In the coronavirus pandemic, the capital markets have collided with modernity. Governments in every land and of every political stripe shutting down the economy to control a disease is an event no one has experienced before — but it is the kind of thing markets will have to get used to.
Severe outbreaks of new diseases are becoming more common, particularly since 2010, fuelled by trends including globalisation, urbanisation, climate change, deforestation and industrialised livestock farming.
Up to now, it has been rare outside wartime for a state to rank any objective higher than economic growth. But in every political system, from China to the US, society now expects government to take charge of such an outbreak and quell it, as a priority.
As a result, in the first half of 2020, markets have suffered a severe shock, whose cause is environmental, rather than economic, and which was entirely unpredicted.
The business world has been turned on its head. Many of the most successful enterprises — BMW, Ryanair, Rolls-Royce, AB InBev, McDonald’s — have had their revenues plummet.
How can markets price such a wreck? How can investors protect themselves, while still feeding money to the economy so as not to make the situation worse?
Many feared markets would seize up altogether as lockdowns were imposed in major financial centres.
“Every chart you looked at was either a cliff fall or a rising mountain. Everything had been flat for 10 years compared with that,” is how Mitch Reznick, head of research and sustainable fixed income at Federated Hermes in London, describes the time in March when the Covid-19 pandemic crashed into markets’ consciousness.
US unemployment soared from 3.5% in February to 14.7% in April. In the global financial crisis it had peaked at 10%.
The result was “a dash for cash — in every corner of the capital markets. Companies, asset managers, clients — all they wanted to know was how much cash they had,” Reznick says. “There was indiscriminate selling to raise cash.”
Day after day, stockmarkets fell 3%, 5%, sometimes up to 12%, while credit spreads ballooned, giving markets the feel of a great crash, perhaps worse than any before.
Private sector bond issuance in Europe dwindled almost to nothing; equity capital raising all but ceased outside China. Sterling fell 13% against the dollar in 10 days, to its lowest level since 1985.
Fractures appeared even in markets usually deemed unshakeable bedrock, such as US Treasuries, repos and swaps. In the last crisis, government bonds had been a reliable safe haven; this time, investors seemed torn between seeking refuge in US Treasuries and fearing they were not safe.
Mood swing
Yet on Monday March 23, from Shanghai to São Paulo, markets hit bottom. Since then, the trend everywhere has been steep recovery.
It is not because the disease has been beaten. Up to March 23 there had been 16,000 deaths from Covid‑19 worldwide, according to the World Health Organization. The figure is now 400,000.
Nor has fear of recession been lifted. The European Central Bank predicts an economic contraction of 8.7% in the eurozone this year; the IMF forecasts a 5.9% decline in the US.
Yet the mood in markets has turned from a dark near-panic to excitement, even delight.
The first anxiety to evaporate was operational collapse. “Something I didn’t take for granted was: ‘is it even possible to do most of our jobs working from home? Does the infrastructure even work?’” says the global head of debt capital markets at a bank in London. “I was always pretty confident we could lead a bond issue and get a loan approved from home — but clearing, settlement, paying agents… I wouldn’t have liked to do the first bond issue. But everything has worked 100% perfectly.”
Needing help
But if the markets’ wiring has stayed connected, the messages going down those wires have been anything but stable.
Much of the past 12 years’ work has been strengthening the system to fight the next crisis — including building up bank capital. Many hail the fact that “banks are in much better shape this time”.
But when the crisis came, hopes that a more robust financial system would withstand it without public support were immediately binned. Every indicator screamed distress.
The extraordinary reversal in markets has been brought about by central banks and governments.
“The Fed was very hands-on in 2008-2009,” says Mickey Levy, chief economist for the Americas and Asia at Berenberg in New York. “This time it has been much more aggressive.”
Over nine days from March 12, the US Federal Reserve, backed by the Treasury, offered $1.5tr of repo funding and $700bn of quantitative easing; cut its discount rate by 150bp and the Fed Funds rate by 100bp; cut reserve requirements to zero; encouraged banks to use their capital and liquidity buffers; established programmes to buy commercial paper, lend to dealers and bail out money market funds; and set up swap lines with nine central banks, including Brazil’s. Much more followed, including plans to buy corporate (including high yield) bonds and lend to small businesses.
Other countries have been similarly ambitious. “The Japanese government has increased deficit spending by 20% of GDP,” says Levy, “the US government by 13%, Europe, if you take the EU’s initiatives and those of governments, by nearly 13%.”
