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23th April Market Commentary - "The eye of the storm"

By Henry Adams on 2020-04-23

It feels to us that we might currently be in the “eye of the storm”.

The extreme liquidity shock that hit the wholesale funding markets in late-March has abated, for now. However, we have continued to see an increasing number of open-ended funds implementing gates over the last few weeks (Fitch summary here). We have also seen some “cash-plus” funds exposed as “cash-minus” funds as their NAV’s dived by as much as 1.5% on the back of investor redemptions that forced sales of less liquid investments. Despite the fact that these losses seem to have escaped the mainstream press, we hope that the recent market moves will shine a light on some of questionable marketing strategies that enticed clients into “cash” strategies that turned out to be rather more risky than investors might have appreciated.

Whilst Central Banks have opened their wallets at breakneck speed over the last month (albeit taking longer to deliver in some circumstances) it is difficult to see how default rates do not rise significantly from here. Despite interest rates globally having fallen to all-time lows, this has not translated into lower borrowing levels for most - we are seeing the [dramatic] return of the credit spread, which appears here to stay, at least in the near- to medium-term. Thus far we have seen approximately $8Tn globally in stimulus and undoubtedly more will follow.

This week’s oil shock (with the May WTI contract trading negative in its last hours) has been passed off as something temporary that only affects small number of traders. But we are seeing the next contract values also deteriorate as supply continues to far outstrip demand and storage space continues to be at full capacity – a dynamic that is unlikely to dissipate any time soon. Whatever your view of the long-term, this week’s moves represented a 40-standard deviation shift – in our experience, most “stress-tests” are calibrated on 3-5 standard deviation moves – so the use of the term “unprecedented” is not an over-statement of the level of volatility that we are seeing in all corners of the financial markets.

There will certainly be spill over effects from this (pardon the pun), in particular to the smaller independent players in the oil sector. Whilst a recovery is of course expected, not everybody can nor will survive. Implications of pricing at historical lows is not just affecting those directly in oil production and refining - there are several already fragile sovereigns for whom oil is the only game in town (think Venezuela, Argentina et al.). Contagion is real, and the stresses of the continued lockdown are already creating significant issues in large swathes of the market from auto loans to commercial property and beyond.

With borrowing costs having remained at historical lows for far too long, sadly it appears that Covid-19 has brought about something of a time of reckoning. With unemployment rates in the US rising to in excess of 20 million new jobseekers in a month and unemployment rates in many other nations also rising at a rate never seen before, it is hard to see how this will reverse as quickly as it took hold. Of vital importance is that the displaced have the opportunity to return to work as safely and as quickly as possible. We are obviously not medical experts but the ability for this to happen swiftly, in the absence of a vaccine, seems questionable at best.

In GBP we continue to see UK Treasury Bills being very well bid - the additional supply is being absorbed easily at fair levels, for now. The various historic programmes implemented by the Government to support businesses of all sizes are helping contain (or at least delay) an economic catastrophe in the very short term. But the longer that this goes on, the harder that it becomes for us to plot our way out of these “extraordinary” “short-term” measures, even when we move out of lockdown.

Whilst this fiscal year that has just begun, we already know that we will see record levels of Uk Government debt being printed. As such, the controversial backstop of the Bank of England and monetary financing seems prudent as a temporary measure to ensure that government funding rises as swiftly (and cheaply) as required. Large swathes of T-Bill issuance have also been a key tool in the US in order to finance the various programmes including helicopter money (where citizens are directly credited an amount by the government).

US money market funds in the “Prime” space have seen huge outflows to the tune of $116Bn since the virus hit (Crane Data/S&P Global) and the necessity for the Fed to step in to backstop these “AAA” vehicles that are perceived “risk-free” (as they did in 2008), has once again highlighted the persistent structural instability of maturity-transformed fixed income funds, which is hidden in “normal” times but is exposed exactly in the circumstances when liquidity is most needed.

Yields on MMFs have also dropped rapidly as funds have started to invest shorter and all seem to be targeting the same “opportunities”, further compressing yield in short-dated repo and bills. It seems inevitable that the taboo of negative rates in such funds denominated in USD may have to be broken in the absence of a very sharp recovery from this crisis.

Losing money to invest in a basket of unsecured credit may have become the “new normal” for EUR investors over the last couple of years but it still seems both counter-intuitive and unwise given the sole purpose of these vehicles have been the promise of daily liquidity and protection of principal. Assuming that the US does its very best to avoid negative base rates (our central case), It will be very interesting to see how this dynamic plays out in USD in the coming months, as current MMF fee-levels would imply negative rates in USD Government MMFs in the near-term.

The EU is meeting today to continue the discussion of the mutualisation of debt. As time goes on tensions continue to rise. The difficulties of centralised monetary policy without commensurate fiscal centralisation was well documented in the last EUR sovereign crisis and it is sadly rearing its ugly head once again. Given the current pace of change, with an almost complete standstill of the economy, the sense of urgency is even greater now.

Whilst everyone is keen to find 0.00 or better for their EUR cash, rates continue to deteriorate and, much like in other currencies, risk-off sentiment continues to prevail with the idea of taking security against the placement of cash with financial institutions appealing more than ever. Rate has become somewhat secondary.

We increasingly hear from clients in all currencies that the return OF capital is much more important than the return ON capital; and we expect this dynamic to be more important than ever enter the next phase of the current crisis.

In more positive news we are seeing the curve flatten in several countries with a cautious easing of restrictions in a number of European countries. Today also marks day 1 of vaccine testing in the UK. Historically to get to human clinical trials would take years, it is amazing what we are capable of when together we focus on the most pressing matters and all do our part to achieve it.

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