When the economy stops
The world has never been as globalised and interconnected as it is today, so when a pandemic such as COVID-19 hits, it’s an enormous challenge to contain. Government and health policymakers are attempting to stage the human impact by reducing the peak of the virus through ‘social distancing’ and limiting exposure.
From an economic standpoint, this causes a simultaneous demand AND supply shock, so rather than an economic slowdown, we are seeing an economic ‘stop’ in activity in some sectors.
Governments and central banks are scrambling to curtail the economic impact. However, to-date they have turned to the playbooks of previous crises, including the global financial crisis (GFC). This crisis is very different to any previous crisis, requiring innovative policy action to fill the short but very sharp contraction in economic growth that nations are about to face.
A recession we didn’t have to have
It’s almost inevitable that Australia as well as other economies around the world will undergo a short, sharp recession, albeit a technical one. In Australia’s case, the first quarter GDP was already dragged down by the bushfire events and the addition of the sudden economic ‘stop’ means Q2 2020 will likely also be a negative quarter of GDP growth.
However, with the right policies, a peaking in the COVID-19 pandemic around mid-year and with a little bit of luck, we should see the Australian economy rebound towards the latter part of the year, with momentum picking up further through 2021.
Critical ingredients for this statement to hold true are the effectiveness of governments’ response to flattening infection rates, very targeted liquidity measures by central banks to restore orderly markets and highly targeted and timely fiscal measures that provide a backstop for small to medium enterprises (SMEs) and employees.
Central banks reach their limits and look to QE
Central banks around the world have acted swiftly to implement emergency monetary policy easing, with most getting to their lower bounds in terms of cash rates. They fully recognise that the transmission mechanism of these actions is not through an increase in consumption or economic activity in the very near-term. Rather, it is designed to assist in arresting an already significant market deterioration from getting worse.
Central bank policy is now shifting swiftly from lowering official rates towards providing liquidity to market participants and the broader financial system. This will be a critical factor in how markets behave from here on. We are likely to see more central bank intervention around providing various forms of liquidity.
To summarise action to-date, the US has cut the Fed funds rate by a cumulative 150bps, taking their benchmark interest rate down to 0-0.25%. This brings them in line with numerous other central banks at or heading towards similar levels including, the Bank of England, the Reserve Bank of New Zealand, the Bank of Japan, the Bank of Canada and the European Central Bank (ECB).
The Reserve Bank of Australia (RBA) is expected to join other central banks in taking the Australian cash rate down to 0.25% and announcing a Quantitative Easing (QE) regime, which may include forward guidance and Yield Curve Control (YCC) measures.
In terms of economic activity, while these actions are helpful (especially for markets), public health and fiscal policy are better placed to help economies regain their footing from the impact of this pandemic.
Will fiscal stimulus be enough?
On the fiscal side, the Australian government has announced a vast stimulus package, with potential for further expansion. Of any government, we believe the Australian Government has the capacity, the willingness and ability to coordinate a strong and targeted fiscal response. By comparison, the American ‘$50 billion flu shot’ was only about 0.25% of GDP, although there are discussions of a materially bigger fiscal stimulus. Our biggest concern is that some offshore governments are not doing enough, nor with sufficient urgency, to arrest the deteriorating conditions.
In Australia we have a number of policy tools which are now being employed; we've got monetary policy, fiscal policy, and in addition, we've also got a weaker currency providing the economy with a longer-term boost to growth and inflation.
With good policy and Australia’s good fundamentals, the economy is well-placed to rebound once the virus peaks or a vaccine becomes available.
However, there is a gap.
The most important aspect of any further fiscal stimulus is the government’s ability to provide a backstop or insurance coverage to those firms, their overheads and employees who are hitting a wall as a result of social distancing measures. It is imperative that further fiscal responses are innovative, targeted at specifically the next three to six months and serve to bridge the gap for businesses and employees during the pandemic isolation period.
The importance of liquidity
Central banks have an acute awareness of liquidity in the post-GFC era where intermediaries such as banks typically have much smaller capacity or inventory on balance sheets. Banks’ ability to broker for the investment community has drastically diminished and is an unfortunate side effect of the post-GFC era regulations that came into effect for banks and their trading activities. These developments, coupled with an exogenous shock, are almost the perfect storm that central banks and regulators had feared. It is fair to say that a major contributing factor of the veracity of the market sell-off, in particular risk assets such as corporate debt, has been lacklustre liquidity and poor price discovery.
