16 Apr 2020
The year started positively, as the US and China signed into effect ‘phase one’ of their trade deal. However, before long, news of the worsening coronavirus (COVID-19) outbreak in China began to drive fear into markets. As COVID-19 spread globally, the combination of the pandemic and the oil price war, combined with initially ineffective policy responses to the pandemic by the US and other developed markets, led to widespread market turmoil across global markets.
A liquidity shock compounded the fall-out from the pandemic and oil crisis. This was caused by a combination of indiscriminate selling by investors and limited willingness among banks to act as a market maker and take on risk, leading to an extremely dislocated market, with bid/offer spreads widening to levels last seen during the global financial crisis.
Emerging market corporate bond prices (measured by JPMorgan CEMBI Broad Diversified Index) fell over the quarter.
Commodity exporting countries have been hard hit, with Latin American energy-related bonds under particular pressure, given the compounding effect of sovereign-related issues in Ecuador and Argentina. The Middle East saw its bonds sell off meaningfully, despite the average credit quality being high, primarily because most of the businesses there are heavily exposed to oil.
In contrast, China and a number of other Asian markets remains in positive territory year to date. China has benefited from a decisive and coordinated policy response, accompanied by draconian measures to restrict the spread of the virus, and evidence suggests the country is through the worst of the COVID-19 crisis. Monetary policy action has provided some underlying support for markets, and loosened fiscal policies should relieve some of the pain of the current economic troubles. Specifically, the US Federal Reserve (Fed) stepped up its support, with various measures having a direct, positive impact on credit markets. The Fed’s participation in the primary and secondary US corporate bond markets, plus a new two-trillion dollar fiscal package, have provided a further fillip for the overall mood in markets. Additionally, the IMF has lined up significant support for emerging market economies.
Most banking systems have responded with additional forbearance measures to alleviate the risk of defaults on loans and remove stress in the system, while some country’s central banks – such as Turkey – have announced quantitative easing programmes.
Despite this, there is a growing realisation that the crisis could bring the global economy to a standstill for significantly longer than anticipated. The risk of a severe recession taking hold has triggered many negative ratings actions, with Fitch – usually the least reactive agency – leading the way.
We expect markets to remain in a state of heightened volatility until more positive news emerges on both the COVID-19 pandemic and oil prices. Although since quarter end some measures have emerged from OPEC+ to reduce future supply, the collapse in oil demand will take a longer time to correct.
The longer the oil price remains at such a depressed level, the greater the risk of ‘stranded assets’ – whereby some energy producers own assets that are no longer profitable to operate. This could create a spike in defaults among some high-yield parts of the global bond market and a protracted global economic slump, especially for states that are heavily dependent on oil revenues.
Outside of the oil market, the risks to the global economy from COVID-19 remain significant.
While it is still difficult to gain conviction on the exact future path of the pandemic, it is likely to get worse before it gets better in Europe and America, and the impact on the global economy will likely be more protracted, dimming the potential for a V-shaped recovery of economic activity. Investors will be rewarded for patience and steady nerves in the months ahead, in our view.
That said, further decisive co-ordinated action from central banks – and the speed of execution fiscal stimulus measures from governments – will likely play an important role in how economies and markets fare over the coming months. Policymakers around the world are already attempting to counter the virus outbreak through both fiscal and monetary policy tools.
The key measures to watch from here are the increasingly likely credit rating downgrades and debt defaults. In emerging market high-yield corporate bonds, we expect defaults to increase over the next 12 months to the region of 6.5%. Downgrades have already started to pick up, with many corporate credit downgrades being triggered by sovereign debt downgrades. We expect the downgrade trend to continue the longer the crisis persists, with oil-related sectors and oil-dependent economies most at risk.
That said, while emerging market companies did not enter this crisis in peak health, in general they were in better health at the entry point to this crisis than at many other similar junctures in the past. They are familiar with market volatility and have maintained lower leverage than developed market peers. They have also tended to be more cautious, retaining higher cash balances with limited capital expenditure (capex). In fact, they entered this crisis with among the lowest capex to earnings (EBITDA) ratios since the global financial crisis. We think the forbearance measures put in place by many banking systems will help to protect vulnerable economies over a six-month horizon, which, judging by events in China, seems the right length of time.
Refinancing risks are somewhat mitigated by the active issuance and pre-financing that has happened in the corporate credit market over the past year, helping to reduce the near-term burden. In the investment-grade market, we are already seeing issuers accessing the bond market again, showing that there is still demand for bonds issued by strong issuers.
However, we must acknowledge that – despite the fact that many emerging market companies benefit from superior access to liquidity from multiple sources and have manageable debt levels – companies have never before witnessed a global shutdown with limited visibility on the trajectory of future economic activity. Corporate management teams are having to make suboptimal decisions based on guestimates as to how best reduce costs and maintain operations in order to minimise the economic fallout of the crisis. Emerging market corporates are transitioning from planning for growth and capacity expansion towards husbanding of liquidity, conserving balance sheet strength and cost minimisation. We expect this adjustment period to be fraught and there will be a deterioration of credit metrics in the short term. Ultimately, this an environment where management objectives will be much more creditor-friendly than shareholder-friendly and that should provide a solid underpinning for corporate fundamentals when looking through the cycle. Overall market valuations reflect a repricing of this credit risk, and spreads on the JPMorgan CEMBI Broad Diversified Index are looking highly compelling again.
While it is understandable that investors require a higher risk premium for the elevated levels of uncertainty and almost certain deterioration in credit quality to some degree, we believe the market pricing reflects an overshoot of negative expectations, driven in most part by the selling pressure of outflows. We see further pressure on outflows in the future as investors need liquidity to survive, but we think central bank buying programmes should now counter some of this flow-driven repricing, reducing the risk of a real liquidity event occurring. Looking further ahead, this whole episode will almost certainly have economic repercussions resulting in higher debt levels and lower growth, strengthening our conviction that investing in relatively resilient corporate bonds offers superior risk-return potential for investors.