As the coronavirus pandemic has spread quickly worldwide, countries around the world are taking steps to shield their national economies.
Central banks and governments worldwide have launched an unprecedented monetary and fiscal front to combat the economic damage wrought by the coronavirus pandemic. The causes of the current disruption to the economy and financial system are completely different from those of the financial crisis of 2008, but many of the tools and stabilisation mechanisms developed back then have been reactivated quickly and efficiently. The aid packages provided by governments and central banks are now in the region of 10 to 15 percent of annual gross domestic product. This covers a shutdown period of 2-3 months.
Almost overnight, the global production shutdown, temporary company closures, and transport restrictions have led to the most severe economic slump in recent history. Unlike previous recessions (including the 2008 financial crisis), this one is due to an exogenous shock and not a systemic aberration. That’s why a prompt and massive official response is absolutely essential, to prevent damage to economic structures that are otherwise intact. Moreover, the exact degree of damage is inestimable and therefore requires even greater measures to head off dangerous self-fulfilling prophecies due to panicky behaviour by individuals and investors.
What does this mean for bonds?
Money managers need to monitor possible differences between sectors and countries. It is conceivable that service-oriented economies (such as the US) will suffer more than countries with a high manufacturing output. Initial Purchasing Managers surveys (PMI) point in this direction.
Sector-wise, energy and transport, as well as aviation and leisure industries remain challenging. This is especially true in the high-yield segment. Even at low prices, there have been no buy signals yet. In order for the situation in the energy sector to improve, oil prices should reach at least $35 per barrel and then move relatively quickly towards $50 per barrel.
The banking sector is likely to remain under pressure. Lower interest rates and the slump in investment banking activity are weighing on profitability. In addition, high write-downs are likely to be necessary as the credit quality of debtors will suffer. However, we believe that the potential for losses is greater for bank equities rather than bank bonds. The reason is that some banks are supporting their creditworthiness by cutting dividends, and regulators are considering, or in some cases have already announced, a relaxation of credit provisioning and equity ratios.
In the convertible bond segment, convertibles are in particular demand from companies with strong balance sheets (high cash, low debt and stable cash flows). This is true for all sectors mentioned below (see the table for preferred sectors and countries).
Foreign exchange markets are supported globally by measures taken by the Fed to increase US dollar liquidity. An excessively strong dollar might cause additional difficulties for some emerging markets.
Monetary policy is not enough
The reaction so far from central banks has been exemplary and more than appropriate. Support has been comparable to that of past crises. In contrast to the global financial crisis of 2008, central banks’ liquidity injections – while certainly necessary, even in unlimited amounts – will not be enough to resolve the economic damage. This time, monetary policy is serving only to maintain market liquidity and payments, and to support banks. Production shortfalls and lost wages, however, can be addressed with government bridge payments and subsidies (and perhaps capital injections).
Fortunately, the tasks were apportioned promptly, purposefully and in the right doses. Government assistance is being brought through support funds. Germany, for example, has made €600 billion (Dh2.2 trillion) available through an economic stabilisation fund for large companies. This alone is equivalent to 17 per cent of Germany’s GDP. Another €550bn will be made available to smaller companies and households through the public investment institution. Other governments are enacting similar rescue plans, often amounting to 10 per cent or more of their GDP. Switzerland’s 40bn francs (Dh150bn), for example, is equivalent, on a per capita basis, to the $2tn (Dh7.45tn) released in the US. It is not yet clear whether these funds will be needed. Even so, the amount actually disbursed will raise government deficits considerably.
Central banks moving rapidly
All this has fast-forwarded to the creation of “helicopter money”, a concept long discussed among economists. Helicopter money is created by the central bank and is either distributed directly to individuals or indirectly by financing public spending through the purchase of government bonds. Quantitative easing, in contrast, only increases liquidity in the banking system, without directly triggering new government spending. Moreover, in contrast to QE, helicopter money would not be withdrawn from circulation, meaning that governments would not have to repay the bonds.
The support that is currently being provided by the Fed, the ECB and the Bank of Japan at least in part meets the definition of helicopter money. Central banks are now also buying government bonds on the primary market, as well as corporate bonds and shares (by the BoJ), and the EU is discussing the issuance of euro ‘corona bonds’. All these purchases are providing money for direct investment and are not just liquidity injections.
Such measures are extremely effective and suitable to the current situation. Moreover, experience has shown that they don’t necessarily push up inflation or interest rates if helicopter money is used moderately and temporarily. And since the purchased securities remain on central banks’ balance sheets at first, the money can later be withdrawn from the financial system through sales. Hopefully, the current monetary and fiscal campaign will be successful in combatting the economic impact of the coronavirus.
Beat Thoma is chief investment officer at Fisch Asset Management, a member of The Gulf Bond and Sukuk Association