Phil Milburn

Quarterly strategy – How we are preparing for the Covid-19 recovery

Phil Milburn

Executive summary

Global growth is now forecast to be -4.3% in 2020, not nearly as bad as it could have been given the nature of the Covid-19 crisis. The recovery is uneven by both sector and country; many nations are reaching their point of maximum mobility given infection rates are rising once again. However, the sheer quantum of monetary and fiscal support has underpinned economic systems and ensured markets remained investable. To be clear, though, we do not want to invest in the generic market and choosing the correct rates exposure and quality credits has never been more important. We have maintained our low duration stance, with a preference for the US market. Within credit, we prefer to spend our risk budget on high yield, where the valuations are much more compelling than in investment grade, provided you invest in the long-term survivors.

Macroeconomics and rates

As countries around the world loosen their lockdown restrictions, Covid-19 infection rates have been picking up again. It is clear that many societies have reached their near-term maximum level of mobility that allows for some virus transmission but does not lead to an exponential R rate. Setbacks in the fight against Covid-19 transmission were inevitable but where suitable contact tracing systems exist, the localised outbreaks do seem containable. There does not appear to be any political or societal will for a return to full national lockdowns. Equilibria are therefore reached between countries’ infection rates and economies but, be under no illusion, a return to the “old normal” for economies will not happen for a long time yet.

On a positive note, progress towards a vaccine continues apace. According to WHO figures, there are 138 potential vaccines at the pre-clinical stage, 25 in Phase 1 trials, 15 in Phase 2 trials, and seven in the large-scale efficacy Phase 3 trials. For those interested, the current vaccine contenders include: University of Oxford/AstraZeneca, Moderna/NIAID, BioNTech/Fosun/Pfizer, Sinovac and two from Sinopharm with respective Wuhan and Beijing Institutes.

Policy interventions saved economies from an even more dire outcome than actually transpired. Forecasts overshot to the downside and, as the chart shows, 70% of countries are faring better than anticipated.

% of countries with positive EASI

Source: JP Morgan, August 2020

Real-time activity indices also provide evidence of recovery. But with no return to the aforementioned old normal, it is no surprise that many sectors and countries are seeing a plateau in activity below the pre-crisis level. A good recent example is car registrations in the biggest five European economies, which were still down 1% year-on-year in July. This is despite the huge dip during the crisis, so the pent-up demand for cars is yet to be fully unleashed.

Looking at policy interventions, on the monetary side, the balance sheets of the G10’s central banks have expanded by over US$6.5 trillion in aggregate over the last year. The underlying trend is for continued growth in balance sheet size, though the US Federal Reserve has seen a contraction recently as emergency facilities and swap lines have been repaid. For most central banks, the pace of balance sheet expansion is projected to slow – assuming current commitments materialise – but there is nothing currently precluding them from increasing the pace of their quantitative easing once more. One day, the public might start to lose faith in the value of money given central bankers’ proclivity to give it away but that reckoning seems a long way off yet.

In the nearer term, it is anticipated that the Fed will announce its long-awaited framework and strategy review at the September meeting. This is likely to take precedence over any changes to the current monetary policy stance and studying the chart below shows why:

fed funds rate and fed funds futures

Source: FRB, Bloomberg, Deutsche Bank, August 2020

The problem for the Fed is that the market usually starts to price in some form of normalisation in interest rates, generally looking for increases (the dotted lines in the chart above). Presently, however, enhanced forward guidance is already priced into the market, with rates expected to be marooned for many years to come. On the strategy side, there has been a lot of discussion among economists about whether a level of nominal GDP should be targeted and, after any downturn, there should be some attempt at catch up.

A different variant of this is to have a symmetrical inflation target where any undershoot has to be compensated for by overshooting in future periods. If the Fed firmly commits to either of these courses of action, then it should result in a big bear steepener for the US Treasury yield curve (yields rise, with longer-dated bond yields increasing more). But the bond market is becoming more of a policy tool than a free market and the Fed won’t want the long end to suffer too badly due to the impact it has on US mortgage rates.

