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27th May Market Commentary - At least the sun is shining!

By Henry Adams on 2020-05-27

There is plenty to be cheerful about since the lockdown began on 23 March (in the UK at least).

Thankfully we have seen what will hopefully be the only peak, and there does appear to be positive momentum by way of a gradual return to normality with further measures announced and more far-reaching parts of our economy and daily lives returning to something closer to normality over the coming fortnight. This is mirrored around many parts of the globe, with Japan removing the state of emergency yesterday and borders across Europe opening once again.

However, some parts of the market seem to fail to appreciate the degree to which the damage has already been done, and the difficulty in reversing the trends in both credit and sovereign risk. Specifically, stock market valuations do not seem to reflect reality. In the US, where the disparity is most extreme, the S&P 500 is off just 7.4% from the beginning of the year and the NASDAQ is UP over 4%. (and futures pointing to a further 1% gain today). Add to this the slashing of dividends, and it is hard not to conclude the very fundamentals of stock market investing will see further scrutiny at current levels. Bear market rally springs to mind...

We have even heard extremely stark warnings from the FED in their latest FOMC minutes and the Financial Stability Report, both highlighting deep concern around levels of indebtedness prior to the health crisis hitting the economy.

"[FED] Participants were concerned that temporary layoffs could become permanent". US unemployment figures have been very hard to fathom. The destruction of jobs since lockdown is now just inside 40 million, with further new jobless claims released in the next 48 hours likely to push this number safely into the 40’s. An inability to reverse this will be extremely painful for this consumption-driven economy. Also worth quoting was that "Participants saw risks to banks and some other financial institutions as exacerbated by high levels of indebtedness among non-financial corporations that prevailed before the pandemic; this indebtedness increased these firms' risk of insolvency" (for more see the Forbes article below).

Just this morning Christine Lagarde, President of the European Central bank has stated that it is very difficult to understand how badly the economy has been affected, that the ECB's "mild" scenario was out of date, and, that risks to the European economy are now classified as between their medium to severe scenarios. One can't wondering whether these messages represent an update in thinking from the Central Banks or whether they have just been "leading us in gently" in order to manage market reactions.

From a credit perspective, we have already seen material deterioration. The number of “fallen angels” (issuers losing their investment grade rating, becoming speculative, (and) historically termed (as)“junk bonds”) has risen by 24 just this year (at 30 April), with the number of issuers potentially within this undesirable definition exceeding forecast to exceed110, including a number of financial institutions. Sovereign (or country) risks have risen too with a swathe of downgrades and several defaults already.

Names such as Hertz, Latam Airlines, Lufthansa and American Airlines are all facing extreme difficulties in servicing debt (which one might expect of course given the nature of the shock), as the economies continue to stagnate at best. Further pain is being felt across the auto and retail sectors (and this) is beginning to seep down the supply chain where many more have historically been safely employed. There is also contagion into areas that were not at the brunt of the initial shock. With consumption down almost across the spectrum, getting the population re-employed (more on this below) and back spending, as well as contributing to the repayment of ballooning domestic government debt piles safely will need to take centre stage.

In the UK last week we witnessed for the very first time a government bond being issued at negative yields, the paper maturing in three years. UK Treasury bills also continue to move towards the zero mark, and with reduced supply this week this may too be tested, particularly in the very shortest issue where £500MM of 1 month debt could easily face bids of almost £3Bn if last week's interest is anything to go by. All of this with record issuance levels. To put this into context, the first month of the fiscal year saw net issuance of UK Government Debt equal total issuance for 2019/20.

Much like everywhere else, there has been a huge debt issuance program in the US to help try to balance the books following unprecedented fiscal stimulus and direct Federal Reserve support. This is not just for financial institutions but, for the first time, corporations as well. Demand for the safest of assets including US Treasury Bills continues to hold up very well given the magnitude of net bond issuance, but at some point one would expect yields to rise (assuming potentially falsely that base rate remains the same and marginally positive!).

Articles of interest:

Credit Trends: Potential Fallen Angels Hit A Record-High 111

If The Fed Is Worrying, Shouldn’t You Worry Too?

An FTF or Fixed-Term Fund is a regulated fund investment that offers exposure to a single investment-grade obligor for a fixed term, without the need for any client infrastructure. An FTF has many of the same characteristics as a term deposit, but can offer exposures outside of the banking sector. TreasurySpring is originating FTFs with sovereign, financial and corporate obligors.

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