Central banks picking up the bill

In April we saw further confirmation of the devastating impact of the coronavirus on both the real and financial economy. We also witnessed remarkable action in the oil markets as the May contract for a barrel of oil plunged deep into negative territory for the first time in history. Such an event reinforces the great level of uncertainty we still face regarding the second and third order effects of the coronavirus shock.

The International Monetary Fund (IMF) rightly describes this as a ‘crisis like no other.’ In its latest quarterly report titled The Great Lockdown, the baseline scenario forecasts -3% global growth for 2020, far deeper than the global financial crisis (GFC) in 2009. A strong rebound is still assumed for most economies by the end of 2021. The U.S. is forecast to grow at -5.9% this year followed by +4.7% next year, the Eurozone -7.5% and +4.7%, Japan -5.2% and +3%, the UK -6.5% and +4% and Canada -6.2% and +4.2%. This time around, there may be little help from China and the rest of emerging Asia. Emerging market economies are forecast to grow -1% this year. Forecasting in this environment is tricky to say the least. The IMF offers another scenario based on a possible resurgence of the virus and longer-term containment measures, which throws up much uglier numbers than those above.

Data throughout the month continued to beat estimates on the downside. In the U.S., the 22m jobs created since 2009 have been wiped out in the last five weeks. The last initial claims number of 4.4m took the total number of unemployed to over 26m. Canada saw its unemployment rate jump to 7.8% from a low of 5.5% in February. In the Eurozone, both manufacturing and services sectors have been decimated, with the composite Purchasing Managers Index (PMI) falling to an all-time low of 13.5. In the UK, services PMI fell to 12.3 and in Australia this number was 19.6, half the April figure.

The other side to this economic devastation is of course unprecedented fiscal and monetary support from governments and central banks around the world. Fiscal policy has been focused on easing the pain on households and small businesses and directing resources to the strained healthcare sector. Most governments have implemented some form of emergency loan or grant package to businesses, as well as wage subsidies, tax delays and in some cases ( Japan, U.S. and Hong Kong) direct cash payments to households. The result will be an explosion of debt to GDP ratios. If the financing of this debt were left solely to the private sector, interest rates would certainly spike and any nascent recovery in financial conditions would be immediately stifled. Central banks therefore, will have to pick up the bill. This harsh reality has forced the UK government to expand its ‘Ways and Means Facility’—the government’s bank account with the Bank of England (BoE)—less than a month after governor Bailey termed the facility simply a ‘historical feature.’ In the U.S. and Japan, it has resulted in a policy of unlimited QE. Currently, the Fed is purchasing $10bn of Treasuries every day, down from $75bn when the policy was first announced.

European Union leaders are yet to agree on a solution that would comprehensively address sovereign default risk and ensure the survival of the union. President Macron declared in an interview earlier this month that ‘we are at a moment of truth, which is to decide whether the European Union is a political project or just a market project.’ A week later, EU leaders convened to discuss a ‘recovery fund’ to assist individual governments in their fight against the virus. Key details are still up in the air, particularly whether grants or loans will form the bulk of the package. It is no surprise that the likes of France, Spain and Italy support the former, whilst Germany and the Netherlands argue the latter. The details and size of the package (said to be in the trillions) must be agreed upon unanimously by all member states and rejection is a possibility. The debate is likely to continue for months to come and funds may not be disbursed until the end of the year or later. For the southern economies however, the situation demands far greater urgency. The Italian-German government bond spread increased to over 2.5% earlier in the month, and this filtered through the system resulting in higher borrowing costs for southern European banks. The main European interbank lending rate, Euribor, reached a 4-year high.

European banks can ill-afford these higher costs as they face a surge in demand for credit from both households and corporates drawing down credit lines. All eyes will now be on the European Central Bank (ECB), who meet at the end of this month. They are, for now, the only game in town.

