June 08, 2020
The jobs of portfolio managers, or any investors, would be easy if they had the benefit of perfect foresight. Or, would they?
Let us take a step back to May 2019 and imagine that we had found an in-depth article from the future, dated May 2020. This article describes a global pandemic called COVID-19 virus that has infected more than 5 million people globally to date, remains uncontained, without a vaccine, and has tragically killed more than 340,000 people. It further details that the extent of the economic impact is still unknown, but the global economy has ground to a synchronised halt. And that most countries are in total lockdown or have been practising social distancing for three months, while since March, almost 40 million Americans have applied for unemployment benefits and those fortunate enough to work are almost all doing so from home. This article from the future does not refer to financial markets and asset prices. So, as portfolio managers, given that we cannot trade futures on economic growth, we have to guess what the impact would be on asset prices. It is fair to assume many of us would not have predicted that in such a scenario the S&P 500® Index would be up over 5.5%, from May 2019.
This is the dilemma that we faced as we approached our May 2020 Macquarie Fixed Income Strategic Forum. On the one hand, we had this incredible backdrop, in which COVID-19 had caused a sudden global synchronised economic stop, the likes of which very few could have ever imagined. On the other hand, this shock was met with significant monetary easing from central banks and a large fiscal response from governments globally. Asset prices reacted to the policy response and seemed to be discounting or ignoring the extent of the economic shock.
For our Strategic Forum, we began our internal discussions with a deep dive into understanding the sequence of events that created this unprecedented environment. The aim of this analysis was not so much to ascertain the depth of the economic impact, as its severity is evident, but rather more importantly to assess how long the environment could last and how quickly a recovery may occur.
The questions that we grappled with and attempted to answer at the Forum were firstly, are asset markets and prices correctly focused on the monetary and fiscal packages, or is there more pain ahead? And secondly, what does this mean for fundamentals?
The framework we used to help analyse these questions was to focus on the nature of the virus, governmental response to the virus, and the resulting economic impact. Then we debated the potential shape of the recovery, how we see that evolving, and finally the policy response itself. Was the response enough to fill the economic void created by the virus?
We concluded that central bank liquidity may “flatten the curve” by creating more time for companies, particularly larger ones with strong balance sheets, to adapt to the new “social distancing economy.” However, we question whether the lack of adequate cash flow to support existing and growing debt service burdens can ultimately avoid widespread defaults in many small- to medium-sized businesses, and also the more leveraged, larger companies that reside in the high yielding areas of the credit markets. As such, we advocated that there will be many holdings, particularly those in the services sector, where for at least the time being or until valuations adjust accordingly, it will be wise to “maintain your distance!”
The nature of the virus, the response, and the economic impact
We first examined the nature of the COVID-19 virus and past pandemics. In short COVID-19 is a serious flu-like, respiratory virus that has progressed to become a global pandemic. It is very contagious with the greatest health impact for the elderly and vulnerable.
Secondly, we analysed the various governmental responses to the virus on the health front, exploring the design and intent of concepts such as “flattening the curve” that have been widely adopted as mitigation policies, now known as “social distancing” or “lockdown.” Here, we highlighted that the flattening the curve / social distancing response is by design aimed at containing, not eradicating, the virus. It was intended to draw out or prolong the impact of the virus to prevent health systems from being overwhelmed and to allow much needed time for medical research organisations to identify treatments or, even better, a vaccine. Social distancing and other mitigation policies do work to constrain the spread of the virus. However, with relation to mitigation policies we noted a high degree of inconsistency between differing countries and in the case of the US for example, even differences within states and counties. The re-opening following the lockdowns is also being pursued differently by country, by state, and even by city. With no effective treatments yet, and a vaccine unlikely within 12 months, as mitigation and social distancing guidelines are relaxed, health research-based modelling (such as the Imperial College of Australia) indicates that the number of virus cases will likely go back up. We can see instances of this evolving with hotspot locations and a number of countries experiencing cluster outbreaks and secondary waves. In conclusion, it seems very likely that the virus will be with us for a considerable period of time, quite possibly following the timelines of previous pandemics.
Finally, we examined in detail the economic impact from this widely adopted response. In short, the lockdown response caused a global synchronised sudden stop centred mostly, but not only, on the services sectors that are the largest components of most developed economies. Everything from airlines, travel/tourism/hospitality, commuter transport, restaurants/sports/entertainment, all the way through to office workers (and by implication commercial real estate) have been severely impacted. The impact is most clearly seen in the unprecedented surge in unemployment levels in the US, with almost 40 million so far, and a similar trend witnessed throughout the world.
In retrospect we pondered, given the incredible economic impact now apparent, was the extent of the lockdown too severe? Quite possibly; however, only time will tell.
Maintaining your distance – the realistic nature of the recovery
With the acute depth of the economic impact now visible, our first important question to answer was “How prolonged will the return to normal be?” As part of our analysis, we leveraged the views of Macquarie’s own well-resourced crisis management team, which has been actively in touch with authorities globally over recent weeks, working to better understand in part how and when a return to normal working conditions might occur. A key takeaway for our team was an appreciation that unless a vaccine is found soon and becomes widely available, all other recovery scenarios include the reality that we will experience a prolonged period of practising social distancing. With this came the realisation that all those severely impacted service sectors will remain so, or at least be required to operate in some form of restricted or adapted capacity for a considerable period of time.
As such, our assessment of the types of possible recoveries was grounded in this reality. So many services are unprofitable in an environment where everyone must remain 1.5 metres from each other. The list of impacted businesses is exhaustingly long.
