As countries begin to emerge out of lockdown, questions are being raised about whether financial assets recovery will help in economic recovery, how long the recoveries can be sustained and what’s next for global liquidity. I discussed these issues with fellow panellists at a recent webinar titled “Surviving the cash crisis: The capital market outlook.
In the wake of the COVID-19 pandemic, central banks and governments across the world responded with tremendous monetary support. This spurred an impressive recovery in financial assets in the second quarter of 2020. But as countries begin to emerge out of lockdown, questions are being raised about whether financial asset recovery will help in economic recovery, how long the recoveries can be sustained and what’s next for global liquidity.
The ramifications of this crisis will be felt for a long time. While markets remain optimistic for now, the second half of 2020 will be defined by how well they can absorb the avalanche of debt that’s coming their way and, once stimulus is curtailed, whether corporates are able to access the funds they need to grow their businesses.
Investors find themselves in the middle of a tug of war: on one side, the virus, its consequences and the threat of a second wave. On the other, powerful economic forces put to work by central banks and governments. So far, stimulus efforts are winning, shoring up short-term liquidity, propelling markets and bolstering debt issuance.
Here are four themes set to affect the capital markets outlook over the next year:
The central bank war chest
Two themes defined the first half of 2020: the global health crisis that emerged and took hold in the first quarter, prompting a Value at Risk (VaR) shock and the forced liquidation of assets around the world. As central banks and governments responded, turning on the stimulus taps, the second quarter was characterised by a recovery in assets, liquidity, and market prices.
Unleashing this mammoth support comes at a cost. The combined balance sheet of the US Federal Reserve, the European Central Bank, the People’s Bank of China and the Bank of Japan spiked to $24.5 trillion, up by around $4.5 trillion since early March, according to Standard Chartered research.
These measures are effectively providing a bridge loan to corporates, financial institutions and investors, backed up by widening national budget deficits as governments put fiscal support measures in place.
While this money markets distortion will persist for the foreseeable future, most developed economies have the tools to control it. Encouragingly, we have seen that in emerging markets, central banks have been able to ease monetary policy measures without impacting their currencies.
For corporates (especially those in less stressed sectors), this has lowered the cost of raising funds during the pandemic. But rationalisation may come when it’s time to pay back the debt, with cost cutting and headcount reductions underscoring the persistent nature of the pandemic’s impact and its deep economic scars.
The recovery will take time, according to a Standard Chartered poll, with 34 per cent of respondents saying it will be W-shaped, and a further 33 per cent saying it will be shaped like a swoosh. Just 5 per cent predict a swift V-shaped recovery, while 26 per cent see a U-shape.
While fiscal stimulus measures have been effective, they come with a longer-term cost. At some point these debts will have to be repaid, and most likely the risks will be borne by governments around the world. But there will be a wide divergence between the impact on different economies depending on their individual appetite for debt or fiscal space.
Despite some wobbles, financial markets have recovered faster than the economy, generating a gap between Wall Street and Main Street. More than half (51 per cent) of respondents to a Standard Chartered survey expect rebalancing, where markets fall into line with the economic outlook, while 34 per cent see the difference between the two persisting, and 16 per cent say the economy will improve.
Markets are supportive for now – absorbing the expansion of corporate and government debt issuance – but they can also be fickle. The pandemic has resulted in huge amounts of public and private debt, and it’s likely that there will be a tipping point where fundamentals come back into view and investors become more discerning.
As fiscal and political constraints tighten, the US may diverge from the eurozone, with European governments continuing to support their economies for a longer period.
In Asia, Singapore and Indonesia both have fiscal space and relatively promising outlooks, while India has less room for manoeuvre. South Korea saw large capital outflows as the crisis took hold and remains exposed to global trade forces, making it vulnerable relative to other South East Asian countries.
The dollar’s critical role
For emerging markets and for corporate borrowers, the trajectory of the US dollar remains key.
As liquidity disappeared, volatility spiked, and investors sought shelter in havens. The dollar surged in March, pushing Bloomberg’s gauge of the greenback against a basket of currencies1 to a record high.
With so much dollar-denominated debt around the world, this caused a further tightening of global monetary conditions and made access to funding challenging, with many markets freezing up. After the Fed offered a lifeline, the dollar weakened2 from its highs and the situation stabilised.
Looking forward, Standard Chartered expects the dollar to depreciate further, as the Fed’s interest rates fall into line with other Group-of-10 central banks, and the relative strength of the US economy wanes. The rise of US-produced shale oil was also a supportive factor for the currency, and the drop in oil prices – which will probably persist through 2021 – has taken away that prop.
Any resurgence in the dollar, particularly back towards the highs seen in March, would reinstate difficulties for emerging market countries and corporate borrowers.
Record issuance – and what comes next
Central bank actions have also pumped up bond issuance.
US investment grade (IG) companies have issued almost as much debt this year3 as they did in the whole of 2019, as central bank assistance keeps borrowing costs down. Average investment-grade yields are close to record lows4, making now a good time to issue a corporate bond, according to 6 out of 10 respondents to a Standard Chartered survey.
For corporates, it’s a question of how much they want to leverage their balance sheet to access cash at the right price. While the withdrawal of capital has slowed, many international investors are sitting on the sidelines, waiting to see how the crisis evolves. On a positive note, we could see an increase in ESG (Environmental, Social and Governance) investing with many governments using debt to finance healthcare projects in preparation for a similar crisis in the future.
Among the key risks is a second wave of the virus. Even so, the shock is unlikely to be as severe as the first wave, since governments and healthcare systems are better prepared, and some governments appear more willing to balance the health risks against damage to the economy. Fresh lockdowns would be damaging, with Standard Chartered estimating that one month of shutdown leads to a contraction of around 3 percentage points in most developed economies.
The fundamentals of governments and companies will be tested in the coming months, as difficult economic conditions bite and access to cash and debt issuance remains critical for survival.
For now, central banks have succeeded in staving off the worst of the liquidity crunch and shoring up investor sentiment. What comes next depends on a complex set of variables: how long stimulus is kept in place, the market’s confidence in central bank and government measures, and the outlook for the dollar.
Whatever the ultimate shape of the economic recovery, it’s clear the legacy of this pandemic will be long lasting.
This article contains insights from the ‘Unravelling Uncertainty’ webinar series in partnership with The Economist.