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Credit outlook: 'The common enemy'

Credit outlook: 'The common enemy'

24-03-2020 | Quarterly outlook

Spreads have moved from historically narrow levels straight to recessionary wides. It is time to buy.

  • Victor  Verberk
    Victor
    Verberk
    CIO Fixed Income and Sustainability and Portfolio Manager of Robeco Global Credits
  • Sander  Bus
    Sander
    Bus
    Co-head Credit team
  • James Stuttard
    James
    Stuttard
    Head of Global Macro team and Portfolio Manager, Robeco

Speed read

  • COVID-19 is causing an economic shock comparable to the global financial crisis
  • Authorities scramble to respond with fiscal and monetary stimulus
  • In just 4 weeks, valuations have collapsed to levels seen only four times in the last 80 years

What a difference one quarter can make. “In December we observed an equity market bubble continuing to inflate and a sustained late-cycle search for yield in credit,” says Victor Verberk, Co-head of the Robeco Credit Team. “Today we face a certain and severe global recession, an equity market crash and spreads that have moved from the historical tights straight to recessionary wides.” 

As he puts it in Robeco’s latest Credit Quarterly Outlook: “The world now has a common enemy. We have to join forces to beat the virus and avoid deep economic downturn. Authorities will provide fiscal and monetary support for the private sector. Governments and banks will need to work side by side to contain the fallout.” 

The short term will be economically challenging, with market pain and many market participants scrambling for cash and withdrawals. But Verberk says the Robeco Credits team is of the view that markets will try to look forward, through the stimulus and beyond stabilization in COVID-19 infections. 

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The Market Cycle - Mapping our view on market segments

Source: Robeco, March 2020

A shock with deep secular and cyclical roots

The longest economic expansion has ended abruptly. The end of the expansion itself is not a surprise; but the nature of the exogenous shock, its speed and the magnitude of the slowdown is. “History is being made. But while COVID-19 is the proximate trigger, we firmly believe current events are not just about the virus. They have deep secular and cyclical roots.” 

Sander Bus, Co-head of the Robeco Credit Team, explains how we got to this stage: “We discussed the debt super-cycle in a number of previous Credit Quarterly Outlooks. Many global imbalances, such as the rise in Chinese private sector debt from just USD 4.5 trillion before the global financial crisis to USD 30 trillion today, have been building for years. At minus USD 11 trillion, the US net international investment position is five times more extreme than it was before the global financial crisis. Social inequality has risen to levels not seen since the 1920s.” 

A build-up of imbalances emerged in this expansion, the result of 11 years of risk accumulation. “Central bank policy, which was too easy at times (e.g. 2014-17), fueled an equity bubble and deterioration in lending standards. Many open economies, such as Germany and Japan, had already weakened before 2020, hurt by mercantilism and trade tensions.” 

This unusual combination of market excesses and real economic fragility left both economies and markets vulnerable to a negative shock. No one knows ahead of time what the exogenous shocks and proximate triggers for crashes would be. If they were known, they would be priced in and there would be no crash. 

“There is no doubt about the proximate trigger this time,” Bus says. “A global recession is now inevitable and could be as severe as during the global financial crisis, when US GDP fell nearly 4% year on year. Credit spreads are already compensating for a deep recession.” 

In this bear market, everything is happening at a faster speed – including the policy response from monetary and fiscal authorities. Jamie Stuttard, Robeco Credit Strategist, believes that authorities have learned from the 2008 experience and are evidently prepared to go further and faster. “We will see a transfer of risk from the private sector to the public sector at the expense of huge fiscal deficits, funded by central banks amid increased asset purchase programs. Such public sector risk sharing is exactly what stopped the 2008 crisis, and is needed again.”

He points out that the costs will be huge, though, and the long-term question is: who will pay the bill? “Will the costs fall on the public sector and translate into a special ‘corona tax’ in coming years or will the private sector bear the burden?”

Stuttard expects that this will probably differ by country, depending on the inclination of governments to accept or prevent corporate failures amid the most vulnerable credits. 

Starting up again after shutdown

It is still uncertain when the global economy will be restarted. COVID-19 is still spreading rapidly and we have not yet seen the peak. As long as the end of corona is not in sight, markets will probably remain extremely volatile, Verberk says. “That said, markets will try to look through all the misery and will slowly price the right COVID-19 premium.” 

In short, the fundamentals are clearly weak. “A deep recession and lots of uncertainty will be with us for some time. But it is evident that we are in the phase of fear, panic and loathing. Regarding policies to soften the blow, expect fiscal support of over USD 1 trillion in each major economic region,” according to Verberk.

On positioning, he points out: “We are known not only for our conservative investment style, but also for our value-based, contrarian approach. Our view is that one should trim risk when the skies are clear, and buy risk when the storm has begun and markets panic. And, we believe that we have now reached the moment to reduce the underweight exposure to high yield markets and to implement a long position in investment grade. This is the big sell-off that we have been waiting for – for years. We recommend that clients with a strategic horizon adopt a contrarian stance, as well, and that they add risk.” 

Verberk acknowledges that this approach may seem counterintuitive. “The near-term looks set to confirm a deep recession and severe market pain in some quarters. We appreciate that it does feel like the worst time to add risk, but that is usually the best time to do so.” 

“It is the end of one cycle as we know it. But that sows the seeds for a new one.”

Download the Credit Quarterly Outlook report

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