…and I thought we’d seen it all in 2008.
We have updated our views on global credit to a more positive outlook in recognition of both the meaningful change in valuations this month and the significant policy response that has been delivered to combat the economic fallout from COVID-19. The speed and magnitude of the move has been breath-taking.
By way of comparison, over the September-October two-month period in 2008, global investment grade credit posted an excess return of –11.3%. By close of play on Monday [23 March 2020], the same asset class had returned –12% in March alone.
Why are we more positive?
As has so often been the case, the significant intervention by the US Federal Reserve (‘the Fed’) has moved us to a more constructive view from a risk perspective, and has increased our confidence that systemic issues have probably been put to bed. While we are not out of the woods, the Fed’s response was both broad and deep and will be aggressively deployed.
We think the market has priced in a lot of the uncertainty and now fully expects the second quarter to be a complete global economic collapse – the scale is such that, arguably, the size of the contraction almost doesn’t matter. It also looks like faith in the ‘V-shaped’ recovery has been eroded substantially within consensus opinion.
Monday [23 March 2020] may not have been the trough - we could obviously experience another test as London and other areas of Northern Europe are braced for a similar escalation in cases and fatalities to that seen in other countries. However, I think we are probably close to the end of this part of the bear process. I become suspicious when I see +10% moves in equities – it suggests a bear market rally rather than something sustainable. So the immediate price action we observed yesterday probably doesn’t yet support this thesis.
My longer-term concerns are threefold:
- Which companies now have unsustainable capital structures? The world is not going to be the same or go back to normal for the next several quarters. The Fed is now buying the front end of US investment grade credit, but it’s dangerous to assume they are going to buy the debt of every company at a given price – they will support the market where it has reached some reasonable fair value. If XXX Inc’s leverage is going from 4x to 6x, it is going to be a BB/B company and that will have to be priced in. So there is still a working out of fundamentals to calculate, because we will have companies with unsustainable capital structures - not just for one quarter, but going forward.
- This is the first wave of the virus. Having begun last November, it is currently expected to ebb and flow for a year, going by recent media reports. The southern hemisphere is likely to suffer more now, when it’s their winter. There’s much debate around a second wave in the developed world, maybe immediately or later this year. We don’t really know at this stage, but there will be ‘echo’ effects from the virus that will continue to move markets.
- Sovereign ratings, especially in Europe. Corporates will not be the only ones to escape the actions of rating agencies. The scale of the fiscal moves taking place here is unprecedented in peace time. Many countries will ultimately come under ratings pressure.
The broader picture
We therefore have a more traditional credit cycle playing out against the difficult backdrop of these unknown virus echoes for the remainder of the year. Many companies have been over-levered for their ratings in the first place, but looking ahead it is more challenging to estimate the going rate for EBITDA for a number of industries.
We’ve had a substantial downdraft in markets, which has taken place in just over a month, but I think we’re close to that being done. You could say it was systemic, or you could almost call it a ‘crash’ or ‘market-driven event’, with a fundamental underpinning. I think any rally should be of sufficient duration to be captured before the challenges above re-impose themselves on markets.