The IMF warns, in its Global Financial Stability Report, that ‘banks could act as an amplifier should the crisis deepen further.’ Yes, regulators have taken important steps over the last decade to improve the capital position of banks, but this crisis is indeed like no other. Bank earnings this month revealed that major U.S. banks have stashed away over $20bn in anticipation of loan losses. This was followed by reports that U.S. banks were pulling back some of their lending to European companies. As UK banks report their earnings over the next few weeks, the BoE has warned against setting aside such large provisions, which would further restrict credit from flowing to stressed borrowers. Furthermore, the oil price shock will hurt those banks most exposed to energy company debt. A notable example in Singapore, oil trader Hin Leong Trading filed for bankruptcy with over $3.85bn in debt owed to various lenders. U.S. shale is certainly dead in the water, with oil prices at current levels. It remains to be seen how committed both the government and the Fed will be in preserving U.S. energy independence.

Despite all the dire economic data releases, the stock market rebounded over April. Economic data releases have been bleaker than expected with the global lockdown prompting the IMF forecasting the biggest global recession since the Great Depression in the 1930s.

So why has the stock market rebounded so strongly? Some market commentators have spoken about a “bear market rally,” when markets bounce in the midst of a severe market downturn. Market moves could be explained by the market simply expecting the economic recovery to be swift and robust after the lockdowns ends. But that’s looking unlikely. Lifting lockdowns is unlikely to see a swift return to consumption as concern will remain that the virus could return in a second wave and as earnings updates are expected to be poor through the middle of the year. Key to looking at such dire economic news has been the significant efforts by central banks to remedy the financial system and underpin key sectors. It seems, yet again, investors have decided that the U.S. government will prioritize preserving stock market valuations regardless of what happens to the rest of the economy.

As we have seen before, most of this cash injection is finding it’s way into risk assets providing a floor to equity markets irrespective of fundamentals. Going into the pandemic, markets were in a bubble due to central bank liquidity injections meaning that despite the selloff and subsequent rebound in markets, markets remain expensive particularly within quality stocks. The Shiller cyclically adjusted price-earnings (CAPE) ratio, a common measure of stock-market valuation, is still at levels that prevailed in the mid-2000s before the financial crisis, suggesting that stocks remain expensive.

Central bank actions and the extent to which they prop up companies that would otherwise have failed, can have lasting impacts. We have seen central banks expand the range of assets that they will consider buying in an effort to provide liquidity but this will inevitably cause distortions. Central banks have not only absorbed large parts of the government bond market, they are now creeping into all corners of the private capital markets, with the aim of preventing a credit crunch that would result in widespread defaults. Both the ECB and the Fed announced this month plans to buy junk-rated corporate debt. These actions have been taken to address the massive ‘fallen angel’ risk in corporate credit, which we have flagged in past commentaries.

If governments commit to supporting asset prices, both the risk and reward of assets could change. Central banks want to dampen market volatility, whilst avoiding moral hazard. However, knowing the central bank will step in will draw money into the market, driving up demand and prices. Clearly this is a windfall for existing asset owners but this will reduce expected returns for new investors. Central bank buying across the capital structure will provide stability for those at the senior end but also those lower down. Stabilizing credit markets has been required due to the vast rise in corporate debt and the potential for credit rating downgrades. Corporate debt profiles have ballooned over the last 10 years, fueled by low rates. The purchase of corporate debt, from investment grade through to junk bonds has been controversial and encouraged the view that it is a “win-win” scenario. If the economy rebounds and earnings are restored, then investors win and if there is further volatility the Fed could be forced into action.

Investors seem to be looking through 2020, looking ahead to 2021 and the potential for some normality to return. Within equities, investors are flocking to high-quality companies as investor sentiment remains fragile. Best in class companies, with stable revenues and little leverage is certainly how we would define a quality company. Such companies can weather hits to revenues over the short-term and recover quickly as the impact of the global pandemic fades away. The fact that low quality companies have lagged suggests that broad positive investor sentiment on a sharp rebound in economic recovery is not in place and that concerns on an extended recovery remain.


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The Purchasing Managers’ Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and service sectors. The headline PMI is a number from 0 to 100. A PMI above 50 represents an expansion when compared with the previous month. A PMI reading under 50 represents a contraction, and a reading at 50 indicates no change.

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