FIXED INCOME PERSPECTIVES
Quarterly insight from our fixed income teams to help clients navigate the risks and opportunities ahead.
Themes in Focus, June 2020
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By Jim Cielinski, Global Head of Fixed Income
- The severity of the economic impact from the COVID-19 crisis is as bad as we thought, with Q2 likely to be one of the worst quarters of growth on record.
- But markets respond to change, and the potential for near-term growth and repair as economies come out of lockdown, coupled with aggressive fiscal and monetary stimulus, is allowing markets to seemingly disconnect from the economy. Without another shutdown, however, what markets are beginning to price in is understandable.
- For those that do have a longer horizon, if we can get growth going again, we might be able to look at this in the rearview mirror and say it was one of the sharpest but also one of the shortest recessions on record.
- Explore our investment teams' insights below and read Jim's recent paper "After the Virus: A Binary World" here.
Hello, I’m Jim Cielinski. And we’ve almost run out of superlatives to describe the current market and economic environment. But when I think back to when the COVID-19 crisis unfolded in Q1, we were recommending that investors focus on three critical questions and it’s worth revisiting those today. One was, what’s the policy response going to be; two was, what is the likely duration of this shutdown; and three, what was the likely severity of the shutdown?
First of all on policy, so policy makers have panicked and they’re still panicking. We have seen the trifecta of policy, meaning fiscal boost is coming. We’ve had enormous budget deficits opened up, but we’ve also seen on the monetary side in QE, balance sheet expansion is going to exceed $6 trillion by the time this is over. And we overuse the word unprecedented, but this is truly a staggering number. And then third, policy rates in the G7 have hit record low levels. Almost everywhere is approaching zero or below. And so this has also allowed policy makers to do the fourth and rather magical kind of policy initiative which is to get investors to believe that they fully have their back and there’s more to come if needed.
On the duration and the severity, the severity, it’s as bad as we thought it would be. Q2 will be absolutely horrible, one of the worst quarters of growth on record. And it will be enough to drag the full-year growth across the globe to about -5% or -6% this year. So the damage has really been painful and that’s why the duration of the shutdown was always so critical. You can’t have this last for very long before you really start to impart, I think, permanent damage to the economy.
And so on the third question of duration, I think that’s probably the most positive development. We are seeing economies come out of lockdown and that’s important. So technically, what we could see if there is not another shutdown, is that the recession ends in the second quarter and that by June, we’re back in growth mode. But to get back to where we were a year ago, it’s going to take at least another one-and-a-half to two years from today. And for some sectors, they might never get back to where they were. And so I think it’s important to keep that in mind.
Markets, though, do respond to change and the mere fact that growth will be recovering, I think, is what’s allowing – in conjunction with the policy response – markets to seemingly disconnect from the economy. But, look, markets always bottom in recessions and so you always get bear markets ending in recessions. And markets do predict the turn and if you believe that we won’t have another shutdown, you can believe in what markets are beginning to price in today.
The real risk is a wave of kind of rolling peaks or second peaks of the virus. But to shut down economies again, I think, is almost out of the question. And that’s for several reasons. One, the political fortitude isn’t there, but two, citizens’ fortitude isn’t there. Three, we’ve learned a lot about how the disease, I think, spreads, who’s most at risk and how to protect those vulnerable parts of the population. But we’ve also made significant advancements in contact tracing, in medication and so we’re better able to deal, I think, with the consequences.
And also really important is the idea that those economies that were in complete lockdown actually have not exhibited statistically a lot better results than those economies that are observing social distancing, wearing masks, washing hands regularly, and so it’s becoming more apparent, I think, that there are ways other than locking down an entire economy to controlling the virus. And this is what will allow growth even though growth is going to be extraordinarily uneven, it will allow growth and it will allow some repair to take place.
What does this mean for some of the fixed income markets? Well first of all on rates, look, central banks don’t want rates to go up. They’re buying enough of the bond market to probably preclude that from happening in any meaningful way near term. I think the financial repression that you get through really low short-term rates but also really low long-term rates is something they’d want to keep in place.
On the credit side, what we’ve seen is liquidity returning and what we’re likely to see going forward because corporations had a lot of debt on the balance sheet, they will now go into a term out and then delever type of mode. And so by terming out debt, they’re removing the liquidity risk that might come in having to meet near-term maturities in a second wave, for example. And they now have a lender of last resort in central banks who are actually buying and funding corporations. And so when I combine all these together, I look at an economy which is still challenging, it will create some defaults. There’s no doubt we’re going to see more of those. But for those that don’t default, what you’re likely to see is a trend toward deleveraging and as that occurs with the liquidity backstop, I think corporates are well poised in this kind of environment, where you get an uneven and very slow recovery, to do well.
Mortgages and asset backed, so parts of that market really haven’t seen the protection that other parts have. But again, we’ve seen quick recovery in those sectors that are more interest rate sensitive like housing, and so this, I do believe, should be enough to kind of carry a lot of those segments of the market, I think, tighter. And so I do see the negative interest rate or really low interest rate environment in this context to providing an additional impetus, I think, for investors to seek out yield with some safety. And combining those things means that some non-government securities, particularly higher quality, should see good demand but also good protection from policy makers.
So again, we’re not out of the woods. There is significant risk that the virus spreads or that we have to lock down certain components of the economy. I think the risk is lower than it was because we’re not likely to lock down the whole economy. But for those that do have a longer horizon, if we can get growth going again, we might be able to look at this in the rearview mirror and say it was one of the sharpest but also one of the shortest recessions on record.
Quantitative Easing (QE) is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the markets.
The Group of Seven (G7) is an international intergovernmental economic organization consisting of Canada, France, Germany, Italy, Japan, the United Kingdom and the United States.
Term Out The recapitalization of short-term debt to long-term debt on a company’s balance sheet and/or extending the debt maturity profile of a borrower during refinancing.
Mortgage-backed security (MBS) A security which is secured (or ‘backed’) by a collection of mortgages. Investors receive periodic payments derived from the underlying mortgages, similar to coupons. Similar to an asset-backed security.
Asset-backed securities (ABS) A financial security which is ‘backed’ with assets such as loans, credit card debts or leases. They give investors the opportunity to invest in a wide variety of income-generating assets.
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