While Western economies are only just beginning to show the first signs of the scale of the Covid-19 economic shock, markets want to anticipate recovery. Certainly, we expect a strategic multi-year opportunity in higher-quality credit, Baa or otherwise. But on the growth outlook, we are skeptical of some of the assumed trajectories.
Western market participants often have a fixed set of scenarios for future growth, parameterized by letters of the alphabet, including V, U, W or L-shaped. But, not only is this an investment-writing cliché, we think it is also a false choice for Covid-19.
Just because our Western alphabet has been around since Etruscan times does not make its letters the best economic guide. The letters V and W, with their sharp bounces, and mean-reversion assumptions, seem to belong to a 1945-2007 world, a prior era compared to post-2008 structural trends. U seems to ignore ten years of lower growth and rates. The letter L seems more suited for Japan.
Covid-19 poses new market and economic questions: we have the competing theories and scenarios of epidemiologists, the second derivative of new infections and the flattening of curves (infection curves, not US Treasuries or credit maturity curves).
We think 2020-21 growth trajectories are better described by the Arabic letter Baa’, in its final form (Figure 1). In an age of lower secular growth trends, low rates, older demographics and higher debt, the elongated horizontal sweeps of the Arabic alphabet seem a better fit than western equivalents.
The consensus expects -16% (quarter-on-quarter, annualized) US GDP growth for Q2, and -1.5% for 2020. The Euro Area Q2 numbers are similar, with full-year 2020 forecasts at -3.5% (based on a selection of recent broker forecasts). We suspect the downgrades to growth, earnings and sovereign and corporate credit ratings aren’t over. All in, our base case sees 2020 real GDP in the US, and the Eurozone at least matching the full-year 2009 economic contractions of respectively about -3% and -4.5%.
Given the massive fiscal easing, we expect government budget deficits of at least 8-12% of GDP. This is necessary in the short term. Yet, further out, it proffers higher sovereign debt burdens and fiscal drag.
Fixed Income opportunities are shifting swiftly away from safe-haven government bonds towards credit.
We think the best allocation opportunities are now gradually to build long positions in investment grade credit, and in BB high yield. We are cautious on emerging market (EM) hard and local currency, and view EM FX mainly as a risk hedge against credit longs. The potential for rolling crises means there are plenty of parts of the EM universe to avoid.
For all of Q2-Q4 2019, we saw very little opportunity in credit. It is hard – but crucial – to be disciplined and patient when spreads are tight and when both valuations and fundamentals are late cycle, regardless of short-term incentives of chasing carry. We came into the Covid-19 volatility with an overweight in EUR investment grade versus an underweight in USD investment grade. We had betas of just over one, and a zero net exposure in high yield. This sets us up with fire power for the current opportunity.
What a change March 2020 has brought. We are now at credit spread levels seen only for the third time since the 1930s: in the early 1980s, 2008 and now, based on Federal Reserve and ICE BofAML data. Policymakers have stepped in, with the Fed breaking new ground by joining the ECB and Bank of England in buying corporate bonds.
On a cross-sectional basis, we find investment grade credit, especially primary, long-dated USD, to be the best opportunity. We look for bottom-up balance sheet quality and cyclical resilience. Next, we favor EUR investment grade, followed by non-energy BBs in EUR and USD.