Quarterly insight from our fixed income teams to help clients navigate the risks and opportunities ahead.

Themes in Focus, Q2 2020

Identifying the signposts: where next for fixed income?

By Jim Cielinski, Global Head of Fixed Income

Key Takeaways

  • Pay attention to the severity and duration of the downturn: Uniquely, both manufacturing and services are contracting simultaneously, disrupting supply chains across the economy. The ability to bounce back quickly is curtailed the longer this persists.
  • The virus is a catalyst that is exposing the overleveraged as it creates an exogenous shock to earnings and cash flow and limits access to capital markets.
  • Provided the downturn is short, existing policy stimulus should ultimately reignite interest in risk assets, including credit, but it is hard to see it fuelling inflation.
  • The common thread in all crises is that they end, and for that to happen, we need valuation repricing that overestimates risk, policymaker panic that leads to strong responses and visibility on control of the virus.

Video Transcript

What effect has the coronavirus had on fixed income?

The effect that coronavirus has had on fixed income markets has been truly breathtaking. We have seen in the first quarter some of the worst performance in risk markets that we have seen in history and certainly since 2008. Many valuations such as credit have gone from being in the most expensive decile to now in many cases in the cheapest decile in the space of 30 to 45 days.

So this is truly, I think, shocking. The speed of this adjustment is what has caught people off guard. Effectively, what we have done is shut down a global economy, and we have done that in the space of a month. Markets are not prepared to deal with those types of risks, and the genuine uncertainty that we are seeing today has really created a lot of panic in the markets.

Are we experiencing a reset of the economy?

I think, in many ways, this will be a reset of the economy. Again, we have closed so many large developed economies in a short space. You cannot just bounce back from that. And one of the big questions I have is both about severity and duration, and it makes a big difference to separate those two. The severity is what has come into clear focus for me. We know this is severe. We know that we are likely now to see a pronounced recession as we go through Q2, just because so many things have stopped.

Unique in this case, it will be a services and a manufacturing recession. We are so accustomed to having services do well, but this will be unique, and services do have supply chains just like manufacturing, and that is why the duration of this is so important. Supply chains, that underlying fabric in an economy, can actually withstand a disruption, say, for 30 or 45 days. It cannot withstand a disruption of 90 or 120 or 180 days. What happens is you get bankruptcies in all the intermediate steps, and therefore your ability to bounce back is really curtailed the longer this goes on.

We've heard a lot of talk, I think, about a V-shaped recovery, and there are many parts of the economy that if you saw the number of virus cases diminish, you would see a sharp bounce back. But for many, it will take a year. And if it goes on for six months before we get to that stage, it could easily take two years to bounce back. So, I think that is why the duration of this is so critical. It is what policymakers are not understanding, or at least until late in the game they did not understand, the knock-on effects, the cumulative effects, the disruption. The fabric in an economy is really important to keep intact, and the longer this goes on, the less able we are to do that. And that is very, very critical.

Have the authorities done enough?

I think it is a question about what policymakers and regulators can do and when is it enough. And that is a really difficult question. I would say this: When I look at panics like this in markets and see big corrections, the one common feature I believe is that crises end. There is not a common thread in a lot of other historical crises, but they do end. And they tend to end when, number one, in the markets, at least, when you get pricing that becomes so cheap that it really is overestimating the risk in markets. We have had dramatic repricing. So, I think if we are not all the way there, we’re at least a good part of the way there.

The second thing you need, typically, is policymaker panic, and it is only when they panic can we stop panicking as investors. So, for me, you needed to see the panic that you have seen, whether it is QE, almost every developed market central bank that can take rates to zero has done so. You need emergency buying programmes of bonds. You need special action to free up liquidity in markets that might be stretched. That is the kind of panic that we are now seeing. We will see more fiscal stimulus will become front and centre. That is the important next step.

Is it enough? Only time will tell. And only, I think, some sight of a bottoming in fundamentals is going to really tell us if it has been enough. So, I think they need to do more. They need to overdo it. They need to err on the side of doing too much here. And I think they can afford to do that. So I expect more. But ultimately the test of whether they do enough comes in a peaking of the number of cases in the virus that we see globally.

Does the stimulus sow the seeds of inflation?

