EUR IG: Looking beyond the crisis

EMAMI NEJAD, ARIO and IANNELLI, ANDREA

What follows are some thoughts on the EUR IG credit market following what have been some very volatile days and weeks.

Needless to say, market sentiment has been extremely negative. Investors have quickly gone from buying the dip to selling at any price, while liquidity conditions have deteriorated substantially. Several theories have been put forward to explain the price action but so far ETF flows and deleveraging by accounts focused in particular in the subordinated and AT1 space appear to have played a major role. With positioning that still remains crowded in some areas, spreads might continue to drift wider from here.

How does the market today compare to previous episodes of market turmoil? Compared to 4Q 18, 2015/2016 and even the 2011/2012 period, moves are similar in magnitude and “gappyness”, but let’s not forget that in pretty much all those episodes, sell offs happened while there was little to no intervention from central banks or governments. Given all the latest announcements from central banks (interest rate cuts, QE, liquidity injections) and governments (deficit spending, wage support, tax support, loan support), it is a little unsettling that things have not yet subsided despite monetary and fiscal policy both rowing in the right direction.

Is this worse than 2008? Maybe not. Looking back, one can assume that 2008 was ugly because no one knew what the policy response was going to be. Until central banks proved the market wrong, investors were assuming a hands-off approach while governments were more worried about their balance sheets and were keen to impose austerity as soon as possible. This time around none of those views are even being considered. What makes today’s episode more unpredictable on the other hand is that we don’t know how the end investors and savers, people, families, are going to react. Today’s situation is not only affecting job prospects (similar to ’08) but also people’s health and longevity prospects (dissimilar to ’08). Hopefully governments actions, including temporary cash handouts, will allay some of the concerns but there’s a lot here that is very difficult to forecast.

The current, volatile market conditions are also unlikely to go away anytime soon, even if the current outbreak in the US or Europe gets contained quickly, given the breakdown of OPEC+ and ensuing drop in oil prices. Following the move, not only BBB-rated Energy names are now trading at extremely wide levels (and therefore weighing on the rest of the USD IG space), but it also raises the risk of downgrade of several energy companies to High Yield. Moreover, it is fair to assume that some oil-exposed EM countries would also face challenges. In aggregate this makes for a very volatile and uncertain environment in the weeks and months to come. Together with a plateauing of the Covid-19 epidemic, another necessary condition for market stabilisation is perhaps some sign of détente between Russia and OPEC, with oil prices going to back to >$50 levels.

If the effectiveness of the response to the coronavirus outbreak does become the main market driver going forward, DM Investment Grade credit has arguably the highest chance of snapping back. In the US, UK and Europe, central banks and governments are working hand in hand and doing whatever it takes, from a fiscal and monetary policy point of view, to ensure the smooth functioning of the respective government and credit markets. So, by the weight of their support, sooner or later these markets will likely stabilise. Other areas of fixed income will have to face their own challenges, be them downgrades or structural challenges in implementing the same policies that we have seen in earnest in DM. So in this uncertain world, being closest to the central bank and government help is a strong plus, and in that respect IG is likely to fare the best..

Credit:
Our overall view has always been that one has to invest based on all possible outcomes. We can’t be too bearish or too bullish at any time. Given that our funds have ample liquidity at the moment, and that valuations have indeed become very attractive, starting from two weeks ago we have been adding selectively to credit risk. We do have, however, a few potential risks at the top of our mind:

1. End-investors flows: With investors reviewing their portfolios and flows that usually follow returns, we do monitor flows in and out of the asset class as an indication of risk sentiment and as a technical driver of returns. With this in mind, liquidity, and our ability to raise cash if needed always at the forefront of our mind. As a result, when allocating to a “high beta” credit we buy, we try not to buy more than 1.5% on a risk weight basis, in order not to have too-highly concentrated exposures in names that may take longer to sell if needed. For low-beta, high quality names we will have more flexibility.

2. Rating agencies: rating agencies have historically had a tendency to amend ratings following large market or macro disruptions, and sometimes they have tended to overreact. This pattern is likely to repeat itself as a result of the Covid-19 crisis.Until we get more clarity on how aggressive rating agencies will be, we are not looking to add any name that has a chance (however small) of getting downgraded to HY, particularly in the automotive and commodity-related sectors. The credits that fall in these sectors that we already own represent <5% of our overall exposure, hence limiting the potential impact on relative performance

In terms of latest changes, the type of names we have been adding include:

- Financials: initially focused on Tier 2s, as this was one of the areas that underperformed the most in the recent turmoil. We are strictly sticking to 1st tier national champions with limited issuance prospects over the next few months.

- Corporates: BBB+ and A rated French and German corporates in low-beta sectors, large employers which are likely to be considered as systemically and socially important, and are thus likely to receive a strong backing by their government.

