Risk assets especially global equity and oil have been rallying of late and Vix has dropped. This piece looks at what has driven this optimism and relief rally, whether its sustainable and where some of the weak credit links remain.
What’s driven this optimism? The best explanation is that signs of peaking or decline in death rates in Europe and closer to peak in US and UK has leads to some thoughts of reopening the economy in the coming months. Markets do tend to be forward looking and price in a change in scenario or a change in its probability. That coupled with liquidity and low rates has contributed to this relief rally. The challenge is that ahead also will bring some potential false starts, collateral damage and probably a much weaker new normal. Similarly hopes of oil output cuts supported the oil price – though such cuts would at best reduce the bleeding of the sector – and there remain major questions about who bears the costs.
Is this optimism justified? Perhaps not? Signs of quarantines lifting in a few months is a relative positive, but it is likely to be a rocky road ahead. Earnings outlook does not yet seem to reflect the challenges that may be faced over the next few months and the weaker growth prospects. It also does not yet reflect concerns that many companies may struggle to survive – admittedly less a concern for bigger listed equity than smaller businesses and groups. Despite the financial lifelines for many households and companies, credit strain is real across key sectors and emerging economies (see below). Markets often price in a slightly better picture when investors believe the worst case scenario has been avoided, the challenge is that the collateral damage from the interlinked health, economic and financial crisis, especially the costs of putting the economy on needed pause suggest that attempts to price in the new normal may be premature and overly optimistic. In particular the recent trends in Asia to move to higher levels of alert and shutdown may prompt concern about what type exiting from quarantine is realistic.
On the energy side, this is set to be a volatile week as hope of cuts interacts with divergence about who bears the cut, for how long. Demand remains weak and the overhang large and OPEC+ remains divided on distribution of any coordinated cut. Meanwhile the non-OPEC players that are not part of the group – US, Canada, Brazil, Mexico, Norway are mostly reducing future production as its uneconomic – but remain less convinced about cutting in most cases. The U.S, messaging remains most concerning – with President Trump moving from potential tariffs (counterproductive and bad for US product exports), potential cuts (unlikely to be mandated) and the preference for big players to force small poorer players out of the market – and force supply chain cost compression. This argues against a grand bargain. Significant cuts are likely but in a lag… and perversely any hopes that the economies will soon slowly reopen may make this more difficult.
Corporate impacts: Is Bigger Better? Is I’ve been thinking a lot lately about divergence within sectors and across the EM credit space. The spread between investment grade and high yield bonds has widened sharply. One potential trend suggests that in some sectors, the crisis and financial challenges could reinforce the role of dominant companies as they are either TBTF or have stronger balance sheets and more liquidity. It looks better for listed equity and larger caps than smaller caps (or smaller privately held companies with weaker balance sheets).
The trends might reinforce divergence within sectors in preference of larger players. Either they may benefit from bailouts – too big to fail or they may begin with stronger balance sheets less debt and more cash. This raises the question whether stronger companies may have the ability to drive consolidation in their sector while smaller and medium peers are more constrained. Two sectors where this may occur include energy and technology, where smaller cash-strapped companies look more exposed despite the financial lifeline from select governments. Still, any such investments might come only after or as part of distressed selling. It is notable that cash-rich companies with broad equity and credit exposure may have reinforced the upside and downside trends.
One positive sign though has been a series of policies to try to preserve earnings. In many cases support to business has been contingent on paying salaries to workers (a more efficient way to do so). Moreover some regulators have encouraged major corporations to cut dividends, and limit buybacks and cut executive compensation. Some companies have done this on their own. These trends are definitely not universal and of course the demand hit is incredible. Still, its an important area to watch for ESG related issues. A similar open question concerns decarbonization and investment in renewable energy in the wake of financial challenges and the impact of the oil price collapse, though that’s worthy of another piece.
