Getting our news straight from the source, we sat down with Mark Mitchell and Justin Tyler, Portfolio Managers of our suite of fixed income funds (ECAS, ECOR and EMAX) to ask them how recent volatility has impacted credit markets.
So, what has happened?
- A decade of easy money via low cash rates and central bank balance sheet expansion on the back of low inflation has created stretched valuations across almost all asset classes
- These stretched valuations created a precarious situation whereby any material catalyst could cause a potentially large correction.
- The likely supply and demand shocks associated with the coronavirus has been the catalyst to trigger a massive correction. When combined with the substantial correction in oil prices and realisation that many central banks are reaching the limits of what they can do, this has led to one of the most severe market corrections ever. This could fairly be described as a perfect storm of events.
- Central banks in the US, Canada, Australia and England have cut cash rates aggressively in a short space of time in response.
How have you responded?
- We have been modestly bearish risk assets for a little while, but the speed and severity of this correction has taken us by surprise. However, we had done a few things to try to protect capital including:
- Tripled our cash holdings in our Core Income fund from 5% to 15%
- Increased our duration (sensitivity to interest rates) from 1.0 to 1.8 years
- We will continue our defensive posturing in the portfolios and look for opportunities to pick up some cheaper assets when we feel the market has found a new clearing level, but we expect this to be at least a few weeks away.
What is the outlook?
- The RBA cut rates in an extraordinary out-of-cycle meeting. Brad Dunn, our Senior Credit Analyst, prepared an excellent summary video linked here.
- Based on the comments central banks have made, you could argue that most of them have reached their theoretical floor in cash rates (at least for now) and now they turn to asset purchases and pushing policy makers for an aggressive fiscal policy response.
- The fact that Central Banks would effectively cut to their “floor levels” outside of their normal meeting schedules and announce aggressive asset purchase programs is probably an indication of how bad they think things are about to get
- We will likely see technical recessions in many developed market economies this year.
- Ultimately demand is not likely being permanently destroyed, but rather delayed until later in the year, however that doesn’t help sentiment and risk appetite in the near term.
- Fiscal policy is nonetheless the only game in town to offset the impact of these shocks on the real economy.
- It’s important to understand this is not the GFC. Liquidity is readily available for commercial banks, trust is there and they are willing to lend to each other. And banks are much better capitalised than they were in 07-08.
- However, one key question will be how readily companies that will experience cash flow shortfalls in the coming months will have access to credit. Central Banks are doing what they can to encourage banks to lend to these companies but it remains to be seen if they will do so.
- We haven’t really started to see the negative economic numbers come through in a meaningful way, which will not help investor psychology when the negative data flow does start.
- We see the market stress continuing for the next little while and would be watching the following to help stabilise markets before we would start increasing risk again:
- The rate of Coronavirus infections peaking and then declining across the G20
- A co-ordinated public/fiscal response across the G20
- Continued monetary policy and liquidity support from central banks
- Signs commercial banks are providing bridging financing to corporates in need
- Markets showing signs of stabilisation with the likely view that enough bad news had been “priced in”
- Capital market deals printing at new clearing levels.
- And finally, not to be all doom and gloom, we actually think this type of correction and potential acceptance by markets that central banks have reached the limits of what they can do to support risk assets will force markets to price risk more accurately. Capital will find its way to the businesses and projects that deserve it rather than too much money chasing too many questionable deals and zombie companies. Returns will likely be lower than we have seen in the past decade, but hopefully this reduces the risk of future major corrections like this. However, that might just be wishful thinking on our part.