When we became more constructive on credit during March’s COVID-19 ‘crash’, we highlighted three key concerns that we thought would affect markets for the foreseeable future:
- Companies with unsustainable capital structures
- Virus ‘echoes’ and the risk of a second wave
- Sovereign rating risks, given the enormous fiscal policy response
Following the second quarter’s sharp recovery in risk assets and economic growth, all three feel as valid today as they did in the midst of that tumultuous period.
Unsustainable capital structures
With markets rallying so strongly, companies have been quick to exploit the demand from credit investors through record new issue volumes. But this necessary and prudent response to plug sizeable cash holes in balance sheets has come alongside substantial increases in leverage. Investors are poring over the latest company earnings to better gauge both the scale of the deleveraging now required, and whether the sharp recovery in economic activity is translating as swiftly to a recovery in company profits. It is worth reminding ourselves that while the fiscal response has been enormous, it was largely designed to protect household income, not corporate income.
Through most of the second quarter, our biggest short-term focus was the US attempting to reopen their economy prematurely; the recent sharp increase in infection rates raises the risk of a more traumatic outcome. We are probably reliant on positive news in the development of a vaccine to help markets side-step growth concerns.
The fiscal day of reckoning
A key question is whether policymakers will address exploding budget deficits, or whether they will continue to run their economies full throttle with both fiscal and quantitative easing taps in full flow. So far, nobody has suggested a replay of 2010, when governments arguably pivoted too quickly towards austerity.
We remain of the opinion that all of this is playing out in, and further contributing to, a geopolitical recession. For us, the ‘Trade War’ was always the opening salvo in a longer period of strained US-Sino relations. This has already had significant economic consequences, but left unchecked, this global ‘decoupling’ could extend from diplomatic channels to the board room.
Beyond the first step
Extraordinary policy measures have done a good job of insulating both markets and, to a lesser extent, economies from the government-mandated economic shutdowns. We remain broadly constructive on credit as a result, despite the improvement in valuations. Nevertheless, we suspect there will be greater uncertainty ahead. Further out, there will be some harder choices on how to ‘allocate’ the accumulated costs of the policy response to the virus. In a sense, the first step was the easiest – no cost was too great and governments’ incentive to spend has not been questioned. Subsequent decisions are likely to be harder.
This article is an abridged version of one which appears in our Q3 Global Fixed Income Outlook. To read the full article and for more on our global fixed income views, please click here.