In this piece we try to isolate 10 of the most common discussion points and client concerns we have encountered over the last few weeks. With so many moving parts, we thought it would be helpful to organize the cross-market risks in one place and provide our high-level take on each of them.
Core Yields Rising and Hedges at Risk
Bond markets are caught between powerful cross-currents and at stake is the principal hedge for the financial system. Forces arguing for higher yields include the massive fiscal effort and supply to come, along with (forced) positioning unwind of some funds (risk-parity or not). On the other side we have central bank buying, an indefinite deflationary outlook, and demand for hedges and cash equivalent. We have a high conviction that the latter force will prevail and yields will remain low for the foreseeable future, even if we get more bumps along the way. We don’t even discard extreme measures such as yield curve control by the Fed if things get out of hand again. Moreover, investors are likely to jump on the opportunity of securing high yields in core countries, capping any increase. But if we are wrong about this, the prospects of a sustained selloff in both equities and sovereign bonds is frightening.
Bonds in Southern Europe have been on a wild ride, even reviving talks about a eurozone breakup, but we think this is a non-starter. Yes, there will be haggling over spending, transfers, and join stimulus, but this is not (we hope) an existential moment for the euro. That said, CDS prices spiked and Italy’s 10-year yield spread to German bunds reached 280 bps, near the highs of last year (though well below 2018 levels, when Italian budget shenanigans spooked the markets). Spreads for Spain and Portugal have also been volatile, but to a smaller extent. It didn’t help that ECB President Lagarde said that the bank was “not here to close spreads.” She reversed this a few days later with by assuring us that there were “no limits to [the ECB’s] commitment to the euro,” but some damage had already been done. There will be rough times ahead for the eurozone, but they will middle through, and onward to the next crisis.
There have been continued reports of dislocations in the US Treasury markets, both at the start of the crisis (yields crashing) and more recently (curve bear steepening), but they seem to be abating. There are many moving parts here ranging from deleveraging of risk-parity funds and lack of liquidity in older government debt issues. There is also the associated problem of ETFs trading at a large discount to their NAVs; the speed of redemptions and poor liquidity prevented the arbitrage that keeps their values in line with the underlying. Once again, we think this is a winnable battle. The Fed has demonstrated its commitment to ensure liquidity, and our assumption is that they will (eventually) succeed. If market depth problems continue in the US, some think the Treasury department could revive its buyback program by which it uses proceeds from new debt sales to buy older (and less liquid) debt from the market.
Recent numbers of outflows are staggering, but they also hint at opportunities. Data from EPFR estimates over $40 bln in redemptions from equity funds over the last two weeks ending on Wednesday. The outflow from fixed income funds were even larger. This is part of the negative feedback loop of redemptions leading to one-way markets and indiscriminate liquidation across the board. But take a step back and try to visualize what awaits investors on the other side of this horrific shock: low yields, a massive monetary stimulus, a huge global fiscal effort, and better valuations. We may quickly find ourselves back in asset price inflation paradigm, even if completely detached from the economic reality on the ground.
Ban on Short-Selling/Market Closures
Shutting down financial markets to stem a sell-off could be akin to breaking the thermometer to reduce a fever. That said, we sympathize with intermediate measures such as circuit breakers and temporary restrictions on short-selling when markets get disorderly. Spain banned short-selling on a group of stocks for a month, which seems a bit exaggerated to us. Similarly, South Korea’s Financial Services Commission (FSC) issued a six-month short selling ban, as it had done during the 2008 financial crisis. Shorter bans were implemented in Italy, France, Belgium. Philippines had a 2-day shutdown. The US was reportedly considering shortened trading hours.
Short-Term USD Funding Markets
Take your pick: FRA-OIS, TED spread, cross currency basis swaps. However you look at it, funding markets have been under severe pressure. Like the liquidity issues in the sovereign debt markets, we think this is another area where central banks can win the battle (even if not immediately). Having been through the 2008 crisis, officials are now far more experienced in dealing with funding dislocation and command an ample toolkit ranging from short-term liquidity measures to international swap lines to irrigate the global financial system with term dollar funding. Indeed, Japanese and European banks have already taken up a big slice of the first swap lines and there are signs that pressure here is abating. This will continue to improve, in our view.
Bank Credit Risk
Our understanding is that solvency is not a first order risk for the major global banks, but pressure could continue rising. It seems only fair to consider the tail risks to any banking system given the prospects of a recession, rising corporate defaults and low rates hurting profit margins. CDS prices have responded accordingly. But we suspect that regulators will be far more forthcoming with help to the financial sector in this exogenous shock than during the 2008 crisis, when one could argue that they were the source of the problem.
Energy Sector Defaults
The collapse of oil prices will almost certainly lead to a material shakeup for energy sector in general and shale in particular, with unpredictable ripple effects cross the credit markets. We assume that Russia and Saudi Arabia will continue to keep crude supply ample, and even if not, the negative demand shock and current supply overhang will keep prices low. This will accelerate what many already saw as an inexorable adjustment for the shale industry. Our base case is that oil will see a “U” shape trajectory: we are approaching the bottom where prices will stay for a while, then there will be a tightening of supply and possibly even an oil shock awaiting us on the other side of the virus recession. We don’t have any special insight into what combination of defaults, restructuring, or acquisitions awaits the global energy sector, but whatever happens, it won’t be pretty.
GCC Pegs Under Threat
Oman is the first in the firing line for bets against GCC pegs. The country’s CDS spreads have blown out from around 230 bps at the start of the year to nearly 600 bps now. Similarly, the forward points on the Omani rial rose dramatically, suggesting increased speculation that the peg could be broken. The country enters this period of low energy prices with relatively few FX reserves, elevated public debt, and a fiscal break-even oil price of close to $90. We don’t think a break of the peg is going to happen. Its neighbours know that a devaluation of one Gulf country will trigger a speculative domino effect across the region, so they will come forth with financial help. But this means an extra outlay by Saudi Arabia, further reducing its capacity to live with low oil prices.
EM Debt Stress
Emerging market corporates and sovereigns that loaded up on external debt could face their day of reckoning, but many opportunities will arise from the selloff. Massive currency depreciation will make foreign debt servicing costlier, which could be made even harder if Treasury yields are high. There is also the fall in oil prices to consider (which has an asymmetric effect across countries), and a drop of tourism-related inflows. Some will rely on FX reserves or stability funds, but this will weaken the sovereign balance sheets, especially if they need to stabilize the currency at the same time. Other countries will rely on swap lines with the Fed and lending from multilateral institutions, but debt rollover could still be an uphill battle if risk appetite remains suppressed. In terms of sovereigns, the usual suspects such as Argentina, Turkey and South Africa stand out for their poor fundamentals. Oil producer (Oman, Nigeria, Bahrain, Angola) will also be on the firing line. On the other hand, we would be inclined to take widening of credit spreads in countries such as Brazil, Russia, Mexico and many EM Asian countries as opportunities for contrarian trades.