On their own, such actions would drive up interest rates and crowd out the private sector’s access to capital. But central banks have been printing money on a record scale.
By June 3, after just three months, the Fed had expanded its balance sheet by $3tr, to $7.2tr. After the fall of Lehman Brothers, it took more than five years for it to grow so much.
Rapid rebound
The response of private capital markets was swift. Outflows from credit and equity funds screeched to a halt and reversed. “When this huge wave of liquidity came from the central banks, a lot of it flowed into fixed income,” says Gordon Kingsley, head of Latin American debt origination at Crédit Agricole CIB in New York. “Many big US companies went to the market and took a lot out, and they paid substantial spreads.”
April, May and March, in that order, have been the three busiest months for US corporate bond issuance ever, by far, with a total of $660bn priced. In euros, May was the busiest month, April the third busiest.
“Have bond and loan markets been able to provide what companies want?” asks the DCM head. “The answer is a resounding yes. No one would have expected that these volumes of issuance were likely, or even possible.”
Participants were soon able to look beyond brutal necessity. Development banks, agencies and regional governments began issuing bonds branded as Covid-19 response debt.
“You do need something to gain investors’ attention,” says Caroline Haas, head of sustainable finance for financial institutions and SSAs at NatWest Markets in London. “This is getting the attention, at a time when it is so challenging, with all the information people are having to digest, to just say: ‘This is important — we need your support. So please, if you have five minutes, have a look at it.’”
So far, public sector entities have issued about $34bn of these bonds, and recently commercial banks have chipped in another $4bn.
Sending in the cavalry
Banks have had adequate capital to help at least large companies through the crisis by lending to them, either through existing credit facilities or new loans.
But, instantly, government support was also needed. Central banks flooded banks with liquidity through refinancing operations. States set up completely new mechanisms to guarantee bank loans or pump credit directly into the economy.
Even the sharp end of capital markets — equity issuance — has returned. May was a record month for US convertible bond issuance, with $26bn, as the market’s volatility-loving investors financed a range of challenging credits, including Air Canada, Lyft and ArcelorMittal.
In EMEA, it has been a poor year for ECM, but remarkably, the €69bn of issuance is up on last year. The crisis has even helped the market overcome structural blockages that had plagued it for years. On the €2.6bn IPO of coffee group JDE Peet’s at the end of May, banks cut the usual two week bookbuild to three days.
Dials point to green
Governments and central banks have saved the markets — and they are using the markets to save the economy.
Kallum Pickering, senior economist at Berenberg in London, has been tracking six indicators for signs of a credit crunch that could tip recession into depression. They are credit default swap indices, spreads between interbank and overnight interest rates, and Italy’s sovereign CDS price.
By the beginning of June, all had reversed more than half their spikes, except Italy’s spread, which had recovered by 47%.
But the sense of unreality is oppressive. Even after an encouraging fall in May, US unemployment is far into post-war record territory. A horrendous set of second quarter corporate results is only weeks away. But the S&P 500 is only 5% from the all-time high it reached in February.
“We are pretty much back to where we were pre-Covid,” says Marco Baldini, head of European bond syndicate at Barclays in London. “Investors are struggling with this rally — it’s all about technicals, not fundamentals, but inflows are material, so they are forced to put money into the market.”
Markets have made a steep V-shaped recovery, while the real economy is still tumbling blindly down the slope.
“It has to be a bad thing if the government owns a quarter or a third of all bonds,” says the DCM head. “It’s not logical. The whole point of having a market is to set a price. If the only way you can have a market is by massive government support, you don’t really have a market.”
The present crisis is unprecedented. But now that state loans, wage support for furloughed workers and extraordinary liquidity injections have been invented, central banks and governments may be expected to use them in every recession.
“Central banks have decided that in perpetuity, whatever goes wrong, they are going to bail the markets out,” says a capital markets banker. “Our expectation is now that the first base rate hike from the ECB won’t be till 2025.”
For the head of DCM, the worry is: “If the response to every crisis is more government intervention in the bond market, what happens next time, in five or 10 years? We haven’t got out of all the debt they took on for the last crisis yet.”
There doesn’t seem to be any way out of this bind. Finance specialists of all kinds, from investment banks to investors to companies, now expect central banks to lead the markets like a good shepherd.
From now on, investors will still be able to distinguish between individual names and industries — as they have done in the past three months, replacing the usual ratings-based scale of credit spreads with a new sectoral one, based on the impact of Covid-19.