One of the biggest risks that market participants are facing at present is a liquidity freeze, largely because the banks are not there to provide pricing and liquidity.
That's not to say there isn't a weight of money waiting to invest and wanting to buy. We're one in that category; but many like us are choosing not to spend cash reserves all at once.
Central banks cognisant of this dynamic are looking for ways to provide much needed liquidity facilities. A number of new categories of securities have become repo eligible, meaning investors can actually sell them to the RBA and purchase back at a later date to access near-term funding. And we expect broader liquidity-focused measures to be announced in the coming days and weeks. So while liquidity is problematic, central banks are going to be pumping a lot of liquidity into the system. It wouldn’t surprise us if in the coming month or two the RBA starts acting more like other central banks, such as the ECB previously. Taking an extreme example, the Bank of Japan as part of its remit can even buy equities. The point here is that central banks, including the RBA will need to be innovative and stand ready to act in order to support liquidity. We feel this is the most important tool for the weeks and months ahead where cash rate settings are a secondary consideration.
Navigating difficult markets
Extremely volatile markets and the unknown magnitude of the near-term downturn in the economy require significant caution and prudence by portfolio managers. Significant emphasis needs to be placed on capital preservation, especially in defensive portfolios. However, experience also tells us that markets lead economic reality and the best opportunities pass during the eye of the storm, before evidence emerges that the economy is responding to policy measures.
Given the economically disruptive nature of this pandemic, there is likely to be significant loss of output ahead of us. This includes a lift in the unemployment rate. Arrears on loans are likely to rise and ultimately lead to a rise in defaults. This, paired with policies to-date that in our view are helpful but not sufficient nor fully targeted to this unique economic stop scenario, are likely to result in volatility remaining elevated.
So far, all of the strategies we manage across the fixed interest risk spectrum have performed in line with our expectations given the market moves observed to-date. Having been defensively positioned within most of our strategies over the past 18 months, due to an assessment of valuations becoming stretched, our portfolios maintain ample capacity to take advantage of dislocated markets and the resulting opportunities that are emerging.
On the rates side, we have remained quite nimble, in particular with duration positioning. As Australian bond yields lifted, when the RBA (in our assessment) is heading towards QE and YCC (lowering longer-term rates), we saw bonds as mildly attractive and have been adding duration to our portfolios. Overweight duration positions offer a hedge against further deterioration in non-government debt valuations.
Probably the one area that's been disappointing for us has been the breakeven inflation trade, with some exposure to inflation linked bonds. Expected 10 year inflation (breakeven inflation) has fallen sharply and is currently at around 50bps, driven primarily by technical factors. That's the lowest on record and while we see an opportunity there, we recognise that inflation expectations will remain subdued for some time. However, with a low Australian dollar and a depressed oil price that is unsustainable over the medium-term, this exposure will likely bear fruit in due course. This trade is for the patient investor.
On the credit side, while we have been defensively positioned, any credit allocation (even very high quality) has been a drag on performance as credit spreads have widened. That said, with extreme moves in markets, we are starting to see some opportunities to add to investment grade credit in high quality “recession-proof” issuers. In higher yielding markets for our credit-based income style portfolios, we've started selectively adding subordinated debt and some hybrids Tier 1 capital notes of major banks.
We are also seeing opportunities starting to emerge in global high-yield markets.
With ample capacity to take on more credit risk, we feel now is a good time to begin averaging-in, fully recognising that markets can become cheaper. Experience tells us that unless portfolio managers have god-like abilities, it is near impossible to time the peak in credit spreads and even if one could, liquidity rarely exists to purchase. Our approach is to commence averaging-in, with the full understanding that while markets remain volatile, it will also increase the volatility of our strategies over the period ahead.
With an eye to prospective returns for our investors over the year ahead, we see good opportunities emerging. Managing defensive portfolios has always been a fine balance between capital preservation and return-seeking activity, where the former should dominate. We feel the pendulum is swinging, favouring those who seek returns on a forward looking basis, utilising the market dislocations being presented. As in all past market corrections, the ripe rewards favour those investors who can be disciplined in adhering to their investment processes, diligently assessing each opportunity and are willing to go a little against the consensus. Most importantly investors must be able to exercise patience to reap the rewards.
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Jay Sivapalan is Head of Australian Fixed Interest and a Portfolio Manager at Janus Henderson Investors. He contributes to both interest rate and sector strategies employed within portfolios and has 22 years of financial industry experience.