Developments surrounding the coronavirus have dominated column inches and rightly so. Equity markets were off 10% at the end of February, the largest one week fall since the financial crisis.
Trade, tourism and production have contracted – Jaguar Land Rover anticipate plant shutdowns within a week, despite flying some parts to factories in suitcases! Fresh cases worldwide have sparked fear that the shutdown required to control the spread of the disease will have a meaningful impact on global growth.
Elsewhere, we saw tangible evidence of the growing risk that excess debt embedded in corporate America could have on the sustainability of that growth. Two household names in Macy’s and Kraft Heinz had their credit ratings downgraded from Investment Grade to Junk. Could the massive overhang of BBB debt in US corporations accelerate the sell-off instigated from outside the US?
This month’s Market Commentary explores these two issues in more depth.
Markets catch a cold
The annual flu season infects and kills a far greater number of people than the coronavirus has so far. Somewhere in the region of 650k people die of respiratory deaths linked to the seasonal flu, compared with just over 3100 deaths of Covid 19 so far. So why all the fuss?
It’s the death rate, not the numbers that matter. The coronavirus death rate is currently running at about 3.5% – some 25 times more deadly than the flu was last year. In addition, its extended incubation period makes it far harder to contain the spread of the disease.
Trade has been capped by the inability to travel, with container ships moored empty outside of ports. Tourism is another area directly impacted – earlier this week the International Air Transport Association estimated the cost to the industry in lost revenue would top $30bn – and that is likely to worsen with time. Elsewhere, factories have shut down and towns are in lockdown where the concentration of cases is high. This has resulted in Apple warning of iPhone shortages, and Jaguar Land Rover flying parts to factories in suitcases.
The longer this disease remains prevalent, and the further it spreads, the greater the impact on GDP. Growth assumptions are being pared back with leading indicators such as the IHS Markit Flash US Composite PMI showing a marked downturn in February (see graph below).
IHS Markit Composite PMI and US GDP
Source: IHS Markit, US Bureau of Economic Analysis
With equities falling over 10% during the last week of February – the largest one week fall since the financial crisis – the market reaction has been extreme. Even more significantly, we saw elevated trading volumes. This wasn’t a small group of speculative investors; this was a broad risk off reaction. The dramatic reaction can be seen in the S&P 500 volatility index below.
CBOE SPX Volatility VIX
Source: FE Analytics
Money taken from risk assets wasn’t limited to equities. There were aggressive redemptions from the High Yield bond market too. The High Yield credit spread to Treasuries went from 3.7% to 4.6% across the week.
This highlights the risks prevalent in the wider corporate bond market. After 10 years of monetary easing and historically low interest rates, low risk investors have been forced out of cash and defensive assets in the quest for yield.
An extended period of capital loss and risk aversion could trigger a wholesale exit from the credit market. With question marks over the liquidity available to sustain this move, that could lead to considerable complications.
For the past decade, any sign of economic risk has been met with central bank support – lower interest rates and/or some form of quantitative easing (QE). The question is: do central banks have the ammunition to make a meaningful impact right now? Interest rates are either low or very low. QE packs a far weaker punch than a decade ago, so do we want to be inflating markets at this point?
The shock caused by the coronavirus is a classic supply side event, reducing goods and services. Whilst the US and Australian central banks have cut interest rates, most other central banks have yet to react either by cutting interest rates or initiating additional QE. Doing so could simply increase aggregate demand, which may create an environment of ‘stagflation’ – high inflation and stagnant demand.
Corporate debt bites back
In October last year, the IMF highlighted an urgent need for action to avoid a financial meltdown in the corporate space. The US was pinpointed as the area of greatest concern, with accumulation of corporate leverage growing, and no signs of policy response. The graph below shows how global non-financial corporate debt as a percentage of GDP is back at a historical high.
Equity returns over the last 18 months have been assisted by share buy-backs and M&A, funded through additional debt on the balance sheet. When interest rates are so low, why not? Credit spreads are tight, and funding is cheap, as you can see in the graph below.
As of today (pre- full implications of coronavirus), global growth and earnings are OK, and interest rate coverage is strong. Because interest rates are so low and are expected to stay that way, the debt on corporate balance sheets is seen as less risky than it’s been at other points in history.
Then came big news from two US household names. Macy’s department stores and Kraft Heinz were both de-rated from Investment Grade down to Junk Status by S&P and Fitch credit rating agencies.
For both companies, it was worsening earnings and profit margins, combined with the size of debt on the balance sheet, that instigated the change.
While these are high profile companies, the impact on the bond market is relatively small. Combined, they make up around 2.2% of the $1.2tn high-yield bond market. The concern is not with these two specific names, but if it signals a wider slew of Investment Grade changes, specifically BBB rated Investment Grade debt. The growth in BBB debt has been monumental over the past 15 years. Back in 2005 it accounted for $677bn, where today that figure is $3.4tn.While revenues remain stable and interest rates low, the servicing of expanded debt is more than manageable. However, risks to earnings leave leveraged companies in a far more precarious position.
Furthermore, the increase in passive investing within this relatively less liquid asset class can lead to indiscriminate selling pressure when downgrades occur. The most recent spike in the US Investment Grade credit spread, shown above, suggests that the market could be re-evaluating the broader risks. And that could cause a reduction in revenue for a wide swathe of Investment Grade corporates.
The Parmenion view
The reaction to coronavirus by equity markets last week was more severe than the initial reaction to the bankruptcy of Lehmans. While it is likely to be a temporary shock, it has weakened business and consumer confidence, tightened financial conditions and reduced corporate cash flows.
Given the level of corporate debt across much of the global economy, particularly within the US, an extended period of economic shutdown adds pressure to the servicing of that debt and the credit worthiness of those corporations.
As we ended 2019, growth was stable, and the US consumer resilient. Corporate debt was high, but servicing costs were low. What the coronavirus highlights is that leverage is always a risk that needs to be appropriately priced, even if you can’t immediately see where the risk will come from.
That is why a diversified approach to portfolio construction, and an active approach to credit risk management is particularly important – and never more so than at points in the market cycle such as these.
Further reading on coronavirus
3 reasons why coronavirus should not change your long term investment strategy
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