To infinity and beyond with QE

There is a race to the bottom among analysts and even some policy officials in terms of calling the scale of the economic shock and hit to corporate earnings. In that context, the sight of global equities and S&P 500 futures starting the week in Asia on Monday with a slide of 5 per cent was no surprise, simply another blow upon a bruise. 

Step forward the US Federal Reserve with unlimited quantitative easing and also embarking on buying corporate debt for the first time. All while Congress engages in making a vast sausage that will ultimately become a $2tn or more stimulus package for the broader economy. 

Of the two arrows in the quiver, fiscal stimulus matters for an economy in dire need due to the brutal blow of lockdowns and quarantines. Apart from a bounce in US investment grade credit measures, equities remained under pressure, and Wall Street erased a late-morning rebound after US lawmakers failed to pass a stimulus deal for the second time.

The US central bank announced two new facilities on Monday. The Primary Market Corporate Credit Facility (PMCCF) backstops investment grade rated companies selling new bonds, while loans issuance provides bridge financing of four years. The Fed also announced a Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity for outstanding corporate bonds. This special purpose vehicle (with an equity investment from the US Treasury that can absorb credit losses for the Fed) will buy investment grade bonds already sold by companies and also US-listed exchange traded funds that track IG credit.

That prompted a modest recovery in the US credit derivative index from its highest level since the crisis, (shown below). The share price of LQD, the ishares exchange traded fund that tracks IG paper briefly rose 7.7 per cent and was holding around 4.3 per cent higher on the day.

As the pace of global infections and deaths accelerate, with a second wave in Hong Kong, and as lockdowns in major cities intensify, the prospect of a severe financial crunch dominates financial markets. 

Shuttering much of the service sector across leading economies will deliver the biggest hit inflicted upon growth during the current quarter since the 1930s (see Quick Hits). The abrupt slide in global equities, (down in the region of one-third since February 19) and hefty rise in credit risk premiums, reflects public markets seeking to establish the parameters of a still unfolding macro shock. This is a journey into the unknown depths of a financial system that is highly indebted and one that propelled valuations well north of fair value, prior to the coronavirus expanding its global footprint.

The past decade of very low borrowing costs provided companies and their managers licence to tap credit markets to fund expansive share buybacks that benefited executives and their share options. This failure to save for a rainy day, means many companies require help from the taxpayer and the purchase of corporate debt by the Fed to prevent a deeper and prolonged bust via a meltdown in corporate credit and other related areas such as commercial real estate. 

Tightening financial conditions means the threat of broader damage extends well beyond highly indebted and cash flow dependent sectors such as airlines, hotels, tourism, retailers and energy, that are enduring the immediate pain from quarantines and lockdowns in big cities. 

Until now the Fed has resisted joining other central banks in buying investment grade debt. This explains in part why US credit has been trading at its widest levels versus those of Europe in a decade.

Andrey Kuznetsov, a portfolio manager at Federated Hermes speaks for many credit investors:

“This is an immediate positive for the investment grade market, but over the medium-term it will support high-yield credit as well as provide better access to the capital markets. Investment grade companies will do whatever it takes to avoid falling into high yield.”

Indeed they will and much depends on just how tough rating agencies act from here. 

Given the sheer size of investment grade rated companies sitting one notch above the high yield of “junk” market, (at triple B) much depends on how rating agencies assess the situation. Almost half of the $6.2tn US IG market is represented by the triple B slice as this chart shows:

As 2020 dawned, rating agencies served notice that corporate debt diets and improving cash flow and earnings were required to keep a number of triple B-rated companies in the realm of investment grade. That outlook has clearly shattered, with the recent cut to double B in Kraft Heinz, the tip of the coming downgrade wave. The scope for so-called fallen angels, or companies being stripped of their investment grade wings, is seen by some as being in the region of $1tn of triple B paper entering the high yield arena when the dust finally settles.

This raises the question as to whether the Fed will need to expand its presence from here to ease the pressure on credit and other markets before the pandemic finally relents.

Those with plenty of investment experience suspect the solutions that stemmed the financial crisis — central banks flooding the system with liquidity and government backed bailouts of banks — face a tougher challenge this time.

Scott Minerd at Guggenheim Investments believes: 

“I can’t tell you how to fix the virus problem, or how long it will last, but this means that the unknown in the investment community and for the populace at large is a lot larger than it was during the financial crisis. And so, in all likelihood we will experience something that is just as severe as, if not worse than, the financial crisis.”

This could well take several years, and as Scott adds:

“In the meantime a lot of debt has to be unwound or restructured. This will result in the Fed having to keep the liquidity spigots open for a long time.”

Such a prescription also applies for a global financial system that has borrowed heavily in US dollars and is now scrambling for the reserve currency. The dollar remains near its recent peaks. This chart from BCA Research highlights how foreign currency debt has soared since 2012, leaving a prominent shortage of dollar-liquidity:

Gauging the need for dollar liquidity outside the US

BCA explains:

“This series trends up with time, but it has declined significantly since 2012 as foreign currency debt has grown significantly. For the ratio to hit its previous high, high-powered dollar liquidity must rise by $1.8 trillion. While commercial banks will create a lot of that liquidity, so large is the increase that it implies that the Fed still has a lot of work to do.”

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Quick Hits — What’s on the markets radar

Gloom and doom is not hard to find via various outlooks. Topping the doom scales, James Bullard of the St Louis Fed believes the US unemployment rate may climb to 30 per cent, while the economy faces a growth hit of minus 50 per cent, taking us back to the depths of the Great Depression.

Here’s the range of outcomes for the US economy as plotted by Bank of New York Mellon, and it adds:

“US GDP could be off by anywhere between 12 per cent and 22 per cent in the second quarter, according to our analysis. A bottom-up analysis under a baseline scenario yields the most optimistic outcome, while a top-down analysis assuming an adverse scenario yields the most pessimistic.”

Given the scale of the drops seen across risk assets, and the gloomy estimates arriving from analysts, some argue the point of abject despair is not that far away. 

Tobias Levkovich at Citi notes that the bank’s “Panic-Euphoria model” has yet to reach panic territory and he makes this telling observation:

“Markets are discounting mechanisms and at a certain point, the health and economic issues will be fully priced-in, and when a bearish headline emerges, the stock market will shrug it off. We feel we may not be there yet.”

A taste may arrive later this week when US jobless claims data are released. They are seen having scope to surge as high as 4m. Economists at Citi estimate there are 20m workers in sectors that have been shuttered by quarantines, and lay-offs in the region of one-fifth provide a ballpark figure of 4m. 

Once big support measures are passed and implemented, risk assets have scope for quite a bounce. Watching how long any bounce lasts is important. Ultimately, a market bounce is simply a natural reaction after any steep decline. A sustained recovery that builds on such a bounce requires a medical solution, or evidence that the pandemic has peaked and is under control.