There is always a question when fiscal stimulus blossoms of are we going to have so much money out there that it sows the seeds of inflation? And that is a good question. I think, ultimately, that if they did it repeatedly and did it often enough and the size was big enough, it probably would. Near term, it is important to realise that the fiscal stimulus here is doing nothing but just replacing lost income. And so inflation will come if you get demand. So a demand impetus might produce price pressure.

Real credit creation, again, can kind of be self-reinforcing and produce price pressure. But this is different. We are talking about sending money to people or helping them out. But all that does is replace lost income. It does not make people go spend. And without that, I do not think you get either of those other two components near term that would lead to higher inflation and probably not at this stage even higher inflation expectations. But it is something longer term I think we do need to keep a close eye on.

Is coronavirus the catalyst that exposes the overleveraged?

The virus and the corresponding economic shutdown I believe is precisely the kind of shock that exposes overleverage. We have always said in credit that you need some exogenous shock to earnings and cash flow, and you need limited access to capital markets to cause defaults. What you have here is a very abrupt loss of cash flow. Credit is very similar to selling an option, meaning that things might be fine in a year or two, say, in the restaurant industry, but if I run a restaurant and no one comes in for the next 90 days, I'm probably bankrupt.

And so the outlook for two years distant is not that relevant to me, and that's why leverage matters in periods like this. If this is long-lasting and severe, the overly levered companies that are in the market will see a large increase in defaults and failures. Equally overleveraged small-cap companies will suffer more. And so I think it is that kind of catalyst that exposes who is overlevered, who is very exposed to a sharp drop in revenues in a short period of time.

Are you surprised by some strange market moves?

Markets in periods of stress always do things that you do not expect or do not adhere to those time-tested relationships, and this time is no different. Bonds tend to go up in value when risky assets like equities go down. And that was holding true until very late in the quarter. But you begin to see just general asset deleveraging, and I think almost every financial asset was for sale. And when you see that, you start to see prices on virtually safe assets, all assets, safe, risky, credit, equity, they are all going down together. And that is often, by the way, a sign that markets are in that explosive sell-off stage.

And so in some ways, it feels very strange when it is happening, but it is often not a reason to panic. I think those relationships do tend to reassert themselves. But I think here we are just seeing asset selling. Many people thought it meant that supply or inflation expectations related to big fiscal packages were going to overwhelm the bond market. I do not think that was the case.

What could fuel interest in risk assets?

When I think about what could cause demand to return for risk assets, I can see a picture where after prices adjust and after you get a stimulus package on the fiscal side and the monetary side. Those were the two really important ingredients. The missing one is the third one that we have talked about and that is some peaking in the number of cases. And that is very critical for me because it is how long do you keep the economy in shutdown. That will tell you if earnings and credit risk is going to be something that you buy back into. And if it is a short shutdown, it is absolutely setting the platform, I think, for risk assets to come back. You always get opportunities in these markets, and many have developed, so that third missing component is what we do not have today. But if you had evidence of that, then the stimulus will really come through in a powerful way, I think.

How might this end?

I do think whenever you have these kinds of huge corrections and movements in markets, people just want to know what is next. And I would focus on identifying the signposts. First of all, do not focus on trying to predict the magnitude of these moves. I think that is extraordinarily difficult. We have talked about some of the things you need for a crisis to draw to a close. Put those up on the map. And as those happen, feel more confident taking risk, but recognise too that bear market rallies can be sharp and severe. People do not want to miss the opportunity to buy in, so they can often be too early. And, for me, knowing where the opportunities are is always critical.

But I hear that every time there is a big correction, it is all about the opportunities. But equally understand that there are risks that are different. Understand the opportunities, but put those in context with the risk. Make sure whatever you are doing fits with your objective but also fits with your time horizon. In these markets, we all tend to make trades that might make us look rather foolish on a one- or two-week period. The important thing is to adapt your time horizon and recognise that volatility is going to be a constant companion for many months to come and take positions by putting things on in a size that will not force you out if the volatility goes against you.

So, I think these are periods where you can step back. Know the rules have changed. We are talking about things, perhaps, like helicopter money. We are now at zero rates almost everywhere. We are probably going to hear a lot more discussion around Modern Monetary Theory (MMT). Do deficits even matter? We will hear about yield curve control. The old policy playbook in a matter of a month has played out, so we have used what we did in 2008. Now new tools will come to the fore, and that is true for every crisis. So be prepared for the environment to change and markets to move a lot. Volatility will persist, and recognise that there are opportunities and risks out there.


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