The waiting room clock is frozen

There is plenty of anxiety, fear and extreme volatility animating financial markets. The speed of the crash in equities and credit from record peaks and narrow risk premiums — just last month — reflects what happens when high valuations run up against a global recession.

The scale of the shake-out, with equities recording a double dose of their worst one-day trading falls since 1987 this past week, suggests a bottom is near. Equities and credit bounced on Tuesday, although volatility remained elevated and liquidity (the ease of transacting) was challenging to put it mildly. A 12 per cent drop in the S&P 500 followed by a rise of 6 per cent is quite the whipsaw trading dynamic. Utilities and consumer staples were the two best performing sectors by some distance, evidence that the defensive trade still reigned. 

Beyond that market noise, long-dated Treasuries — a harbinger of recession since late-December — have notably struggled in recent days. This is a signal of a market that may have set its lows for the cycle (for 10- and 30-year yields) now that the Federal Reserve has cut overnight rates to the bone and is reviving emergency lending facilities from 2008, such as one for commercial paper. Governments are also upping their emergency spending for businesses and citizens. This means bigger deficits and an economic bounce that should push long-dated government yields a lot higher. The US 30-year bond yield is near 1.5 per cent, up from last week’s record intraday low of 0.7 per cent.

The UK government on Tuesday announced a £330bn emergency rescue package for businesses, saying it would do “whatever it takes” to protect companies and incomes on a huge scale. The White House is pushing Congress hard for a stimulus package worth between $800bn to $850bn.

The case for a degree of hope is outlined by Russ Mould at AJ Bell: 

“Two of the things sought by investors are at least beginning to be put in place, namely that central banks are providing massive liquidity and lawmakers are offering spending and support to cushion the impact. The tricky bit now is containing the virus.”

Indeed, that is the all -pervasive problem at the moment. As highlighted in Monday’s note, the likelihood of a market and economic bottom rests with signs of infection rates from Covid-19 peaking in Europe and North America. The waiting room is full of would-be buyers of the market dip, but we’re not there yet and may not reach that point for a while. 

Pressure within the market plumbing is also intensifying, highlighting how shocks between markets and the broad economy are feeding off each other, with scope to become very nasty. (See Quick Hits for updates on dollar and credit stress.)

Greg Faranello at AmeriVet Securities notes:

“With many businesses shut down globally, this has moved to a liquidity and cash crunch environment. The breakdown in the commercial paper market [is] adding fuel to the fire. Similar to what we encountered in 2008, the cash needs to flow into the right market and hands, with the hope and goal of getting past this liquidity crunch and economic standstill.”

Financial turmoil and the ensuing blowback into the economy warrants strong action from governments to bolster the efforts of central banks. UBS has tallied recent government support measures (as shown below) and writes:

“The global fiscal impulse (proxied by the change in the cyclically adjusted primary balance) has increased further to 0.92% of global GDP (up from 0.8% of GDP last week).”

While that’s the “most expansionary fiscal stance in 10 years”, UBS points out this remains “short of the stimulus in ’08-’09″. 

As the fiscal response builds, many argue that speed and scale is of the essence.

Steven Ricchiuto at Mizuho Securities writes:

“Markets are not confident policymakers on Capitol Hill will do what is necessary to limit the fallout and set the stage for a solid recovery. If policymakers get their act together soon, the macro disruption may result in only a quarter of negative GDP in this country instead of two or three as investors are beginning to fear.”

Quick Hits — What’s on the markets radar

A strengthening US dollar is a serious problem in a word awash with debt that is denominated in the reserve currency. Cutting risk and raising cash also mean intense demand for dollars, a sign that the world financial system is experiencing a massive wave of deleveraging.

The Fed has bolstered swap lines with leading central banks, but more is required. Brad Bechtel at Jefferies notes:

“While the FRA/OIS spread has cooled a bit given the moves by the Fed over the weekend, the cross currency basis swaps are still blown out and getting worse. Cross currency basis swaps more reflective of USD funding pressures abroad.”