Rates:
We came into this sell off, with funds having a duration overweight to Italy in the Euro aggregate franchise, some exposure to Spain in the Euro Short Term franchise and higher exposure to Portugal in both franchises. Thankfully, as soon as the outbreak situation started to become more serious in Italy, we brought our exposure to Italy to flat initially and then short by and also sold out of all our exposure to Spain and Portugal across all of our Euro Short and Euro Aggregate portfolios.

As a result, over the past 3-4 weeks, our portfolios have been very concentrated in core markets, and in German and Dutch bonds in particular, with no exposure to any semi-core or periphery (ex-Italy) country. We were hoping for an underwhelming ECB meeting, which indeed transpired, but didn’t get too concerned over Lagarde’s mishap regarding “closing the peripheral spreads”. We were under no illusion that ECB would eventually do whatever it takes, especially under the circumstances. However, we didn’t expect that the ECB’s revised announcement, with a new facility, the Pandemic Emergency Purchase Programme (PEPP), would come so soon. While the sharp retracement in the higher beta areas of the market weighed somewhat on performance, it has not changed our overall view and positioning, for reasons that we will shortly explain.

There is no doubt that the ECB bazooka is big enough to contain government bond spreads in the near term. It is no coincidence that just as BTP spreads approached 300bp, the PEPP got announced to avoid any concerns of a “fragmentation” of Eurozone bond markets. So, from this angle, there is definitely limited upside in having a too negative view on Italian and peripheral spreads, which are unlikely to see the most recent wides in the near future.

However, the PEPP is not a permanent facility, but it will end at the end of 2020. That it was devised so swiftly and announced with no obvious opposition points to the fact that all European nations are facing the same threat in similar magnitude and repercussion.

This opens up various possibilities in the months ahead:

- Scenario 1: this outbreak would be a recurring theme across Europe in the months if not years ahead. A sizeable portion of all European economies would have to be shut down, service industries will be affected, with all governments that will have to step in to support various parts of the economy. Counterintuitively perhaps., this is the most bullish case for spreads, with the ECB buying “whatever is necessary” to ensure a smooth transition of monetary policy.

- Scenario 2: northern European countries manage to deal with and contain the outbreak better than their southern European counterparts, where it instead remains a recurring theme. This is the worst outcome for peripheral spreads since it risks undermining, at some point, the currently-broad-based support that fiscal expansion enjoys across Europe as well as reducing the chances of an extension of PEPP beyond 2020.

- Scenario 3: all countries manage to get the outbreak under control by 2021. In this case PEPP would come to its natural end in 2020. From then onwards, markets will go back to focusing on the more traditional issues of debt sustainability, with peripheral countries once again under the spotlight. By then, and given current fiscal expansions under way, Italy’s debt/GDP would be closer to 150%, Spain’s and Portugal’s would be >100%, and they will all be under pressure to bring these statistics back under control. This won’t be easy however, and we should expect a potential return to intra-European skirmishes over budgets and the appropriateness of the “3% deficit rule”. Such a scenario would obviously be a challenging one for spreads in the sovereign space.

We can’t put probabilities on the above three cases, but inherently we tend to believe in the strength of “human innovation”. In other words, given the amount of intellectual capital dedicated to fighting the virus, and firmly believing that “when there is a will, there is a way”, we believe it is likely that the Covid-19 outbreak will be tamed in the next few months. On this basis, it is more likely that we will find ourselves facing either scenario 2 or scenario 3, rather than scenario 1. As a result, the outlook for European government spreads will remain challenging, and we are cautiously positioned accordingly.

If we are not going to go very overweight in sovereign spreads, where do we see the opportunities? Corporate credit remains a standout opportunity in our view, for two reasons:

- With the ECB PEPP not just focused on the sovereign space but also on corporate bonds, it will provide an explicit support to credit spreads. In particular we see opportunities in very high-quality credits (BBB+ and A-rated) from low beta sectors - such as consumer and utilities - where not only corporate bonds are trading at historic wides versus their respective sovereign curves, but also wide to Italy. Looking one year ahead, we expect most of these corporates to have weathered the current crisis, with balance sheets on an improving trajectory, something that we won’t be able to say about sovereigns such as Italy, Spain or even France, who would be coming to the market with large debt issuance to finance their fiscal promises.

- Once hedging costs stabilise, EUR-denominated government bonds will look expensive compared to either JGBs or even US Treasuries. A part of PEPP will therefore have to be spent on replacing existing foreign holders which may no longer find semi-core and peripheral bonds attractive. Also, for the first time in 5 years, USD-denominated credit is looking extremely attractive both on a spread basis and on a EUR-hedged yield basis. The raft of USD issuance over the last week has come anywhere between 30-100bps wider than BTPs, all from issuer that are BBB+ and A-rated with less headwinds than Italy ahead. We have participated in a few of these deal for the EUR IG Franchise, not just on the back of valuations but also in order to diversify our liquidity sources in case we need to reduce the credit exposure we are currently adding to the funds.

In the near term, we are aware that semi-core and peripheral spreads, where the ECB backstop is potentially stronger, may outperform corporate credit. Over the medium term, we see fundamentals taking over, with credit more likely to outperform the sovereign segment of the market.