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Insight 20.03.2020

"Whatever it takes": fiscal edition

Spotlight - With the US and broader European economies entering the ‘acceleration’ phase of their respective COVID-19 infection cycles, fiscal policymakers across Europe and the United States have begun outlining plans to bear down on this growing shock to demand and confidence.


Key points

  • Much like former ECB President Mario Draghi promised ‘whatever it takes’ to preserve the Euro-area economies in 2012, US and European fiscal policymakers have sprung into action implicitly making the same commitment in the face of the COVID-19 pandemic.
  • Though these measures in combination with recent moves from the US central bank in particular are certainly necessary, policymakers must avoid losing sight of another potential shock to the global economy that remain on the horizon that, if it remains unaddressed, has the potential to extend and magnify the virus-related economic shock. In particular, elevated disfunction in US credit markets means active intervention on the part of the US central bank and fiscal authorities is needed. Given the pace of recent actions, measures appear imminent.
  • With global authorities increasingly moving to a ‘whatever it takes’ strategy, investors should expect the one-way risk of the past two months to pivot increasingly to two-way risk as fiscal momentum looks to blunt the ongoing global demand shock.
  • As a result, already conservatively positioned investors can prepare portfolios to exploit opportunities to capitalise upon market mispricing in both risky asset (e.g. equities) as well as risk-off segments within portfolios.

The global economy is currently being buffeted by a SERIES of shocks

Though the focus of media reports is rightly on the COVID-19 virus and the human impact it is having on communities around the world, what makes this volatility episode in markets different to previous ones in the post-Global Financial Crisis era is that it is in fact composed of a series of shocks to the global economy rather than a single event such as investors have experienced in the recent past.

The crisis has morphed from a single, China-centric demand shock which was expected to be contained much like the 2002- 03 SARS episode was. However, the regional infection has expanded into a global demand shock in the past month.

In Europe and the US in particular, it is changing its shape once again, infecting global credit markets and risking a global credit shock and without more aggressive policy responses, a global USD liquidity shock.

These new, emerging shocks are coming against a backdrop of growing demand shocks in both the US and Europe. Indeed, the evolution of infections outside of China appears to be taking a similar shape in subsequent regions. In particular, we believe we are now squarely in the acceleration phase in Europe and the United States as anticipated in our previous Spotlight,’A COVID-19 Framework for Markets’.

Using the experience of China and other Asian economies, once their aggressive quarantine/social distancing measures were implemented, infection growth continued apace for another 2-3 weeks (chart).

With measures and enforcement in the US and Europe still short of those seen in China, HK, Singapore or Korea, this phase in Europe may take longer, perhaps closer to what Italy has been experiencing over nearly the past month. In the US, this phase has yet to begin given a yet piecemeal approach to social distancing/ containment suggesting that our mid-April expectation for a peak in infections remains reasonable though with a risk of extension.

Mitigating these escalating demand pressures in the US and Europe, are the stabilisation and signs of rebound emerging in China and other parts of Asia following their near two-month ordeal.

Beyond this, however, is the risk that these demand shocks are compounded by credit market shocks as well as a USD liquidity shock around the world.

Given the highly leveraged state of the global economy, rapid and unexpected changes to corporate revenues have the potential meaningfully to change their ability to service the debt on corporate balance sheets in sectors not only directly affected by the outbreak (like travel and leisure), but also industries that will be impacted by the broader economic slowdown underway as social distancing and outright quarantine efforts spread.

In addition, as corporates draw on credit lines in the face of revenue shortfalls, bank balance sheets will become increasingly constrained from providing liquidity to the economy. This becomes increasingly problematic as non-bank financial institutions (like asset management firms, fintech companies, and insurance companies) source their liquidity through overnight markets in particular.

Just as importantly, a large number of non-American firms require the same USD liquidity for their regular operations. However, facing even more constraints to this limited pool of USD liquidity has the potential to create an even more acute shortfall in US dollars internationally potentially triggering an additional shock within the global feedback loop.

The fiscal version of ‘Whatever it takes’ has begun in Europe

Fortunately for investors, policymakers are moving on several fronts to offset this demand shock brought about by not only the virus but also by the escalating containment measures being implemented.

To address the demand issues across economies, European governments began timidly and later expanded their measures to provide proactive support to the small and medium enterprise sector in Europe via credit backstops and guarantees. They have rapidly escalated their efforts further with German Chancellor Angela Merkel recently opening the door to discussions on long sought after, mutually government guaranteed European sovereign bonds.

Such a move would, at a single stroke, put aside questions around country specific debt sustainability and increase by a magnitude the firepower to offset the demand shock available across the continent. Just as importantly, it would demonstrate a pan-European commitment to the Euro at a time of extreme crisis.

In the United States, ‘whatever it takes’ has taken the form of a proposed US$1.2 trillion fiscal package that includes industry support for travel and tourism sectors as well as providing as much as US$500 billion in tax cuts and direct cash payments to consumer households.

While the spending initiatives to offset the demand shock have been large and surprisingly rapid in both the US and Europe, important differences have emerged in both approaches to dealing with the potential fallout for bank lending and credit markets.

The US has taken a direct approach by incorporating into a funding bill heading for Congress of as much as US$200- 300 billion in assistance for small businesses affected by the widening shutdowns across the American economy.

In contrast, in addition to direct assistance to small and medium sized business, the European Commission has outlined a plan to allow for credit holidays for existing debtors negatively affected by the outbreak. France has offered a 90% public guarantee for overdraft facilities and public support to renegotiate credit terms. Italy has put forward a moratorium on debt payments while Germany has gone a step further providing for unlimited public loan guarantees to firms.

