Phil Milburn

Be nervous and buy risk

Phil Milburn

While I can claim no expertise in infectious viral pandemics, I can hopefully offer a couple of insights into the economic part of the Coronavirus situation. After dramatic falls in risk markets, comparisons are being made with the 2007-09 credit crisis but, economically, this crisis is nowhere near as bad. So why do I say this?

An existential crisis for the financial system? No

Put simply, the whole system almost collapsed in 2007/08; the world was a matter of days away from paper money being almost worthless and if that money was stored in a bank account, it would have disappeared.

Coronavirus will cause a global recession; for the pedants who use the technical definition, which is two negative quarters, Q1 might scrape into positive territory due to the delayed impact of the virus but the run rate is recession. We believe the correct reaction is to worry about the depth and length of this recession, but unless it becomes a multi-year event, the system will survive. Do bear in mind that the global economy was in good shape coming into this crisis with an upswing starting post 2019’s trade wars.

Accessing liquidity more important than the price

Central banks around the world have been cutting interest rates to help mitigate the worst of the economic impact. In my opinion, these cuts pale into insignificance compared to the liquidity measures being provided: the Federal Reserve announced a $1.5trillion package on 12 March for example. The key here is accessing money, not the price of money.

In 2007/08, when liquidity dried up, large corporates drew down on their committed, previously undrawn, bank facilities; in this cycle, the banks have far less exposure to this sudden balance sheet expansion. Crucially, the central banks are providing liquidity lines to enable the financial system to comfortably fund these needs.

As an aside, a few large companies, and those owned by private equity, are already drawing down credit lines, thinking they have a first-mover advantage; this is analogous to someone buying all the hand sanitisers from the supermarket and also entirely self-defeating. If you drain all the liquidity, then you hurt your customers and suppliers; if you buy all the hand sanitisers, other people are more likely to catch the virus and pass it on to you.

For smaller companies, the need to access money is even greater as the temporary shutdowns create a major drag on working capital as well as profitability. This is where programs such as the Bank of England’s TFSME (term funding for SMEs) come in to play. There is a mismatch as it is not term funding that most small companies will need, rather a drawing on their revolving credit facilities (basically like an overdraft facility) for a few quarters. The banks’ treasury departments can easily manage this.

Another way of freeing up banks’ lending capacity is to reduce capital needs; the Bank of England has removed the counter cyclical buffer and the European Central Bank has relaxed capital rules.

The liquidity injections from central banks are all about managing the supply side of the equation and designed to help the real economy by providing huge funding through the financial system as an intermediary. So, what about the demand side of things?

Keeping the consumer solvent

Included in the financial system measures are policies to encourage loan forbearance, this includes corporate lending and household mortgage servicing. These vary by jurisdiction with Italy being a leader for obvious reasons. The point here is to avoid creating corporate insolvencies, rising unemployment and homelessness during what should be a temporary disruption to activity.

The fiscal side of the equation is also essential here, providing sick pay, subsidising temporary reduced hours or covering wages if possible. Labour markets were tight going into this crisis so one should envisage that most companies will do their best to hold onto staff, albeit with some on reduced pay.

The most economically vulnerable are the self-employed and gig sector workers, for whom a financial safety net during the virus would be a massive boon. Overall, provided employment remains solid then the consumer will stay strong and this sets us up well for a decent growth rebound in H2.

Other fiscal packages are also being worked on. The US is likely to pass its act through congress later today. Germany is now actively talking about temporarily sacrificing their budgetary “black line” and I would expect an announcement next week.

Minding the temporary gap

In conclusion, there already have been a lot of policy responses to help mitigate the economic damage caused by Coronavirus. The financial system will comfortably remain solvent. Given the amount of monetary and fiscal stimulus, if the virus impact peaks in Q2, then the second half of the year should see a significant growth boon.

Strategic Bond funds’ actions

The valuations that have materialised in credit offer a great opportunity to buy risk. We have been averaging into high yield and have a little over 30% through a combination of physical holdings and a CDS (Credit Default Swap) index overlay. Our maximum is 40% and we are saving risk budget to buy more should valuations overshoot further.

Within investment grade, we had no additional tier 1 (AT1) nor corporate hybrids, on the latter we have bought one so far – AT&T. We are lightly weighted in financials and in more defensive parts of the capital structure. I should also highlight our lack of retailers, only 1.5% in energy, no reinsurers, no airlines, cruise companies and so on.

The funds’ duration is about 2.5 years with one year of this in TIPS (Treasury Inflation Protected Securities). Up until Monday (9 March), these had been making money, just less than their conventional cousins. The oil price war between Saudi Arabia and Russia has massively hit inflation breakevens this week.

This price war will definitely pass as neither country can afford it; roughly two-thirds of Saudi Arabia’s fiscal revenues are related to oil and at current price levels they would run about a 15% fiscal deficit. To say that this level of fiscal deficit is unsustainable is an understatement: ultimately Saudi Arabia and Russia might manage to compete some other capacity out of the market but will not want to do this for too long.

Considering the aggregate portfolio shape, we entered this crisis with a good defensive credit position but with hindsight we should have had more duration. Our cross-market rates positioning has been excellent and we have also generated alpha from the curve.

We have steadily been adding credit beta and reducing the beta within the rates side of things. There are also a lot of alpha trades occurring as we continue with our day jobs, but some of these are being swamped by the beta. The funds are now positioned firmly “risk on” as we anticipate the worst of the forward-looking part of this crisis to pass.

We still have risk budget to buy almost 10% more high yield and there is a lot of risk we could add to investment grade if there is further market deterioration so we are prudently not yet “all in.” We are following our own advice: don’t take unnecessary risks in your personal life over the next few weeks but do buy “risk” in financial markets.

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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.

Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Friday, March 13, 2020, 4:32 PM