What about risk of sovereign default in EM? Many EM have already faced credit downgrades as ratings agencies followed priced in trends – and some countries were very slow to loose their reputations. There are likely to be further declines in credit rating cycle and increase in defaults, but there is significant divergence. Almost all EM are facing financing and liquidity challenges due to capital outflows, lower export and domestic revenues and thus widening spreads. Solvency is also weaker – though that’s more where the divergence emerged. The only exceptions are some surplus Asian economies such As China and especially smaller richer Asian countries, who already tend to have access to swaplines. In practice these market access issues may reinforce divergence. The IMF and other financial institutions are quickly trying to bring into action financial support to avoid austerity.
EM and frontier countries could be divided into four main groups based on their liquidity and solvency needs, resiliency of balance sheet and dynamics of the national capital structure.
- Countries already in or near default: Lebanon, Argentina, Ecuador, who might have already been in talks with lenders. These countries tend to have high levels of foreign currency debt, unsustainable debt burdens and high debt service. Others like Ukraine who were in talks with IMF for financing before, may find it even more difficult to calculate what a realistic debt sustainability path looks like
- Countries where covid has meaningfully impaired revenue outlook and buffers are already depleted. these are countries that were already experiencing financial challenges, but were able to make payments, in part due to low interest rates and bridge financing. However, recent shocks call that into question. mostly oil producing economies or those suffering export revenue drop. These countries, which had already been strongly relying on debt issuance to address fiscal gaps before the crisis face a more acute challenge, especially as they face a range of revenue shortfalls at the same time. Oman, Bahrain, Iraq, Possibly Nigeria, Ghana and some other SSA Eurobond holders. These countries tend to have more FX debt than local currency (and local currency financing costs have also been increasing rapidly.
- Larger more liquid EM experiencing capital outflows, Currency adjustment and higher local interest rates. These countries may be unlikely to face outright defaults, in part due to relatively low external debt due but their balance sheets are weakening and pre-existing fiscal conditions make it even more difficult to do targeted lifelines to the population or to businesses or to bolster health systems. These include South Africa, Mexico, Brazil, Indonesia, Colombia – many of which had previously been struggling with lower growth rates, contingent liabilities of large state owned enterprises. Those with larger external deficits like Colombia and Turkey, and possibly even South Africa are likely to face more challenges. These countries have a need for liquidity support to help manage the capital outflows, avoid even more extensive fiscal cuts.
- Historically surplus countries or those with larger stockpiles of foreign currency reserves. These countries tend to be in east Asia or richer middle eastern countries. While the governments tend to have significant savings, private sector borrowing or bank borrowing may be extensive, adding to dollar liquidity needs. These countries may be able to use past stockpiles to support the liquidity needs of local business, but doing so might add to market disruptions. Some countries benefit from existing swaplines or liquidity provisions. Others may still have the market access that their peers in the other groups lack – or rather may have market access at a still low price. This may avoid selling down less liquid assets – say in the portfolio of sovereign funds. These countries will face pain and strain too, but like counterparts may be more able to find bridge financing,
So… who will come to the rescue? China? Fed? IMF? All of the above? Some countries already benefit from Fed swaps –three of the four “EM” with access have tapped them with only Brazil holding off. These measures are useful – and others may use the new CB repo window at the Fed. However, more meaningful debt service holidays, may be in order, such as the IMF has suggested. China, the largest purveyor of bilateral loans, has so far been quiet on debt service holidays and loan forbearance abroad. Indeed it already pulled back on some BRI lending in the last few years. Its notable that we haven’t seen RMB swap lines in this crisis. Those swap lines are less helpful as they serve mostly to facilitate purchases from China – and few countries have RMB liabilities. Still, it is a notable exception.
This all suggests that the IMF support could be key to avoiding fiscal austerity reinforced by capital outflows, leading to a mutually reinforcing contraction, adding to the hit for demand. The IMF has quickly provided emergency financing to several frontier markets, mostly in Sub-Saharan Africa, though volumes would likely not do much for larger emerging markets. Stigma remains an issue as the ongoing debate in South Africa illustrates (ANC has ruled out IMF for potential restraint on national sovereignty). And some of the countries that could most benefit may struggle to show the “strong fundamentals” needed for a potential new emergency facility. The Institution will need to move fast – followed by its regional development peers. In its favor is ongoing surveillance and work with authorities, the challenge will be avoiding political pressures. Doing so might help avoid deepening the global recession.
Ziemba Insights 