The approach being taken in different formats across Europe appears to provide a more substantial firewall between the demand erosion being seen across the economy and bank lending and wider credit markets, helping to lessen the prospect of a wider euro-area credit shock looking ahead.

Recently, the European Central Bank has moved to bring in effective backstop efforts to prevent government yields from rising in the market by announcing a EUR750 billion bond buying programme while at the same time hinting that it would be operating without constraints such as the ‘capital key’ and the 30% limit on the purchase of any individual sovereign nation’s bonds in the Euro area.

US monetary and fiscal measures are running behind the curve

In the US, this fiscal-monetary collaboration is less apparent. With the high yield market (where energy issuers represent as much as 15% of the market) already buffeted by the sharp drop in energy prices, the absence of debt moratoriums and/ or backstops from the US sovereign balance sheet leaves the prospect that the demand shock translates into a meaningful default cycle within the US economy.

While a number of Global Financial Crisis-era monetary tools are available, they are yet to have been deployed. Most recently, the Fed has enacted a version of the Commercial Paper Funding Facility (to replicate France’s efforts to ensure short-term funding). However, beyond this, the Fed could restart the Term Auction Facility (TAF) which allows the Fed to take non-US government guaranteed securities (i.e. private securities) as collateral from member institutions (i.e. banks) in an attempt to re-start credit market functioning.

Most effective, however, we suspect would be a re-opening of the Term Asset Backed Lending Facility (TALF). TALF is similar to the TAF but allows the Fed to deal with non-bank institutions AND offers much less onerous mark-to-market requirements.

With the Commercial Paper Funding Facility now in place and given ongoing instability in markets, the Fed should move rapidly through these other Global Financial Crisis-era tools, finally injecting itself directly as the lender of last resort into credit markets to restore their functioning and hopefully buying time for both fiscal policy action in the United States and measures to address the growing threat of a USD liquidity shock around the world.

Indeed, we expect these actions imminently given the pace of policy activity in the past week. In particular, the US Federal Reserve appears to have addressed one of the other key threats that remained outstanding, the shortage of US dollars globally and the risk of a USD liquidity shock, especially outside the US.

The Fed earlier this week lready announced coordinated action with the Bank of England, Bank of Japan, the European Central Bank, and the Swiss National Bank to provide USD liquidity to key developed economies outside the United States. This need is increasingly acute given the estimated US$3.3 trillion in USD liabilities that sit outside the United States and the signs of increasing stress in this market.

More recently, the Fed followed up by announcing coordinated action with an expanded suite of central banks. In Southeast Asia, the Monetary Authority of Singapore maintains significant dollar needs due to their role as a regional banking centre. The Bank of Korea has significant needs due to large hedging requirements of domestic life insurers; whereas Scandinavian nations with large asset management industries have similar hedging needs. Central banks in Brazil, Mexico, New Zealand, and Australia have similarly established relationships with the Fed to access greater US dollar liquidity.

As a result, we suspect the Fed may be on the cusp of finally deploying the necessary tools install an effective backstop for USD credit markets just as it has moved quickly to ensuring functioning of offshore USD markets looking ahead. These measures should buy time to begin more active coordination between fiscal and monetary policies as increasingly seen in Europe.

Two-way risk rather than one-way risks looking ahead

If correct, that the ‘whatever it takes’ mantra will increasingly be adopted by both the Fed and ECB following on what China had begun in early-February, investors should prepare increasingly for two-way volatility in the markets rather than necessarily the one-way volatility that has characterised them over recent weeks.

Though we acknowledge that risks have not fully dissipated in light of the ongoing acceleration phase of COVID-19 in the United States in particular, tactically, we expect the prospect of meaningful Fed policy action to reinstate functioning of US credit markets that has the potential to end the one-way derisking of portfolios around the world in favour of more normal though still elevated, two-way risk within asset classes looking ahead.

As a result, already conservatively positioned investors can prepare portfolios to exploit opportunities to capitalise upon market mispricing in both risky asset (e.g. equities) as well as risk-off segments within portfolios.

With risk-off segments of portfolios, reducing long-duration bond exposure is prudent as the asymmetry that worked in investors’ favour as central banks eased and yields fell, is now working against them. As the reserve currency to the world, we believe the Fed views a negative interest rate environment for the US as a risk to financial system stability and, as a result, will seek to avoid it is possible. Thus, long duration bond investors no longer have the protection offered by the prospect of falling yields though may face capital at risk should yields trough and rise looking forward.

Similarly, we have moved to asymmetric exposure in gold, favouring options exposure over direct holdings of the metal. We expect the still very leveraged long positioning in futures markets to continue to present a headwind in the near term to the price of gold. In the long term as risk of monetisation by central bank grows, we continue to believe that gold remains an attractive tail risk hedge against such an outcome.

We continue to favour long Japanese yen and Swiss franc exposure as components to ‘risk-off’ positioning given continued undervaluation.

Within risky asset portfolios, with our expectation that the Federal Reserve will lend its own balance sheet to create a firewall in credit markets like it did in 2008 via the TALF, we retain our US high yield bond exposure. In emerging markets however, until wide swap lines are opened with emerging market central banks, investors will continue to see meaningful volatility and thus should focus on very selective high quality, hold to maturity exposure.

We are similarly rotating our equity exposure, locking in gains realized in our select group of long-short equity hedge funds and alpha generated across a range of our structured equity exposure over the past several months and preparing for more directional global equity exposure looking ahead.

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Michaël Lok
Group Chief Investment Officer (CIO)
and Co-CEO Asset Management

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Norman Villamin
Chief Investment Officer (CIO)
Wealth Management and
Head of Asset Allocation

patrice_gautry150x150.jpg

Patrice Gautry
Chief Economist

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Yves Cortellini
Deputy Head of Asset Allocation

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