The multiple stimulus policies announced worldwide are all very interesting.
Still, what counts most in the short term is the progress of the Coronavirus through populations at large and the related human toll.
The problem right now, after the to-be-expected policy-triggered post-crash rally, is that the number of cases is still rising in Europe and, of course, in America, though there has of late been some encouraging evidence that the curve is flattening.
Coronavirus Cases in Europe (log scale)
Coronavirus Cases in The US, NYC and UK (log scale)
This is not an exact science. But a glance at the “curve” suggests that the infection rates could be peaking in Europe around mid-April, while the same may be the case in New York City, the worst-hit city in the US, if not in the rest of America.
And, remember, Wall Street-correlated world stock markets are first and foremost driven by sentiment, where the epicenter is New York.
A peaking out in coming weeks should drive a narrative, which is also the base case here, that the health crisis is more the equivalent of a national disaster, rather than the trigger of a prolonged depression.
This means the crisis is more likely to prove to be a three- to four-month cycle and the Western world can start to return to normal by the end of this quarter.
This is the critical point because the duration of the health crisis will determine whether this is a liquidity issue or degenerates into a solvency issue.
Risk Still Abound from U.S. Leverage
Clearly, the longer the duration of the downturn the more likely those who were carrying too much debt heading into it become victims. And, of course, corporate debt in America was at a record high at the end of last year.
US non-financial corporate debt rose by 4.8% YoY to a record US$10.12tn at the end of 2019 (see following chart).
US Non-Financial Sector Corporate Debt
This raises the issue of the support provided by governments.
The most important support, and the most justified from a public policy standpoint so far as this writer is concerned, is meeting small firms’ payroll, rent and utilities costs for a limited period providing they do not lay off employees.
Apparently, this will be for a two-month period in America, while European countries have come up with similar if not more generous schemes.
Still it is important to understand this is not a stimulus. It is simply trying to replace lost demand in what it is hoped will prove to be a short -term emergency in the hope that businesses can survive.
Still the developed world has an advantage in this respect since most emerging markets do not have the same fiscal latitude, or indeed administrative capability, to provide such support.
This is pertinent for countries like India, where the news flow over the past two weeks has been alarming to say the least in terms of reports of panic exoduses from the cities as the suddenly unemployed, courtesy of the mandated lockdown in activity, seek to return to their villages.
In such countries there is a real risk that efforts to contain the virus prove more damaging than the virus itself.
In this respect, it is hard to see how the lockdown in India can be sustained for more than the three-week period.
Indeed, the same argument will apply in the West if the assumption that the virus peaks out this quarter proves incorrect.
This is because a continued lockdown in activity into the third quarter would be an economic catastrophe, meaning it would cause a bigger problem than the virus itself.
Fallen Angels are Why the FED is Buying Junk Bonds
But returning to the issue of policy support in the Western world, from a Federal Reserve credit market standpoint, a critical detail is what securities the Fed is buying as part of its latest ramped-up quantitative easing.
Until Thursday, the buying has been limited to Treasuries bonds, mortgage-backed securities, investment-grade corporate bonds, commercial paper and municipal debt.
It should be noted that the Fed never bought corporate bonds in the global financial crisis.
Still, the Fed has not been buying high-yield bonds or collateralised loan obligations (CLOs) though that now looks like it will change based on the latest Fed announcement on Thursday which extended Fed purchases to higher-quality high yield bonds and CLOs.
Thus, the Fed will expand its corporate bond buying programme to include corporate bonds that were investment-grade as of 22 March but have since been downgraded to no lower than BB-, or three levels into high yield.
The Fed has also expanded its TALF programme to include previously issued AAA CMBS and newly issued AAA “static” CLOs.
What was interesting about this latest expansion of what the Fed can buy is that it came after the biggest weekly percentage rally in the US stock market since 1974.
The S&P500 rose by 12.1% last week, the largest weekly gain since the week ended 11 October 1974.
This raises the interesting issue of how much further Fed purchases will expand again if there is a renewed market collapse.
Meanwhile, a technical issue for the Fed is the growing risk of investment-grade bonds being downgraded to “junk” given the huge bunching of Triple-B credit issuance prior to the outbreak of the health crisis.
US BBB-rated corporate bonds outstanding have risen from US$670bn or 33% of total US investment-grade corporate bonds at the end of 2008 to US$3.02tn or 50% of the total in early March 2020 and are now US$2.79tn or 47% of the total, based on the constituents in the Bloomberg-Barclays US Corporate Bond Index.
US BBB-rated Corporate Bonds Outstanding
Indeed this “fallen angel” risk is probably the main reason the Fed extended the purchases into high yield last Thursday.
Meanwhile, there is no doubt that Fed buying of investment-grade bonds has revived confidence in the credit markets as investors have “front run” the Fed buying.
US investment-grade corporate bond spread and BBB-rated corporate bond spread have declined from 373bp and 457bp respectively on 23 March to 233bp and 306bp
US Investment-grade and BBB-rated Corporate Bond Spreads
Can China Go Back to Normal?
The other big issue facing markets is whether China can continue to contain the virus as the country has returned to work.
This writer continues to give the central government the benefit of the doubt on this issue.
And, indeed, it remains the case that most of the new infections in China recently have come from those returning from America and Europe.
There have been 1,060 new imported cases in mainland China since 16 March, or an average 41 cases per day.
By contrast, there have been only 33 local cases over the same period, or an average 1.3 cases per day.
Daily New Coronavirus Cases in Mainland China
Still, a renewed surge in China remains a risk that cannot be denied.
But if anyone can manage this risk it is the Chinese Communist Party.
For now, it looks like China will have the most resilient economy of the world’s major economies in the current quarter.
Still it will not be a V-shaped recovery even if the health risk is managed successfully.
Global demand for Chinese products has collapsed while the service sector will take time to recover.
It will, for example, take time for people return to restaurants en masse, let alone cinemas.
The best-positioned companies are Chinese Internet giants and their online business models.
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