Although non-US banks are getting dollars via their central banks, the problem is that not all borrowers will receive that supply at the end of the financial-system food chain. Banks are seeing companies tap lines of credit and are therefore hoarding their inventory of greenbacks.

George Saravelos at Deutsche Bank has been vocal in his warnings about a dollar squeeze. He says:

“We worry that fixing this dollar shortage may be more difficult than policymakers think. The source of liquidity stress is ‘real’ people, but central banks only have funding lines with banks. New QE announced by the Fed overnight will help increase dollar liquidity. But the money needs to flow down to the real economy. Governments may need to step in to directly and immediately guarantee liquidity provision to thousands of corporates and even individuals — this may (literally) require helicopter drops of money.”

Given the way policy officials were forced to act during the financial crisis, don’t rule anything out from here. 

Over in the credit market, the situation remains fragile. Some companies, including Verizon, ExxonMobil and Pepsi, were in the market for selling US debt on Tuesday, but the backlog of pending corporate debt deals has grown towards $100bn, according to traders. The inability to refinance and roll over debt explains widespread drawing down of bank credit lines by companies and the strains seen in commercial paper.

Also picking up the pace are credit-rating downgrades across sectors feeling the brunt of the pain, such as airlines and car-rental groups. S&P on Tuesday placed both Hertz (rated B+) and Avis (rated BB) on credit watch negative. Little wonder that credit risk premiums are widening and this is becoming broader, reflecting indiscriminate selling, aka a bigger exit trade.

. . . a similar story confronts emerging markets. The Institute of International Finance says fund outflows since late January “are already twice as large as in the global financial crisis and dwarf stress events such as the China devaluation scare of 2015 and the taper tantrum in 2014″.

It concludes:

“Even if containment efforts and supportive macroeconomic policies have a positive impact soon, the shock to flows will remain unusually severe.”

Rising supply and a demand shock will crush commodity prices a lot more after big slides of late, says Goldman Sachs. The bank expects a drop in commodity prices by at least 25 per cent over the next three months and notes:

“While financial markets are forward-looking and are likely to rebound once the contagion stabilises, commodity markets are spot assets and must clear the surpluses developing today from weak demand and rising supply.”

Plenty of challenges loom for share markets once peak anxiety is reached and a rebound ensues. The likelihood of companies suspending dividends in order to preserve cash is not good news for investors reliant on income. But it does present opportunities for stockpickers and suggests that once the dust settles, quality and growth will lead the recovery. 

Here’s AJ Bell’s Russ Mould:

“A one-off suspension of the dividend could give some companies some breathing space if they are financially stretched by the coronavirus disruption. However, it mustn’t be an excuse for any company to stop payments simply because some of the peer group are doing it.”

Russ highlights the danger for investors eyeing a forward dividend of 6.5 per cent for the FTSE 100, when cash is zero and a 10-year gilt yields 0.5 per cent:

“Earnings cover of 1.68 times was thinner than ideal before the viral outbreak knocked the global economy and a slowdown or downturn will leave many dividends exposed and at risk of a cut, so that yield figure could prove to be deceptive.”

At this stage, “50 FTSE 100 firms currently offer earnings cover of 2.00 times or more, which is traditionally seen as the mark that offers some sort of buffer in the event of a downturn in trading”, adds Russ. 

The other avenue of returning cash to shareholders is via buybacks, an activity that is certainly off the table for many companies. There is also the prospect of significant equity issuance as the economic downturn deepens.

Nick Colas at DataTrek writes:

“As soon as capital markets/the economy stabilise, corporate priorities for free cash flow may shift and many public companies will need to issue stock.”

Nick adds: 

“Cyclical companies tend to issue stock near bottoms, not out of ignorance but because they simply need the cash to survive. Yes, they will get beaten up by investors for issuing stock at $30 when they bought back the same shares for $100 last year, but this is a decades-long phenomenon and we’re sure it will happen again.”

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