News & Insights
Market context: Global Financial Markets will remain volatile and dislocated until the peak of the pandemic is reached in the US. For medium term investors, the dislocation in the financial markets and the indiscriminate asset liquidation offer opportunities to put money to work at a discount where there is visibility on how and when the capital will be returned and if cash flow will actually be generated during the asset holding period.
1. Global Macro: The month of March was one of the worst in the history of financial markets. The impact on financial assets caused by the virus worsened mid-month when several countries around the world started to announce nationwide lock-downs and mandatory confinements, subsequently bringing most of the economy to a halt. Almost immediately following these announcements, corporations warned about potential defaults and some emerging market countries warned about the urgent need for liquidity in USD and requested USD liquidity swap lines with the US Federal Reserve. At the same time Lebanon defaulted on its debt. Subsequently, High Yield corporate bonds as well as emerging market bond prices collapsed as well as their local currencies.
2. Financial Markets: Equity: Year to date the Hang Seng sold off -29.5%, SP500 -20.6%, Eurostoxx -25.7%. Fixed Income: 10 year US yields decreased -43bps in March to 0.70%. Emerging market government bonds in USD and EM local currencies sold off 20% mid-month. Corporate bonds sold off with High Yield spreads widening back to the level of 2008. Currencies: USD remained a safe haven and remained strong whereas EUR +0%, AUD -5.8%, CNY -1.3%, and RUB was -17.8%. Safe havens: JPY +0.6%, CHF +0.4%. Commodities: There was a global sell off of industrial commodities while precious metals were steady: Gold +0.3%. However, Oil was -55.2%,
3. Risk Management: As high yield credit spreads got closer to 2008 levels on their way to 1000 basis points, and sovereign emerging market bond spreads widened fast, in price terms some High Yield and Emerging Markets bonds sold off 20% which is the level at which these holdings are entering “distressed debt territory” generating liquidity risk. This triggered forced sales from institutional investors, due to limited visibility on the future recovery. Professional investors started to “get ready” to progressively increase their equity exposure in order to be positioned to benefit from the market normalization when it happens. Our analysis indicates that liquid, quality and growth developed equity market indices will outperform distressed high yield and emerging market bonds.
Conditions for financial market normalization: in addition to the Central Banks' and Governments' stimulus, the three following conditions are necessary for a sustainable financial market normalization and recovery:
1- The number of daily newly infected people in the US has to go down. Currently the peak is expected in late April for the U.S.
2- The market volatility has to go down to investable levels for institutional investors to reenter the market, i.e. the VIX has to go down below 30%. It went up to 85% and is now close to 60%
3- The market participants have to become less sensitive to bad news. i.e. sentiment has to improve.
4. Base case scenario for 2020:
We are facing a large amount of bad news and their gravity is not correctly anticipated by what is published by the data and news networks. Unfortunately, the number of deaths in the US, the unemployment rate, the corporate earnings revisions and bankruptcies will be severe. Based on these observations and the conditions for the financial market normalization, it is likely that the market asset prices deteriorate further before they normalize. In this base scenario, where lockdowns will be wound down throughout June or July, we anticipate a financial market normalization in the second half of 2020.
5. Opportunity: Investment grade financial issuers. Our analysis shows that the indiscriminate sell off of investment grade financial institutions’ bonds created an opportunity to put money to work at a discount with visibility of capital redemption and cash flow generation.
1- Expected capital gains: The bonds from investment grade banks sold off approximately 15%: the bonds will pull back to par as the crisis progressively ends, generating a potential 10% to 15% pop in price.
2- Sustainable cash flow generation: Bank bonds’ coupons will be paid in full. The Central Banks asked banks to cut dividends but confirmed that the bonds’ coupons or principle will not be affected.
3- Redemption of the capital: The capital is returned as the bonds reach their maturity. Investment grade banks are robustly capitalized and supported by central banks.
Conclusion: We expect market volatility to persist until the peak of the pandemic is reached in the U.S. and the World, potentially by the summer. Following the “pandemic's peak” signal, we expect the market to start normalizing to levels corresponding to the anticipation of the state of economic activity going forward. According to our systematic portfolio management process the portfolios will stay invested in order to gradually benefit from the market normalization and take the opportunities arising in this dislocated market.