{"id":90449,"date":"2020-04-02T01:52:45","date_gmt":"2020-04-01T23:52:45","guid":{"rendered":"http:\/\/beta.next-finance.net\/strategie\/asset-allocation-update-credit-upgraded-amid-fluid-and-uncertain-backdrop\/"},"modified":"2020-04-02T01:52:45","modified_gmt":"2020-04-01T23:52:45","slug":"asset-allocation-update-credit-upgraded-amid-fluid-and-uncertain-backdrop","status":"publish","type":"post","link":"http:\/\/beta.next-finance.net\/en\/strategie\/asset-allocation-update-credit-upgraded-amid-fluid-and-uncertain-backdrop\/","title":{"rendered":"Asset allocation update: credit upgraded amid fluid and uncertain backdrop"},"content":{"rendered":"

The ultimate public health costs and economic impact of Covid-19
\nare at this time unknown. Public health responses have weighed the
\nhuman cost of intensive care units being overwhelmed and the
\nnumber of preventable deaths exploding against the jump higher in
\nunemployment, collapse in investment and demand destruction
\nattached to social distancing. Governments have, understandably,
\nchosen life over wealth.<\/strong> <\/em><\/p>\n

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 \u2013 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.<\/p>\n

Perfect cryogenics appropriately discounted with perfect foresight would leave financial markets
\nrelatively unmoved \u2013 deferring or missing the first six months of a perpetual stream of earnings is
\nsomething that might warrant fairly minor market movements. Imperfect cryogenics would see
\ncash flow problems within the affected economies and their trade partners become widespread
\nsolvency problems: firm failures abound and the recent weakness in financial markets is just a
\nprelude to a more meaningful collapse that accompanies a synchronised global depression.<\/p>\n

While the future is unknown we do know some things about the present.<\/p>\n

The first thing we know pertains to valuation. The additional yield above government bonds
\noffered by investment grade corporate bonds has tripled this year from around +100 basis points
\nto around +300 basis points. Fixed income markets at times last week ceased to function and
\nlarge dislocations attached to bid-less liquidations were abundant.<\/p>\n

It was not uncommon to see long-dated investment grade bonds drop ten points one day, then
\nten points the next; the most important news came in the form of the lack of market depth and
\nthe pressure from the seller to raise funds. Backing out what might be priced into market spreads
\nleaves us with an estimate that the market is compensating investors for a c.25% cumulative
\ndefault rate versus the c.0.5% that typifies investment grade corporate credit. In high yield and
\nemerging market debt we have seen meaningful spread widening and huge negative return
\nnumbers and high yield corporate spreads compensate for a c.42% cumulative default rate.
\nThese default rates far exceed the maximums so far recorded in any period over the last
\ncentury. Equity markets have swooned, but have remained functioning, and despite the falls in
\nprices they have outperformed the kind of performance implied by fixed income market
\nmovements.<\/p>\n

Policy<\/strong><\/p>\n

The second thing we know pertains to policy response. A large fiscal package can cure Covid-19
\nno more than can a cut in interest rates, the resumption of quantitative easing, daily foreign
\nexchange US dollar swap auctions, or the alphabet soup of liquidity supports from central banks.
\nBut these fiscal and monetary programmes can address and ultimately resolve the dislocation
\nseen in fixed income markets. A central bank controls the money supply and can \u2013 with enough
\nwill \u2013 buy every asset in an economy with newly created reserves. While central banks cannot
\ncure the virus, nor might they be able to deliver perfect cryogenics to the economy at large, they
\ndo have ultimate control over whether the acute fixed income market dislocations are allowed to
\nthrow the financial system into disarray and deliver a second Global Financial Crisis. And they
\nhave announced actions of mindboggling magnitude and with stunning speed.
\nThe third thing we know is that the shock to economic activity is going to be enormously large in
\nthe short run as sectors of the economy simply shut down. It is not clear yet whether attempts at
\ncryogenics will succeed. As such, the sort of leading economic indicators that we look to have
\nlittle meaning and feel extremely lagging. Analyst estimates of company earnings have not fallen
\nwith the magnitude that our colleagues across the investment department are looking for, but nor
\nare analyst estimates for 2020 seen as important data points \u2013 what matters is how the world
\nemerges in 2021-22.<\/p>\n

What are we doing with these understandings?<\/strong><\/p>\n

Safely tucked behind screens, portfolio managers talk about \u201cthe fog of war\u201d in times of
\nmeaningful uncertainty. The phrase resonates, but with real threat to human life all around it
\nsounds flippant. Instead we proceed tentatively based on how we understand the world to have
\nchanged, and how financial markets have priced it to evolve. We continue to characterise the
\nCovid-19 pandemic as a serious but temporary shock, and understand that while policymakers
\nwill not be able to deliver perfect cryogenics, they have demonstrated a determination to cap
\ndiscount rates on financial assets and so prevent the public health crisis metastasize into a
\nglobal financial crisis.<\/p>\n

So today we upgraded investment grade credit from neutral to favour, and we also upgraded our
\nProspective Return to Risk (PRR) score from neutral to favour. All else equal, we will be
\ndeploying more portfolio risk with the view that this risk will be compensated with super-normal
\nreturns over the next 12 to 18 months. But the situation remains fluid.<\/p>\n

As fixed income markets have become dislocated so the absolute volatility of their returns have
\nrisen, and the correlation of their returns has shifted higher versus other risk assets such as
\nequities. As such, portfolios with exposure to corporate credit have seen the risk contribution of
\nthese credit exposures jump higher, and their aggregate level of portfolio risk jump higher.<\/p>\n","protected":false},"excerpt":{"rendered":"

The ultimate public health costs and economic impact of Covid-19
\nare at this time unknown. Public health responses have weighed the
\nhuman cost of intensive care units being overwhelmed and the
\nnumber of preventable deaths exploding against the jump higher in
\nunemployment…<\/p>\n","protected":false},"author":1,"featured_media":90447,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":[],"categories":[1483],"tags":[1809,1655,2073,1943,1651,1437,1807,2148,2068],"_links":{"self":[{"href":"http:\/\/beta.next-finance.net\/en\/wp-json\/wp\/v2\/posts\/90449"}],"collection":[{"href":"http:\/\/beta.next-finance.net\/en\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"http:\/\/beta.next-finance.net\/en\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"http:\/\/beta.next-finance.net\/en\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"http:\/\/beta.next-finance.net\/en\/wp-json\/wp\/v2\/comments?post=90449"}],"version-history":[{"count":0,"href":"http:\/\/beta.next-finance.net\/en\/wp-json\/wp\/v2\/posts\/90449\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"http:\/\/beta.next-finance.net\/en\/wp-json\/wp\/v2\/media\/90447"}],"wp:attachment":[{"href":"http:\/\/beta.next-finance.net\/en\/wp-json\/wp\/v2\/media?parent=90449"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"http:\/\/beta.next-finance.net\/en\/wp-json\/wp\/v2\/categories?post=90449"},{"taxonomy":"post_tag","embeddable":true,"href":"http:\/\/beta.next-finance.net\/en\/wp-json\/wp\/v2\/tags?post=90449"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}