Global stock markets continued to display unprecedented levels of volatility last week but, for the first time in a while and despite a sell off on Friday, all major markets ended the week very much to the positive. The Dow Jones gained over 15%, the S+P 500 around 13%, the FTSE just under 9% and the European bourses all up by a similar amount. Even Italy, which has very much been at the epicentre of this crisis, moved up by over 7%.
The reason for these gains has very much been down to government and central bank intervention, which is intended to support business and individuals through this economic shock. In the US they announced a $ 2 Trillion package that includes measures to support companies with loans, assist health facilities that are under enormous strain and even direct payments (often called helicopter money) of $1,200 to each individual that earns less than $75,000 and an extra $500 per child. There is to be extra unemployment benefit to be provided too and this will most likely become extremely relevant as the crisis causes business MARKET UPDATE 30th MARCH 2020 to lay off workers. There were an additional 3.3m people made unemployed in the US when the last figures were published and this number is only going to rise. Together with the measures already taken by other governments, again with the promise of more to come, it seems that authorities are getting their act together and responding to the crisis. One thing that needs to be considered when praising or criticising government response, is that actions can have consequences and these need to be evaluated before making a knee-jerk action. For this reason, Rishi Sunak is getting praised for taking time to consider outcomes and, when he announced his plans, many of them were back dated to the beginning of the crisis. Clearly nothing is perfect in the current situation and most people will suffer at least a degree of hardship, but the scale of intervention across the world does seem a step in the right direction.
One consequence of the stimulus being given, however, is a distortion in bond markets, or Fixed Interest. Fixed Interest is the process whereby countries and companies borrow money over a specified time and at an agreed rate of interest, at the end of which they repay the initial amount. The mechanics are complicated but, in essence, the better the credit rating of the borrower, the less interest they would expect to pay with government debt (gilts in the UK, treasuries in the US) being the best rated. All debt is effectively priced against government bond prices (interest rates) and the extra premium a lesser quality borrower might be expected to pay, because of the increased risk to the lender, is called the spread.
In the past few years this spread between corporate and government bonds has narrowed significantly, as low central bank interest rates have tempted lenders into making loans to less credit worthy companies in order to get a more attractive rate of return, or yield. Many commentators had their reservations about this lower credit (high yield) market before Coronavirus, believing that investors were taking excessive risk to try to generate a better rate of return. A consequence of this has been to push the price of these lower credit assets to a higher price than can be justified. Many of these high yield borrowers work on very fine margins making them extremely sensitive to the rate of interest they have to pay. Therefore, as their ability to make money is curtailed by the economic shutdown, it follows that they struggle to maintain their existing debt. As this happens, any future lenders demand more of a risk premium in the form of a higher rate of interest, amplifying the problem. It can become a downward spiral as concerns over credit worthiness increases borrowing costs which puts the company under increased pressure.
The situation is not all downbeat for the sector, as central banks have also announced new rounds of Quantitative Easing (QE). This was one of their main weapons during the financial crisis of 2008 onwards, QE is the process of central banks buying bonds to put more money into the economy. It is significant that in the US ,the Federal reserve has said it will now buy corporate bonds in addition to its own, government bonds. This is a measure beyond anything they did in 2008 and should be supportive of better rated corporate bonds, but there remains a significant question mark over how the high yield market will react.
As always at this time things are very much in flux and markets extraordinarily sensitive to governmental announcement. While it is true that markets rallied last week it would be foolish to call the bottom and this situation would seem likely to have many more twists before it ends.