Central banks and governments have injected ~US$18 trillion into the financial system since February 2020 to cauterise the bleeding in economies and markets.

But instead of lying still in intensive care and progressing with a slow and steady rehabilitation, the combination of stimulus packages is creating ecstacy in asset prices. Some equity indices are roaring close to record highs while bond spreads are tightening to the extent that they suggest everything is hunky-dory with credit quality and the economy.

Has the financial cure been found? Or is the market just on a drug-induced high? We reached out to bond managers for their take on the matter and the top risks that could deter investors' exuberance. Responses come from:

• Garreth Innes of Aberdeen Standard Investments
• Kate Samranvedhya from Jamieson Coote Bonds
• Jay Sivapalan of Janus Henderson
• Adam Bowe from PIMCO

Kicking the debt can down the road

Garreth Innes, Aberdeen Standard Investments 

After a month like March it is difficult to get too comfortable as the wounds are still raw, but it does appear that the combination of expansive monetary and fiscal policies have stemmed the bleed and have given investors the ability to look through the immediate period of economic pain.

This comes at the cost of a material step-up in global debt levels, which will need to be paid for in the future, most likely through higher taxation and real devaluations of fiat currencies. 

While it is comforting that global central banks recognised the risks and took action against the heightened corporate bond market and short-term funding market illiquidity, their involvement is hardly encouraging. To use central bank mandates to ‘cover’ either of these issues is misguided, even if it averts a reckoning in the short-term. However, this philosophical soul-searching says nothing about the potential for credit spreads to continue tightening.

What risks are we watching?

1. The obvious one is that of a second breakout as economies attempt to open up. Governments and central banks have used up a large amount of ammunition covering the economic hole left by the first round of covid-19; a more extended period of forced shutdown could be calamitous in terms of economic growth, public finances and – potentially - central banking. Either that, or officials simply resign themselves to the idea that the cat (or bat?) is out of the bag and it is better for the economy to remain open and take on the public health challenge that that entails.
2. We also think equity markets are facing a technical challenge as share buyback programs are scrapped. Corporates themselves were a large net buyer of stocks in recent years and that tailwind will be scuppered as corporates find religion with respect to credit metrics and maintaining credit ratings, benefitting investment-grade credit (in a risk-adjusted sense) at this point in the cycle.

Staying highly sceptical

Kate Samranvedhya, Jamieson Coote Bonds

As the world comes out of lockdown, we have to adapt to a new normal until vaccines become available worldwide. The investment team at JCB is frankly amazed at how fast equity markets have rebounded. On the one hand, we respect the wall of liquidity that central banks throw at markets, but on the other hand, we remain highly sceptical of the sustainability of this optimism.

As the acute phase of the crisis passes, the key thing going forward is whether central banks globally will allow market participants to function as efficient allocators of capital. That is a fancy way of saying that the markets should decide and take risks on which companies will thrive, and which companies will not be able to survive in the new post-COVID-19 economic era without the intervention of central banks.

What risks are we watching?

1. So far, yields have responded to the prospect of lower growth, lower inflation, and central bank purchases that partially offset the increase in supply. If inflation were to arise, it is possible that politics may move a country away from the low-cost supply chain model to either a nationalised supply chain or a supply chain within a political alliance.
2. If the pandemic prolongs, countries with much weaker fiscal stance will need help. It could be a small oil exporter who does not earn enough oil revenue to pay for expenses or a small economy with too much external debt in foreign currencies. The risk is these crises pop up at the same time. Imagine the IMF as having limited capacity to heal weak countries, quite similar to the way hospitals have limited capacity to handle sick patients on a pandemic scale.
3. The elephant in the room is Italy, the third-largest debt market after the US and Japan, where debt to GDP will probably rise to 160%. Ironically, two-thirds of its debt stock is held domestically, so it will hurt Italian banks and Italian pensions the most. This year, the ECB will buy enough of Italian net issuance, but the friction already appears to create mistrust in the European Union.

Expecting a short-lived depression

Jay Sivapalan, Janus Henderson 

Looking at the size of the stimulus measures put in place so far, this is a GFC-style bailout, but rather than bailing out the banks, it’s bailing out society and markets as a form of fiscal ‘welfare’.