We also undertook a case study on China that asked the question, “Is China back?” Again, our assessment focused on the lingering impact of social distancing through ongoing consumer caution. Our analysis highlighted that as an export economy, China is now also dealing with the rebound effect of sorts, in that the global economy and its buyers are no longer demanding products anywhere near previous levels of demand. Another related headwind is that with the approaching US election, we are likely to see rising geopolitical tensions between the two regions further weighing on the global recovery. This case study highlighted the difficulties the global economy is likely to endure in its attempts to recover as quickly as possible.
Therefore, in terms of recovery, we concluded a quick “V”(a V-shaped recovery) is really only possible if a vaccine is found. Otherwise, it is unfortunately very likely that the recovery will be inconsistent, entail varying degrees of restriction, be messy, bumpy, and ultimately a prolonged one. If we were to just focus on fundamentals, there is little doubt that we would apply the social distancing guidance to financial markets and “maintain our distance,” particularly in the areas where current valuations do not appear to reflect the prevailing risks.
Can liquidity prevent insolvency? The nature of the policy response
With this robust knowledge, we then turned our attention to the other response: the equally astounding “all-in” liquidity support offered by central banks and the sizable fiscal support afforded by governments all around the world. We are hesitant to use the word “stimulus” when considering the various fiscal initiatives globally, instead believing they are better characterised as “life support” designed as a partial bridge to somewhat offset the incredible and growing hole that COVID-19 has had on economies. It is not stimulatory – rather, essential support to so very many.
With respect to the massive central bank liquidity support, this is primarily designed to ensure smooth market functioning, keep credit markets open, and to ensure credit continues to flow into economies. Markets have embraced this incredible support as they have throughout the post global financial crisis years. Yes, central banks have “just been doing more” for over a decade already now, and have been called upon once again, and this time in enormous amounts and with unbelievable speed. Markets know very well how to respond by now, and this has driven a significant improvement in credit spreads and supported equity market valuations considerably.
As the saying goes, “Don’t fight the Fed.” The US Federal Reserve is a powerful factor that market participants know very well not to ignore or dismiss. Yet in highlighting this, we also must observe that while central banks can keep “doing more,” they actually cannot really address the virus itself, nor can they influence the period of time we will be required to socially distance. Therefore, central banks as well as governments will likely be challenged in their attempts to return business cash flows to the required levels that so many sectors in the economy so badly require.
This left us with another important question: “Can central banks’ liquidity support prevent the impairment of cash flow or deficient companies from becoming insolvent?” Particularly if the return to normal includes a considerable period of social distancing, the recovery will be very challenging and prolonged. Ultimately this question boils down to a simpler question: “In the face of enormous policymaker intervention that can and most likely will expand further, do fundamentals matter?” Can central bank liquidity and asset purchases maintain elevated valuations even if cash flows, particularly those in the many sectors in the services industry, remain largely and even permanently impaired?
Our answer to this question is that yes, central bank liquidity can create more time for companies, particularly the larger ones with strong balance sheets, to adapt to the new social distancing environment. However, we question whether the lack of adequate cash flow to support existing and growing debt service burdens can ultimately avoid widespread defaults in many small- to medium-sized businesses and also the more leveraged larger companies that reside in the high yielding areas of the credit markets.
Unless there is a vaccine, or a swift, adapted return to normal, our answer to this second big question is nuanced although it can be summarised neatly as the following: There are sectors, industries, sub-segments, and individual issuers that will endure or even thrive in this environment. However, we fear there will be many, many others, particularly those in the services sector, where for at least the time being, or until valuations adjust accordingly, it will be wise to “maintain your distance!”
Fixed income asset class implications
Against this backdrop and our already defensive yet selective positioning from earlier this year, our asset class implications follow:
Credit | With many companies withdrawing guidance, the backdrop is uncertain from a fundamentals standpoint; however, companies have levers they can use to dampen the impact. Within investment grade credit, the team has moved higher in quality and lower in cyclical exposure, advocating to maintain overall exposure with the potential to add on weakness. Within high yield and bank loans, the team is positioned more cautiously with a quality bias, reflecting the disconnect between valuations and fundamentals, effectively identifying sectors and industries where it is prudent to “maintain distance,” believing valuations will in time adjust accordingly.
Structured products | The asset class continues to have divergent performance with those securities eligible for central bank support, performing the strongest. The team remains constructive on agency mortgage-backed securities (MBS), although acknowledge the limited potential for significant tightening from here. AAA-rated commercial mortgage-backed securities (CMBS) and collateralized loan obligations (CLOs) remain attractive, while lower-rated commercial real estate is likely to face medium-term headwinds and warrants maintaining our distance for now.
Emerging markets | Against a backdrop of mixed fundamentals, fair valuations versus developed markets, and neutral technicals, the team has an overall quality bias. Emerging markets’ (EM) fair valuations tend to reflect the indirect nature of central bank support they are receiving, and given the challenged outlook for many EM countries, a selective approach is warranted in taking advantage of opportunities. On a risk-adjusted basis, the team believes that the most attractive opportunities in the asset class are in US dollar-denominated investment grade and sovereign bonds. We are maintaining distance on EM currencies for now, awaiting more attractive opportunities.
Rates | With developed central banks at their effective lower bounds for monetary policy for now, the overall strategy is to accumulate duration on any pick-up in yields. While bonds are unlikely to act as the risk diversifier as effectively going forward, they continue to play a role as high quality liquid assets in portfolios.
Currency | The team is taking an overall defensive stance with a positive outlook on the safe-haven currencies of the US dollar, the Japanese yen, and the Swiss franc. A cautious to negative stance on the euro, British pound sterling, and G10 commodity currencies is warranted along with deficit EM currencies.