Thematics Views - July 2020

Vision for the EU

The third fragmentation comes from the national vision for the EU, which is more complex than the traditional federalists vs nationalists dualistic debate. Whereas the EU project was considered, still a decade ago, as a positive way forward in bringing peace and wealth to Europeans, diverging aspirations have arisen among and within member states. It should be remembered that, at the origin of the euro, all EU countries were supposed to join the monetary union. Today the European project has become ambiguous. The Brexit requires a rethinking of objectives beyond the EZ’s economic and financial dimension. European institutions such as the ECB and the ECJ are being challenged by the German Constitutional Court, illustrating a deeper divide on the axis of the political legitimacy of the institutions. In addition, national opinions are keen to maintain a degree of sovereignty over sensitive issues (such as foreign policy and migration policy), which is reflected by the rise of ‘anti-establishment’ parties in national elections. The debate between federalists vs nationalists has changed into globalised elite vs real people. These tensions should not be underestimated as they are at the heart of the Brexit vote.

That said, the difficulties encountered by the British Government with Brexit (and the economic cost associated with it) are a deterrent. It can be observed that the anti-establishment parties (in France and Italy) no longer put an exit from the euro on the agenda. Ironically, Brexit could even open up new prospects for the EU project. Indeed, the Eurozone’s share of EU GDP rose from 72% (EU-28) to 86% EU-27). France and Germany, taken together (which account for more than 50% of the Eurozone’s GDP), are de facto becoming Europe’s new centre of gravity, which could make it easier to set up a “new project”.

The Covid-19 crisis has increased economic fragmentation in the EZ and illustrates once again the need to strengthen the Eurozone’s financial architecture. The debate on risk sharing goes far beyond the debate on fiscal federalism, which northern countries refuse to implement. The crisis illustrates the need to forge “tools” that can absorb asymmetric shocks without putting taxpayers in the north in a position of having to pay off the south’s debts one day. There are many proposals to share risks better. The strengthening of the capital market union, the creation of a common debt instrument, and the revision of the budgetary rules of the Growth and Stability Pact (which have proved too procyclical) are all on the table. But, like any compromise, it will require concessions from the countries that will potentially benefit from transfers in crisis times. Member states will request a ‘right of scrutiny’ of the policies put in place.

Increased imbalances and fragmentation could become irreversible if they are not addressed. The forces in play are more complex than the classic north/south public debt imbalance, as economic models and vision for the EU are two other axis of discord. The Next Generation EU instrument partially deals with those risks but requires more political support in order to help the union moving forward.

1“Countries and regions with economies dependent on client facing services, exports or a high number of small businesses, will be hit much harder than others. And while every Member State has supported its workers and companies as much as possible, not all can do this to the same extent. This creates the risk of an imbalanced recovery, an uneven playing field and widening disparities.” EU Recovery Fund proposal

Markets will discount the no deal exit in 2H2020

The risk of a “Brexit cliff” at the end of 2020 is therefore real, with trade between the EU and the UK governed only by WTO clauses. As this deadline approaches, markets may be concerned. Indeed, the economic cost of introducing tariffs and trade frictions (border controls, divergences in standards) could be significant. The perception of that cost could increase in a few months, when the UK economy starts its convalescence, and all the attention is no more grabbed by the immediate GDP collapse due to the pandemic. Moreover, if not fully resolved by this date, the issue of the Northern Irish border could have serious political implications both for the UK (as a physical border could threaten the 1998 peace agreement), and for the EU (as an open border could be a breach in the integrity of the Single Market).

Sterling, which has lost almost 20% against the US dollar since the June 2016 referendum, could fall again (especially against the euro) if the probability of a “no-deal” increases. The market for Gilts (British Treasury Bills), which is mainly driven by domestic investors, is not expected to be impacted, especially as the Bank of England is engaged in a substantial programme of repurchasing crown debt. However, the corporate bond market could be penalised, as could some sectors of the equity market that are strongly intertwined in the Single Market (such as industry and finance). Over the past four years, UK equities have underperformed the world’s major markets (-20% against Europe and -50% relative to the US in USD). As it usually happens with political catalysts, markets will probably discount the risk exists way before the year-end deadline, and then move in the opposite direction postevent. Therefore, the downside risk on UK risk assets could be concentrated a 2H2020 topic rather than a 2021.

BBB-BBs, best investment profile in credit

In an environment of low growth, low interest rates and rising default rates, investment grade and BB-rated issuers remain the ideal segment for investing. (1) The major central banks will support directly these issuers for an extended period through their asset purchase programmes. (2) Investor demand will remain strong, driven by a need for yield in a low interest rate environment. (3) The probability of default of these issuers remains very low.

A slow recovery underpinned by unprecedented coordination between fiscal policy and monetary policy

The shock caused by the Covid-19 crisis is unprecedented in scale. The lockdown measures that helped to save lives have also led to a significant and rapid decline in global economic activity. The OECD and the World Bank recently announced there would be a decline in global GDP in 2020 of 5-6%. In parallel, the responses to the crisis by the various governments and central banks were also unprecedented in scale and rapidity. The governments that initially put in place support measures to help companies maintain their operating capacity and to prevent households from losing too much income, are now putting in place stimulus measures. The crisis has brought government deficits to historically high levels. In the US, the CBO estimates that the federal deficit will reach $3,700 billion in 2020 and $2,100 billion in 2021, representing around 18% and 10% respectively of GDP. The European Commission estimates that the public deficit in the Eurozone will reach around one trillion euros in 2020, equal to 8.5% of GDP. All of these estimates are likely to be revised upward over the coming months.

