3rd May 2020

🗞️ Looking Beyond the Sombrero

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Glass half full…

March especially – and Q1 as a result, was awful. April’s final trading session ended on a sour note, leaving the month witnessing only a decent recovery for risk markets with the FTSE adding 4.1%, the Dax 9.3% but the S&P a not too shabby 12.7%. Concerted, aggressive and unprecedented stimulus packages did the trick. Investors were also mostly looking beyond the Q1/Q2 slump in macro – and trying to bag a bargain.

It might not be a V-shaped recovery, but we’re going to get some kind of a return to growth. The odds probably favour a ‘jagged swoosh’. Credit plays into it as well in primary, where demand for deals has been nothing short of insatiable. Unfortunately, the recovery in spread markets after the initial snap back – which was significant – is now becoming more laboured across the board.

Some of that might be to do with the record-breaking level of issuance in the IG non-financial market (€57bn in April). But, mostly, it has to do with the poor news flow and issuer headline risk associated with the collapse in economic activity. Opportunistic, defensive and desperate the primary activity has been – but treasury desks obviously feel they need the liquidity on board. We know there is a lot of pain to come.

IG spreads have tightened by over 60bp versus the late March wides (+90bp still year to end April). IG credit returned 3.7% in the month and total returns now sit at -2.7% year to end April. The most impressive snap back in spreads has been in the AT1 market where record wides of B+1515bp have since seen a recovery to B+875bp. Returns in April came in at +8% and for the year to end April the index is showing -11% in total returns (-18% in Q1).

The most confusing market has been high yield. GDP across the Eurozone has collapsed. In Q1, the Eurozone shrunk by 3.8%. French GDP fell by 5.8% in Q1 – and it will be worse in Q2. The region’s activity is on its knees and the scale of the damage is going to be unprecedented in peacetime.

Lagarde suggested the ECB’s ‘severe scenario’ was of -15% GDP in Q2 for the region and a fall of anywhere between 5 – 12% for the year. The central bank didn’t make any fresh policy moves, but made some adjustments to LTRO conditions, charging banks -1% for loans and extended the PEPP until the crisis ends.

Yet the high yield market has seemingly looked immune to the worsening conditions. At the worst point of the coronavirus panic sell-off in March, spreads on the index jumped to B+912bp – whereas the index rocketed to B+2200bp back in 2008 at the peak of the financial crisis. Spreads have ratcheted tighter as equities have rallied (B+650bp) and returns in April came in at 6%, but for the four months to the end of April, investors sit on losses of 10%.

The facts are that the market now is 7 to 8 times bigger (at €350bn) than it was in 2008. It’s more mature (more investors involved and fund lock-in dynamics prevent much of the panic exits) although we are still waiting for news of borrower hardship to filter through in a more meaningful way. But the news flow is bad and worsening. Weaker covenants might be helping. The default rate hasn’t yet jumped – it will. Borrowers have also spent the last 10-years terming out maturing obligations (less reliance on banks as funding disintermediation rose dramatically) and that might be helping.

There’s little by way of material action that investors can take (save for buying protection) given that the ability to trade at a reasonable price is severely curtailed. For others, there are some opportunities.

Needing to look beyond May’s poor macro

So we were met with a raft of poor economic data towards the end of last week. GDP in the US and Europe cratered, unemployment is rising sharply still, retail sales have plummeted, investment has stalled and inflation is falling although not as fast as we might expect. And we are braced for worse to come through May with a stemming of the tide, so to say, likely only occurring in June. Lagarde, Powell et al suggested as much.

We are going to look at it from a ‘glass half full’ viewpoint. Progress on all counts will be made, in our view. The policy action has been aggressive – from both a financial perspective but also from a health one where trial red tape has been cut massively in order to accelerate the process of drug development.

And we have coronavirus drugs trials going well – and plenty of them, with breakthroughs in cures/vaccines and the like quite possible. There’s also hope that we keep that ‘R-nought’ figure (well) below one, as the easing of lockdowns commence through May.

That jagged-swoosh recovery will have its pitfalls. But in the main, we are looking at some sort of upward trend from late May/June onwards in the recovery process. It also means that we are going to get some big down days in risk asset pricing. But we’re not going to get bogged down by them.

Clawing back some performance in April

For the year to date, those April performances pulled back from the worst of the Q1 numbers. The Dax in the period to end April is now down 18% (-25% in Q1) and the FTSE -21.7% (-24.7% in Q1). The S&P lost 20% in Q1 but is 9.8% in the four months to the end of April.

Credit has likewise recovered, with IG total returns at -2.7% in the four months versus -6.2% at the end of March. Financials total returns show a total return of 3.0% but the non-financial sector is outperforming, with -2.4% of returns in the Jan – Apr period. IG spreads will grind out some more performance but that might depend on how much primary feeds into the market.

The IG sterling market is the winner, up by 0.5% in the four months to end April, although Eurozone sovereigns show total returns of +0.7% in the same period. Sterling hasn’t been hit by a massive wave of deals although what has been issued has been lapped up. Gilts have held firm – if not better bid, and IG spreads have ground out some good tightening.

We have another shortened week, with the UK holiday on Friday, but we end with that non-farm payroll report for April. With the US losing over 30 million jobs as evidenced by the initial jobless claims (almost 1/5th of the workforce since the pandemic began), it is not going to be a pretty sight. The consensus is for 21 million non-farm jobs losses in April (yes, you read that right, 21 million!).

We’re halfway through the earnings season and it has been as bad as we might have thought, the problem being that Q2 will be worse. How much of that is factored in will go some way in determining how markets trade through the second quarter. Before that, Trump has been on yet another China-bashing spree and the threat of further tariffs has unnerved markets.

On the data front this week, there’s lots of it. We have the Caixin manufacturing PMI for April (expected 50.3), the Eurozone’s number is also due (exp 33.6) along with factory orders in the US – all on Monday. Crammed in thereafter before those non-farm payrolls we have services data, retail sales, industrial production numbers and so on across the various jurisdictions.

Have a good day.

Suki Mann

A 30+ year veteran of the European corporate bond markets and in his role as Credit Strategist, Dr Mann has been ranked number one in the Euromoney Investor Survey eight times in ten years. Previously with Societe Generale and UBS, he now shares views of events in the corporate bond market exclusively here on CreditMarketDaily.com.