As policy intervention drives markets higher at the same time as economic data nosedives, Ariel Bezalel, Head of Strategy, Fixed Income at Jupiter AM and Harry Richards, Fund Manager at Jupiter AM discuss where they are finding opportunities and avoiding pitfalls in today’s bond markets.
Is fiscal policy losing its potency?
Risk assetshave had a spectacular recovery since the middle of March, yet government bond markets signal a very different reality. Almost $12.4 trillionof government bonds now yield below zero, with Canada, the UK, Ireland and Belgium joining the negative-yield club.
It’s an overused word, but we really are in‘unprecedented’ territory – over 90% of global economies are in a recession, which is even higher than in the Great Depression, while 40% of countries are seeing falling inflation. Global debt levels have soared, with governments adding around $10 trillion of debt in the last few months. When combined with centralbank measures, this amounts to around $25 trillion of stimulus. Corporate debt levels have also ballooned as companies issue debt and drawdown on bank facilities. Evidence shows that centralbank support, such as the TLTRO in Europe, is being used to boost corporate cash balances, rather than invest in productive assets, which is likely to be a big headwind to growth.
But you can’t cure a debt problem with more debt. The debt burden means that fiscal policy is losing its potency. Back in the 1950s, $1 of debt generated around $0.8 of GDP; today it’sless than $0.4.This is a global trend. Fiscal stimulus is acting like a sugar rush –it’s effective for a couple of quarters but then starts to wane as too much debt and ageing demographics weigh on economic activity.In our view, this accumulation of debt will hasten the ‘Japanisation’ effect across the developed world with yields grinding ever lower.
As bond yields fall, we believe yield curves will continue to flatten. The 10-year US Treasury yield could well drift down to zero, perhaps even lower,while the 30-year bond yield could trade below 1.0%.This is supportive for government bond prices and that’s why weare bullish on medium- to long-dated US Treasuries. Australia is another market where we believe there are strong returns to be made in government bonds.
Deflation vs inflation
There has been a lot of excitement about a spike in money supply recently. But while central banks have been printing money aggressively through quantitative easing, it doesn’t appear to be finding its way into the real economy. Credit standards have tightened in Europe, while in the US the uncertainty over the economy and a sharp rise in loan losses means banks are reluctant to lend to corporates.
Importantly, the velocity of money – the rate at which money is exchanged – is declining. In fact, it has been doing so for several decades in Europe, the US, China and Japan. Until we see the velocity of money pick up, it’s unlikely we’ll see an increase in inflationary pressures.
In our view, we are still in a deflationary environment. The game changer would be more extreme policy innovation, such as Modern Monetary Theory (MMT). This could lead to mounting upward pressure on government bond yields and would likely cause the Federal Reserve to introduce yield-curve control measures to keep longer term yields low. But we think that point is still one to two years away.
Taking calculated risk
Dodging the landmines is just as important as picking credits that can thrive in this environment. While central banks may have prevented a liquidity crisis, an insolvency crisis is looming. In the US, the base case from Moody’s is for default rates in high yield to rise to about 14%, rising into the high teens under a more pessimistic forecast. In Europe, default rates are expected to rise to 8% under their base case and low double-digits in a more pessimistic scenario. These are levels of default rates not seen since the 2008 financial crisis.
That’s why we are focusing on companies with robust fundamentals. We are avoiding more cyclically exposed sectors, such as autos, industrials and some of the materials businesses, that we feel are extremely indebted, especially after accessing the emergency loans used to shore up liquidity during this crisis.
Case study: Albertsons
Q3 and Q4 reporting seasons will inevitably deliver a lot of negative surprises. The key to avoiding these, and to delivering strong performance during these periods, is thorough credit analysis.
In high yield, we are currently focused on the better-quality end of the market (BB-rated credits and high Bs) and avoiding low quality Bs and CCCs. We like through-the-cycle businesses with bonds that offer security against high quality collateral. Many of these are in the pharmaceutical, food and beverage, and TMT sectors. Some of these businesses are seeing an improvement in their credit profile as a result of Covid-19.
Albertsons is a good example of a high yield business with an improving credit profile. The BB-/B2 rated US supermarket chain owns around 40% of its stores and its in-store pharmacy makes it a convenient one-stop shop for consumers. Our calculations tell us the company’s store portfolio, manufacturing plants and distributions centres are worth over $11 billion which equates to more than 1.6x their net debt, providing strong asset coverage and some downside protection for bondholders. Albertsons was already paying down debt ahead of its recent IPO, and with Covid-19 driving food sales up, deleveraging is accelerating meaningfully.
We expect that rapidly improving fundamentals should drive strong outperformance of the bonds over the coming months. We also think rating agencies are likely to upgrade Albertsons given its financial metrics are now approaching those of its investment grade rival, Kroger, which would act as another catalyst for spread tightening in the company’s bonds.
Conclusion
The rally continues to be driven by stimulus rather than economic fundamentals, which across many data series still indicate stresses that comfortably exceed those seen in the last financial crisis. We believe that an insolvency phase should be expected over the next year.With that in mind, we think this a credit picker’s market and we remain focused on finding companies with robust business models that can withstand the uncertainties ahead and also offer attractive total return potential. With deflation likely to dominate proceedings for a while yet, a healthy allocation to government bonds, even at these low yields, also remains warranted.