This epitomises the dilemma for bondholders over the next few years. Central banks will strive to keep nominal rates incredibly low and their desire is to have negative real rates. The alignment with fiscal authorities is high given the need to fund deficits. Thus, the vast majority of policymakers are aligned in wanting to erode the real value of debt; financial repression truly is upon us.

Turning to those fiscal deficits, the impulse here has a far greater efficacy than the marginal effect of extra monetary stimulus when rates are already suppressed. It is interesting to look at the different approaches to fiscal stimulus during the crisis.

Fiscal measures announced in G20 countries

Source: IMF, Deutsche Bank

We would best characterise this as the deficits showing governments using their cash flow to cushion the economic blow of lockdowns, whereas the loans/guarantees use the government’s balance sheet as a safety net. There is no one size fits all policy, but the differing approaches have had meaningful impacts on employment and activity levels.

Latest forecasts from JP Morgan show the US economy shrinking by 5.2% in 2020, a larger contraction than the global real GDP forecast of -4.3%. Employment growth is crucial for the US recovery; it is reassuring to see initial claims drop to a number oscillating around one million, but this is still high in any historic context. Most of the layoffs during lockdown were temporary in nature with approximately two million deemed permanent; sadly, more of the temporary unemployment is bound to shift to permanent.

The next few months, ahead of November’s election, sees the CARES Act payments tapering off; this matters a lot as there is an annualised unemployment compensation rate of US$1 trillion. A compromise on a further fiscal package is likely to be reached, otherwise consumption will fall and those in the lower sociodemographic groups will be hit hardest. Presently, retail sales in the US are growing, with levels above those in February, showing that pent-up demand is being released on this occasion.

On the subject of the election, current polls show Biden ahead at 50 compared to Trump at 42 and the probability of the Democrats controlling the Senate is even higher. It is our opinion that a Biden presidency would be more supportive for risk assets than Trump gaining a second term. This is based upon the likelihood of greater fiscal spending on infrastructure under a Democrat government, as well as fewer erratic policy announcements on Twitter.

Chinese growth is dragging up the global average. The economy is currently growing year-on-year, with 2020 forecasts for an expansion of 2.5%. This has been very much investment-led with consumption still detracting from growth in Q2.

Global inflation predictions stand at 1.6% for the next 12 months. By the end of 2021, developed market economies are forecast to have GDP below end-2019 levels in real terms but above in nominal terms. To restate the obvious, a successful vaccine would hugely change this dynamic; we would then only have to worry about creating new businesses and employment, as well as paying down all the debt created during the crisis.

Looking at regional inflation, CPI has been bouncing as the energy drag in March/April reverses. There remain huge issues with the inflation basket measurement during the crisis; clearly the output gap is deflationary but price rises are being seen in the stuff that people now want to consume, such as restaurant food. US inflation break-evens have widened, as can be seen in the chart below. We have rotated exposure into the 30-year tenor which, duration adjusted, is lower beta and could perform more strongly if the Fed’s framework change exceeds expectations.

Year on year CPI inflation rates

US inflation breakevens

The short end of government bond markets remains firmly anchored and you do not get a pivot until around the 5-7-year tenors. Longer term, the direction of travel is for curve steepeners, but these have overshot and we are tactically opposing recent moves with a flattener. Cross market, Canada is expensive relative to the US and Sweden offers value compared to Germany. Strategically, our preference for US duration exposure over that in Europe is retained; we don’t like either, but the former has more room to rally.

Spread product

The top lines of most companies were hit hard during lockdown. We are pleased the majority of the quarterly results for holdings in our funds were not nearly as bad as they could have been, with margins and cash flow both holding up far better than anticipated. Examining Deutsche Bank figures on the market as a whole, gross US investment grade leverage has crept above 3x, with the aggregate net debt/EBITDA figure at approximately 2.5x. The largest driver of the increase was the 10% average fall in EBITDA. Interest coverage remains a non-issue for companies. High yield figures operate with a greater lag, but ex-energy and mining they are holding up reasonably well too.