There may be periodic mini-sell-offs, such as have pockmarked the markets in the past few years. But if any serious risk threatens, the authorities will come running.
The other side of the tracks
If developed capital markets are under the strict maternal hand of central banks, emerging markets are the plaything of developed markets — and they are an altogether wilder master.
“EM debt is a respectable and permanent asset class, but it doesn’t have that back bid from the central banks that government and corporate debt now enjoy,” says Kingsley at Crédit Agricole. “The shifts into and out of it are driven by flows into and out of more liquid, investment grade asset classes, like SSA and investment grade corporate bonds. When markets go into risk-off mode there is a pullback — investors sell EM and go back to core credits.”
Between mid-February and mid-March, EM equities and debt were hit by the largest capital outflow ever: some $100bn in 40 days, according to the Institute of International Finance. The MSCI Emerging Market Index of shares tumbled 30%; some markets far more, such as Brazil, down 44%.
A devastating credit crunch threatened emerging markets. To make matters worse, they were in much poorer economic health going into the crisis than in 2008, when they were being powered by China’s mighty growth, leading to high commodity prices. Once the 2008 crisis hit, China “had a lot of firepower”, said Levy. “They invested very heavily in infrastructure around the world, in a lot of EM nations. That really helped a strong recovery.”
This time, commodity prices are low, China’s growth has been faltering for years, and “the pandemic has been a major body blow to China — the leaders have lost a lot of credibility,” Levy said. “They’re not going to be able to flex their muscles in EM.”
The situation for emerging markets looked very bleak, and there were soon moves to grant debt relief for the poorest countries. The IMF has extended $23.5bn of emergency financing to 66 countries.
EM bond issuance almost shut down for a while. But it would be wrong to think the issuers were quaking. “EM issuers are used to cyclicality — they’ve seen this movie before,” said an EM debt banker. “They had more patience. Some of the sovereigns like Panama and Mexico went ahead and issued, and paid up a bit. But the corporates and banks said to us: ‘We liked the levels in January’. We said: ‘Haven’t you noticed, the world has changed?’”
But the issuers were right to wait. In the past three weeks, EM assets have rallied strongly, as Fed liquidity has poured into the US bond market. “Funds still have cash and they can get yield in top quality EM names,” said Kingsley.
Cemex, the Mexican cement company, which is double-B rated in a tough sector, raised $1bn of seven year debt on June 2. “We got a book of $7.5bn, from real money emerging market and high yield accounts,” said Kingsley. “With that kind of demand, Cemex was able to compress the yield by 62.5bp and the book hardly dropped. Everybody now wants to get involved. The primary issuance is repricing the secondary market.”
The following day, Brazil raised $3.5bn of five and 10 year debt, attracting an $18bn book and printing inside its secondary curve.
“Brazil is one of the epicentres of the pandemic and yet the sovereign just printed at one of its tightest coupons ever,” said Kingsley. “In some ways it defies logic, but liquidity trumps everything."
Investors are reading the Fed's body actions as a guarantee that it will keep the market's wheels greased to dampen volatility.
Despite Brazil’s dreadful Covid outbreak and Argentina’s debt default, both countries’ stockmarkets have followed the same pattern as that of the US: rising steeply since March 23 and recovering most of their losses.
Hive mind
In all aspects of life, human beings are becoming more risk-averse, more connected and less independent. We sue if we suffer accidents, surrender our privacy to internet algorithms and allow software to steer our aeroplanes. We expect the collective to give us safety and convenience, and will give up freedom for it.
Financial markets are no different. In harmony with modern tastes, they are sanitised and controlled.
That was evident after the 2008 crisis; in the Covid pandemic, that steering has extended much further into the real economy.
“Most nations in Europe are social democracies — the US is more free enterprise, with the UK in between,” says Berenberg’s Levy. “But the US is tilting in the direction of a larger role for government, with the pandemic and the government’s response to shutting things down.”
Across the developed world, governments will extend their reach, with higher spending, more regulation, assertive monetary and fiscal policy and social safety nets — though Levy argues it is a double-edged sword, which could also lower potential growth.
“If you go back to the 1930s, there was no income support or social security,” says Levy. “That was a watershed. I think this is going to be another.”
Taming the savage power of financial markets may be a breakthrough for humanity — or a hubristic ambition doomed to failure.
Unfortunately, the other side of modernity is less in doubt. Severe environmental perils, from disease to climate change, are on the rise. This will not be the last time governments and central banks have to take charge of the markets.