liquidations were abundant.
It was not uncommon to see long-dated investment grade bonds drop ten points one day, then
ten points the next; the most important news came in the form of the lack of market depth and
the pressure from the seller to raise funds. Backing out what might be priced into market spreads
leaves us with an estimate that the market is compensating investors for a c.25% cumulative
default rate versus the c.0.5% that typifies investment grade corporate credit. In high yield and
emerging market debt we have seen meaningful spread widening and huge negative return
numbers and high yield corporate spreads compensate for a c.42% cumulative default rate.
These default rates far exceed the maximums so far recorded in any period over the last
century. Equity markets have swooned, but have remained functioning, and despite the falls in
prices they have outperformed the kind of performance implied by fixed income market
movements.
Policy
The second thing we know pertains to policy response. A large fiscal package can cure Covid-19
no more than can a cut in interest rates, the resumption of quantitative easing, daily foreign
exchange US dollar swap auctions, or the alphabet soup of liquidity supports from central banks.
But these fiscal and monetary programmes can address and ultimately resolve the dislocation
seen in fixed income markets. A central bank controls the money supply and can – with enough
will – buy every asset in an economy with newly created reserves. While central banks cannot
cure the virus, nor might they be able to deliver perfect cryogenics to the economy at large, they
do have ultimate control over whether the acute fixed income market dislocations are allowed to
throw the financial system into disarray and deliver a second Global Financial Crisis. And they
have announced actions of mindboggling magnitude and with stunning speed.
The third thing we know is that the shock to economic activity is going to be enormously large in
the short run as sectors of the economy simply shut down. It is not clear yet whether attempts at
cryogenics will succeed. As such, the sort of leading economic indicators that we look to have
little meaning and feel extremely lagging. Analyst estimates of company earnings have not fallen
with the magnitude that our colleagues across the investment department are looking for, but nor
are analyst estimates for 2020 seen as important data points – what matters is how the world
emerges in 2021-22.
What are we doing with these understandings?
Safely tucked behind screens, portfolio managers talk about “the fog of war” in times of
meaningful uncertainty. The phrase resonates, but with real threat to human life all around it
sounds flippant. Instead we proceed tentatively based on how we understand the world to have
changed, and how financial markets have priced it to evolve. We continue to characterise the
Covid-19 pandemic as a serious but temporary shock, and understand that while policymakers
will not be able to deliver perfect cryogenics, they have demonstrated a determination to cap
discount rates on financial assets and so prevent the public health crisis metastasize into a
global financial crisis.
So today we upgraded investment grade credit from neutral to favour, and we also upgraded our
Prospective Return to Risk (PRR) score from neutral to favour. All else equal, we will be
deploying more portfolio risk with the view that this risk will be compensated with super-normal
returns over the next 12 to 18 months. But the situation remains fluid.
As fixed income markets have become dislocated so the absolute volatility of their returns have
risen, and the correlation of their returns has shifted higher versus other risk assets such as
equities. As such, portfolios with exposure to corporate credit have seen the risk contribution of
these credit exposures jump higher, and their aggregate level of portfolio risk jump higher.
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