The credit ratings drift is high, akin to 2008-09 levels. The quantity of fallen angels - companies whose rating is cut from investment grade to high yield - is also approaching levels seen in the credit crunch. We are very sanguine about fallen angel risk as we can judge each one on its own merits as to whether it will be a good recovery play that has been oversold. Moody’s has reduced its peak default forecast due in Q1 2021 from around 11% to 9.3%, again reflecting the outcome of the crisis being better than feared. It is incredibly important to be selective; this Moody’s table shows how forecast defaults are very much a sector not market phenomenon:

One year default rate forecasts by industry

Source: Moody’s, data as at 31 July 2020

M&A activity has been subdued relative to history and even post the April-May slump, there does not seem a rush to return to deal making. We suspect that as confidence increases, a combination of highly rated equity paper and cheap debt will reinvigorate M&A. It will probably take longer for capex to return to normality, as the aforementioned output gap has many companies unlikely to be operating at peak capacity for a while. Utilisation has bounced off its bottom but we posit that it needs to return to a number in the mid-70s before companies start meaningfully investing again.

Investment grade credit spreads have retraced the majority of their widening. We would characterise any further tightening as likely to be a slow grind; thus, investing in the investment grade market is now mainly about the yield carry as opposed to capturing the market’s capital upside. High yield has more scope for a recovery and our favoured valuation measure, which excludes the energy sector and CCC-rated bonds, still has a spread of 400 basis points. Historically this has been a good entry level.

Assuming a 40% recovery rate, Deutsche Bank figures show the high yield market at the end of July was pricing in a 34% cumulative default rate over the next five years, more than double the historic average realised rate. During July, BB-rated US credits significantly outperformed their European cousins, so we are tilting portfolios towards the latter due to their better valuations.

Regarding supply and demand, the all-powerful technical tailwind created by central bank buying of credit should not be underestimated. The credit market is becoming a policy tool in a similar way to the manipulation of the sovereign debt market. This has meant the market has easily been able to absorb record amounts of supply; US corporate supply is approaching US$1 trillion and you get another US$0.5 trillion when you add in bonds issued by financials.

European investment grade is also on course for a record year of supply, as is US high yield. European high yield is running with a gross rate similar to prior years but the net figure is higher. We view this supply as being a bullish indicator as companies increase their liquidity and demonstrate the ability to access funding. The one area where supply is moribund is leveraged loans, which should come as no surprise given the predominance of private equity deals the loan market funds and the hiatus in M&A.

US investment grade inflows are over US$50 billion year-to-date, triple the rate of last year. US high yield is not too far behind at US$40 billion, this flow being one of the causal factors behind US speculative grade recently outperforming Europe. The latter is seeing money return to the asset class but is still a net €5 billion down year-to-date.

The basis between credit default swap (CDS) spreads and those on cash bonds is still negative, meaning you are rewarded for taking funded positions. The extreme negative basis has retraced but physical bonds are still preferred to CDS index overlays. Market positioning in CDS indices is back to pre-crisis long risk levels with investors having capitulated during the crisis; our unitholders were rewarded for us being contrarian and value focused.

Sentiment indicators have been improving; the US yield curve, measured by 2-year versus 10-year yields, has been steepening in line with other rates markets. The VIX volatility index is fading down to lower levels and the LIBOR spike has disappeared. This does mean we will continue working down floating rate notes, switching into conventional bonds.

One should not expect everything to be calm after such a crisis and one indicator that is flashing amber is lending standards. The SLO (Senior Loan Officers) survey shown in the chart below shows a significant tightening in standards – up is bad on the graph. One other factor to watch is the Target 2 balances; these have been setting new records highs but are not currently an issue due to the high European cohesion we have seen.

US Fed senior loan officer survery commerical industrial

For a comprehensive list of common financial words and terms, see our glossary here.

Liontrust Insights


Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.


The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing. 

Wednesday, September 2, 2020, 4:19 PM