Given the nature of this shock, not only to the financial system, but to the economy and even corporate and household behaviour, we sit here today wondering if this time may indeed be different. Who would have thought that 6.6 million Americans could file for jobless claims in the space of one week (with over 3 million the week prior), when the weekly peak during the financial crisis was 665k?
Add the impact on the human psyche of a genuine health crisis and it makes us wonder whether traditional reference points for assessing valuation serve as a useful guide to navigate the period ahead. We have to consider the outlook and the appropriateness of value in the context of unprecedented uncertainty in the absence of guidance from past episodes. We question whether the ‘buy the dip' and mean-reversion strategy that may have worked in the last 10 years, will work again.
We still do not know whether the policies enacted by central banks and governments will be enough. We still do not know how the virus will playout, whether we see a secondary wave of infections, and one cannot look to the recovery in China as a template for all. We still do not know the true impact on corporates given the severe lack of earnings visibility. Throw-in the oil price war and the potential for unknown unknowns and the picture becomes even more bleak.
We know that we have witnessed a significant shock to the economic system that is globally synchronised and we are headed for recession. The key is determining what type of recovery this will be. For us, it will not be U-shaped but rather L-shaped. We welcome the actions taken by policy makers and it was reassuring to see the speed at which governments reacted, which suggests to us that they too see a pure monetary response to this crisis as inadequate.
We do not feel that central banks have run out of ammunition in their ability to support markets. The Fed and Bank of England have included high quality corporate bond purchases in their response and it should not be thought of as impossible for global central banks to consider purchasing equity ETFs or even BB-rated names.
Credit valuations look attractive but tread carefully
Certainly, valuations look more attractive relative to recent history and spread levels (and outright yields) have improved. We would highlight that short-dated credit markets have been particularly beaten up as investors looked to raise cash.
However, it is difficult to frame these spread levels against the right reference point given how unique this crisis is. We are certainly not out of the woods yet, but this opportunity is allowing us to pick-up good quality assets as attractive levels.
Downgrades and ‘fallen angel' risk
We have already seen record levels of downgrades within investment grade (IG) let alone the largest ever recorded fallen angel from IG to high yield (HY). The second order implication of these downgrades needs to be considered.
Firstly, within IG, single-A rated names moving to triple-B have big implications for insurers in terms of the level of capital required against this. Secondly for HY, fallen angel risk is material and warrants caution. Ford being downgraded from IG to HY was the largest ever fallen angel and we see more of this to come. There are big questions over whether HY investors can absorb these large debt stacks. Further worryingly for HY investors is the ability to absorb debt that is long in maturity which IG companies often have.
The great reset
This current crisis therefore marks a line in the sand for companies, ratings agencies and investors alike:
- Corporates: in order to satisfy shareholders, corporates had indulged in unprecedented levels of share buybacks and dividend payments which have often been a headwind for corporates and bond holders (we would highlight British American Tobacco as an example of this). This crisis will allow companies to reset to more affordable dividend levels and reset their level of buybacks too. We have already seen a number of banks suggest they will cut their dividends. Government support to corporates will come with conditions and we see other sectors moving to cut dividends too and large scale cuts will have big implications for equity investors. Investors seem to be getting more bullish on risk assets on valuation grounds alone, despite there being no conviction/foresight on dividends, share buybacks or earnings.
- Ratings agencies: many companies have been operating above their true bond rating and this crisis will serve as an opportunity for ratings agencies to reset their views and ratings to more appropriate levels. We have already seen a wave of downgrades and we see more of this to come. Active management and large research functions will be absolutely essential in the months and years ahead.
- Investors: Finally, we see investors resetting. After the 2008/09 crisis it look a long time for investors to get the Fear Of Missing Out (FOMO) feeling back, and we think the same will happen again. Once this immediate health crisis recedes and the global economy is on its knees, investors will prioritise capital preservation rather than capital appreciation once again, just as they did during previous crisis periods.
Lessons from Japan
Recent events accentuate the global debt problem and reaffirm our "lower for longer" thesis. In order for this level of public sector spending to be sustainable and/or for governments to remain solvent, yields will have to remain low, just as they have in Japan for decades. Central bank balance sheets will remain elevated to help cap yields and should the bond vigilantes try to push yields higher we could even see yield curve controls introduced, just as they were in Japan.
We can take some lessons from Japan as we continue down the low-growth, low-yielding and low-inflationary path. In Japan, high-quality and non-cyclical companies have done well relative to their cyclical peers and relative to equities. Over the last 20-years, high-quality bonds issued by Japanese utilities companies have outperformed their financials counterparts and the Nikkei 225.
Tentative signs from today's sterling new issue market suggest this will be a high-quality and non-cyclical rally too. New issues have come with big discounts and non-cyclical credits have tightened more so than their cyclical peers. It seems bond investors are looking through to state of the economy after this immediate health crisis ends, and it is not a rosy picture.
High quality corporate bonds sit in a good spot but active management is key
When considering the reset theme, the central bank and government support for high quality corporate bonds, the history of high-quality corporate bond returns in Japan, the level of uncertainty still out there and the risk-return characteristics of corporate bonds, we feel the asset class sits in a very good place. Governments leaning on corporates to cut dividends are positive moves for creditors. Indeed, it makes the income argument more attractive for fixed income.
That said, there are big challenges for corporate bond investors as we move through to recession with all the associated outcomes from this; migrations across the ratings spectrum and a pick-up in defaults. Monetary and fiscal support are no substitute for intense scrutiny of corporate balances sheets and liquidity. A large research function will be paramount to navigating this challenging period ahead. This is absolutely the time when active management has to step-up.
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