Central banks have sent a clear message: this is not the time for a financial crisis triggered by capital markets.
Grim assessments of the economic outlook by policymakers in Japan, the US and eurozone this week were accompanied by expressions of determination to keep pumping liquidity into the financial system. The rapid expansion of central bank balance sheets beyond $18tn will continue. As Jay Powell, the US Federal Reserve chair, said on Wednesday after the bank’s policy meeting: “We’re still putting out the fire.”
Such a task involves maintaining orderly credit markets and extending loans to smaller businesses. Central banks are pulling together. This week the Bank of Japan said it planned to quadruple its purchases of corporate debt to ¥20tn ($186bn) until September 2020, while the Reserve Bank of India announced a new credit facility for mutual funds worth Rs500bn ($6.6bn).
In a way, this is a suspension of disbelief. Credit risk has experienced “systemic mispricing due to low interest rates over the past decade”, said David Bowers at Absolute Strategy Research. Still, shattering the illusion now would be dangerous. “Credit is the ‘Ground Zero’ of this crisis,” he added.
At a point when some countries are edging towards a staged reopening of activity, investors need to consider transitions. Until now, owning top-tier government bonds such as US Treasuries has been a winning strategy, and has helped offset losses from other assets. But it has largely run its course, unless deflation becomes entrenched. A shift into credit and equities is under way, led by a tilt towards high-quality companies in the tech and healthcare sectors.
Whether this narrow and selective trend broadens to other sectors requires evidence that the pandemic is truly receding, and whether economic activity is rebounding. Right now, neither is obvious.
Such uncertainty helps explain why credit risk premiums remain high compared with the levels of early February. In US credit, the limited narrowing in spreads — the additional yield over benchmark government bonds — also reflects pressure from a deluge of debt sales from companies looking to refinance their commitments with the backstop of the Fed.
The Fed’s purchases of riskier corporate debt have not actually started yet, but the effects are clear. Mr Powell knows he has managed to shift sentiment in this market before it spends a dime, and has said the Fed “will follow through to validate that announcement effect”.
That is music to the ears of fixed-income investment managers, particularly those who have snapped up corporate bonds on the cheap in recent weeks. The lesson for many is that periods of elevated spreads are usually followed by solid returns over the next few years as economic activity rebounds, and companies focus on paying down debt and reducing their leverage.
Some investors are probably thinking back to the turmoil of 2008 that gave way to strong gains in corporate credit. One notable difference is that then, the risk of insolvency was concentrated mainly in the financial sector. More than a decade of easy access to capital markets later, the non-financial sector around the world is far more vulnerable to impairment, restructuring and default.
Last October, the IMF warned in its global financial stability report that companies across China, the UK and the US had some particularly worrying income statements, where earnings did not cover interest expenses. Spain and France were not far behind. Investors may cheer the support of central banks, but their efforts indicate the high stakes facing credit markets.
Central banks are in the business of providing liquidity. But as Matt King, credit strategist at Citigroup, warns: “The challenge from the coronavirus is less about liquidity than about solvency. Sovereign, corporate and household credit quality are all taking a very big hit.”
A default cycle is coming. The question is the scale and duration of the damage. Buying selected areas of riskier credit may well be vindicated over time and here, active managers have an opportunity to shine and justify their fees.
Central banks may succeed in containing credit angst and blunting the default cycle, but Mr Bowers warns of a sting in the tail two to three years from now. “The corporate debt burden will be greater and the pressure to keep interest rates low will only intensify.”
Central banks are clearly trapped and stemming financial turmoil at the moment entails longer-term costs that may not insulate investors.
“Fed purchases cannot turn bad debt into good debt,” says Scott Minerd, global chief investment officer at Guggenheim Investments. “A buyer who is not careful can mistake Fed liquidity for credit strength and pay the price down the road when downgrades and defaults start in earnest.”
michael.mackenzie@ft.com
Source: Economy - ft.com
