Co-Head of Global Bonds Nick Maroutsos discusses the US Federal Reserve’s (Fed) recent efforts to ease financial conditions and why he believes uncertainty will continue to be a headwind for markets.
- Following the Fed’s extraordinary actions over the weekend, we expect all global central banks to follow suit with rate cuts and/or quantitative easing.
- The easier financial conditions should, in our view, help well-managed and well-capitalised companies weather this storm, but other pockets of the market appear vulnerable.
- Lower prices in risk assets reflect the prospect for considerably slower economic growth in the US while globally the risk of recession has materially increased, in our view.
- We do not believe that the eventual recovery will be V-shaped. Rather, we expect that this episode will have long-lasting repercussions on supply chains, consumer behaviour and future policy, and that uncertainty will continue to be a headwind for markets.
In an extraordinary weekend move, the US Federal Reserve (Fed) cut interest rates by one full percentage point to a range of 0.0% to 0.25% – effectively its zero-bound. Furthermore, Chairman Jerome Powell announced purchases totalling US$500 billion in US Treasuries and US$200 billion in mortgage securities. Zero interest rate policy (ZIRP) and quantitative easing (QE) are back. Once again, the Fed has forcefully established itself as the swing buyer in the US Treasuries market and therefore positioned itself to greatly ease financial conditions by lowering the cost of credit across the economy.
A bazooka yes, but we may need a missile
While monetary policy will not solve the public health and economic crisis caused by the breakout of the COVID-19 coronavirus, it may provide policymakers time and corporations a needed cushion to weather the most acute period of this global storm. We believe that the Fed had no choice given the magnitude of uncertainty hanging over the economy and financial markets. In fact, our expectation is that all global central banks that have room to move will follow suit in cutting rates and/or implementing some form of QE.
Unfortunately – and as we have previously stated – every iteration of QE has resulted in diminishing returns. Furthermore, despite the 100 basis-point (bps) rate cut, one must ask how much of a credit impulse will reverberate through the economy when rates were already low by historical standards. The Fed knows this, and in light of this reality, we don’t think policy makers are done. Next, in our view, will be targeted programmes aimed at the most vulnerable segments of the economy. One prescription that we expect to get consideration is fiscal initiatives aimed at smaller businesses and wage earners most affected by these economic dislocations.
The infrastructure of US fixed income markets changed greatly in the wake of the Global Financial Crisis (GFC). Until now, the inner workings of these markets have yet to be tested. With banks unable to hold securities to cushion large price swings, the spread between buyers and sellers is resulting in extremely thin liquidity aggravating price swings. In the coming days and weeks, we expect these concerns to come to the fore, and cause the Fed to address this market vulnerability.
Similarly, given the large reliance upon short-term funding for banks, we believe authorities will need to step into this market to ensure proper functioning. Addressing potential liquidity constraints in the commercial paper market is likely on top of their agenda.
Why healthy balance sheets matter
Heading into this crisis, corporate balance sheets, by and large, were strong. Companies were flush with cash, and although debt loads have crept up, leverage ratios remain well below levels that existed prior to the GFC. The easier financial conditions brought about by the reimplementation of ZIRP, in our view, should help well-managed and well-capitalized companies weather this storm. Other pockets of the market appear more vulnerable. Companies that have barely held onto investment-grade credit ratings and feasted on cheap credit to grow for growth’s sake and reward shareholders at the expense of resilient balance sheets, may suffer should top-line growth decline considerably.
Recession risk increasing
Investors’ understandable allergy to market uncertainty is responsible for much of the pronounced price action in markets over the past weeks. But, to be sure, lower prices in riskier assets also reflect the prospect for considerably lower economic growth in the US and globally. One cannot turn off the consumption engine that is 70% of the US economy1 and not expect a very real hit to revenue growth. Consequently, the risk of recession, in our view, has materially increased. Globally, the virtual lockdown of Italy and Spain – not to mention China’s earlier massive curtailment of economic activity – will also ultimately be reflected in 2020 growth data. Hand in hand with lower economic activity is lower prices on riskier assets – both bonds and securities.
Caution merited at home and in markets
Prior to this crisis, US policymakers had the good fortune of having relatively more dry powder than other developed countries in the form of higher interest rates and balance sheet levels off their post-GFC peaks. Those have proven fortuitous. Similarly, corporations largely have sound balance sheets and banks remain well capitalised. Some investors may not have been so prudent, eschewing diversification while loading up on risk. Many bond investors abandoned the core tenets of a fixed income allocation – capital preservation and steady income – and instead approached the asset class as a slightly less volatile equity beta trade. In that respect, lopsided markets positioning may be adding to the downdraft as investors seek to raise liquidity.
We sincerely hope that authorities and populations take the necessary steps to halt the spread of this pandemic. Until then caution in both everyday life and financial markets is merited. Unlike others, we doubt that the eventual recovery will be V-shaped. Rather, this episode will likely have long-lasting repercussions on supply chains, consumer behaviour and future policy. In that respect, uncertainty will continue to be a headwind for markets.
1. Source: The Balance, 30 January 2020 (https://www.thebalance.com/components-of-gdp-explanation-formula-and-chart-3306015)