We will continue to see low interest rates over the next few quarters. In our view, this massive supply of sovereign debt is not likely to give rise to a significant increase in interest rates. The major central banks are purchasing assets at an unprecedented rate and absorbing governments’ new financing needs.

• The ECB increased the amount of its pandemic emergency purchase programme (PEPP) by €600 billion to €1,350 billion and has extended it until the end of June 2021 at least.

• At its last meeting in March, the Fed announced unlimited purchases of Treasuries and MBS. Federal Reserve Chairman Jerome Powell specified that the pace of purchases would be at least $ 120bn per month with $80bn of Treasuries and $40bn of Mortgage Backed Securities.

The central banks took substantial measures to improve financing conditions on the credit markets. 

Progress were rapid.

• Spreads tightened, particularly on shorter maturities.

• The markets benefited again from inflows as investor demand was underpinned by the central banks’ engagement.

• Activity on the primary market for investment grade issues reached record levels in the US and Europe. Volumes on the US IG primary market have already reached one trillion dollars in 2020, equivalent to the total full-year issuance seen in 2019.

• Activity on the high yield market resumed in the US following the Fed’s decision to expand its support to investment grade securities that dropped into high yield (fallen angels) due to the crisis.

• Companies used the funds raised to strengthen their balance sheets and raised their cash holdings

We anticipate an increase in defaults over the next few quarters. The company default profile could spread out over time and differ from the peak seen in 2008. This would see companies not going into default due to a lack of liquidity but rather due to a lack of profitability in relation to high debt levels.

In this context, investment grade and BB-rated issuers remain the ideal strategy in an environment of low growth, low interest rates and rising default rates.

1. The major central banks will support these issuers for an extended period through their asset purchase programmes. These companies will be favoured to bolster the recovery and limit an increase in unemployment.
2. Investor demand will continue to be driven by a need for returns in an environment of low interest rates. The coordination of fiscal and monetary policies should help to avoid an increase in bond yields.
3. The probability of default of these issuers remains very low. Companies have used the funds raised to shore up their balance sheets.

Finalised on 22/06/2020

Supply surplus

Every year, new homes are built in order to satisfy the incremental demand from the new households that are being formed. In the near term, home prices fluctuate to balance housing supply and housing demand. In the years immediately before the GFC, spurred by an errant price signal, home builders rushed to add supply, only to see housing demand plummet at the onset of the crisis. The subsequent surplus exacerbated price declines. Since then, single-family housing starts (new construction) have yet to recover to a rate that matches long-term household formation rates. As a result, the housing market entered the current crisis with the lowest inventory levels in decades. In our view, there are two implications for home prices going forward. First, entering the current crisis from a position of shortage rather than surplus could insulate the housing market from drastic home price declines. Second, while housing demand decreases as unemployment and uncertainty spike, a new equilibrium could largely be met through quantity rather than price, as new home construction will decline far more than prices.

Declining income

Housing is a real asset whose price has tended to fluctuate with incomes. With incomes expected to decline, home prices should be expected to decline as well. This is the one factor affecting home prices that overlaps with the experience of the GFC. In fact, we believe unemployment could climb more rapidly during the current recession compared to prior recessions. That said, we believe the focus for home prices belongs on income, due to the long-term and intuitive relationship between home prices and income, and because unemployment has historically been an imperfect proxy for income. Unemployment statistics are distorted by underemployed and discouraged workers, and there is a mismatch between the employment trends across the broad labour market versus the subset of the labour market that comprises current and potential homeowners. Finally, in the current recession, we note that the unprecedented income stabilization programs from the federal government should alter the historic relationship between unemployment and income.

Like many investors, we have leaned upon the lessons from the GFC to inform our expectations for the current crisis. Given the aforementioned differences between the GFC and today’s crisis, we assign low probabilities to scenarios that mirror the home price experience witnessed during the GFC. We note that in the three recessions since the 1980s, the only one in which housing declined in the aggregate was the recession that housing itself caused.

Where Do We Go From Here?

We expect home prices to follow the broader economy lower, with modest single-digit declines in the coming year, followed by a recovery in home prices alongside an expected recovery in income and employment. In terms of supply and demand for housing, equilibrium should be reached largely through quantity rather than price. We expect extensive mortgage forbearance and modification programs to take place prior to lenders resorting to foreclosures and short-sales. With Fannie Mae and Freddie Mac having already announced up to twelve months of forbearance for borrowers experiencing hardship, and with typical liquidation timelines in the range of 12 to 24 months for borrowers who are unable to recover, we expect several years to pass before distressed supply meaningfully arrives, at which point incomes will have already begun to recover.

What Could Go Right?

We entered into this crisis with the expectation that home price gains would modestly outpace inflation, but with risk to the upside due to the tight housing supply situation. We believe any improvement to the macroeconomic environment should translate into marginally higher home prices through marginally higher incomes and a return to a market characterized by a housing shortage. In addition, interest rates provide an upside scenario, even in less benign environments. Mortgage rates are currently near all-time lows, and yet mortgage rates are at their widest levels versus Treasury yields since the 1980s (with the notable exception of the three months immediately after the failure of Lehman Brothers in 2008). Today’s record-low mortgage rates already provide a tailwind for home prices, but to the extent that the spread between mortgage rates and Treasury yields normalizes to historically normal levels, we believe this tailwind will only grow stronger.

Finalised on 17/06/2020