We see this crisis as an economic ‘stop’ and expect a very deep, very sharp depression-like recession, though one that is finite, likely to last months rather than years. Australia’s success in flattening the COVID-19 infection curve raises the prospect of a shorter than expected period of ‘controlled hibernation’ and we look for the economy to trough in the September quarter before rebounding.

Much of the policies by central banks so far have been to restore normal market function and to provide liquidity. While these policies will help to cushion the impact of the pandemic, they do not address the economic environment we will enter when we get to the other side. We believe the peak in credit spreads is actually now behind us, though we acknowledge there will be some volatility and risk-off periods ahead.

What risks are we watching?

1. If the development of a COVID-19 vaccine was delayed beyond current expectations, it would delay the economic recovery due to continued precautionary measures such as social distancing. With recent speculation that the virus may never be completely wiped out, this raises the potential for ongoing economic impact due to outbreaks and the measures required to control them, including businesses being closed and periods of quarantine.
2. Outside of COVID-19 specifically is the potential for geopolitical risks. A further escalation in tensions between the US and China, or a prolonged period of diplomatic tensions between Australia and China, which is currently affecting our agriculture sector but could broaden out into other sectors including education and tourism would further impact the economy, making the economic recovery more difficult than it would have otherwise been if the COVID-19 and bushfire recoveries were the only focus.

The impact to fixed income markets of these risks playing out is that cash rates and cash rate expectations would be kept very low and possibly even push central banks toward alternative monetary policy methods not trialled to-date. These could delay a sustained recovery in credit spreads and credit markets, including potential for higher levels of defaults through the cycle.

Portfolios must be stress tested

Adam Bowe, PIMCO

Given the unprecedented nature of this shock, and the equally unprecedented scale of the policy response, I think we have to be humble with regards to our ability to confidently forecast developments from here. The shocks and responses have been uneven across the world and second order implications are still playing out. 

 So while the fiscal and monetary policy actions have stabilised conditions the effects of this pandemic will likely be felt for quite some time. 

 Until an effective vaccine is in place the risks of false starts or double dips when reopening economies are real, and a second wave could have damaging implications for downgrades and defaults.

So although financial market functioning has improved and illiquidity and forced selling has eased, credit risk premium imbedding in spreads will likely remain elevated in the near term. Importantly as investors we cannot rely on simple model forecasts of V or U shaped recoveries. Given the uncertainties portfolios must be stress tested and managed against a wide range of plausible scenarios. 

What risks are we watching?

1. As various countries gradually reopen their domestic economies over coming weeks and months the path of the pandemic, the timing of reopening, and a potential second wave of infections remain the largest risks to our outlook. This represents both upside and downside risks to our baseline forecasts. On the upside if new virus cases are successfully isolated and contained allowing businesses to reopen more rapidly than we expect growth may rebound more sharply than we anticipate. Alternatively a more prolonged period of slow activity or a double dip recession could result in widespread business failures and an extended period of elevated levels of unemployment.
2. Geopolitical tensions between the US and China also pose a risk to the outlook. Questions about China’s handling of the coronavirus outbreak, rising tensions again in Hong Kong, and Trump’s view that being hawkish on China is a political winner for him in an election year mean investors should expect more volatility on this front. And this isn’t just a US/China issue given many countries will feel forced to take sides with potential ramifications for bilateral relations.
3. On a more micro level, we believe the most resilient market sectors of the global bond market will stabilize well ahead of an economic recovery. But some segments, industries, and issuers could face permanent capital loss. This risk is particularly real for lower-quality unsecured corporate bonds. The economic fallout has already been significant, and despite their best efforts policy makers cannot save everyone as we have already seen with isolated cases of bankruptcy filings around the world. 

In conclusion

The almost ridiculous market bounce over the past month is certainly bringing out the rose-tinted glasses among investors. As tempting as it is to think the worst is over, the fact is the risk of further outbreaks is climbing as economies reopen. Furthermore, the debt overhang from government spending will inevitably manifest as frontpage headlines at some point in the future.

For those reasons, Gareth, Kate, Jay and Adam will discuss how they're building fixed income portfolios to capture returns while managing downside risk in the next iteration of this Collections series. Click FOLLOW below to get it first.