21 Aug 2020
Are governments and central banks trying to cure a debt problem with more debt? As policy intervention drives markets higher at the same time as economic data nosedives, Ariel Bezalel and Harry Richards discuss where they are finding opportunities and avoiding pitfalls in today’s bond markets.
Risk assets have had a spectacular recovery since the middle of March, yet government bond markets signal a very different reality. Almost $12.4 trillion of government bonds now yield below zero, with Canada, the UK, Ireland and Belgium joining the negative-yield club.
It’s an overused word, but we really are in ‘unprecedented’ territory – over 90% of global economies are in a recession, which is even higher than in the Great Depression, while 40% of countries are seeing falling inflation. Global debt levels have soared, with governments adding around $10 trillion of debt in the last few months. When combined with central bank measures, this amounts to around $25 trillion of stimulus. Corporate debt levels have also ballooned. Evidence shows that central bank support is being used to boost corporate cash balances rather than invest in productive assets, which is likely to be a big headwind to growth.
But you can’t cure a debt problem with more debt. The debt burden means that fiscal policy is losing its potency. In the 1950s, $1 of debt generated around $0.8 of GDP; today it’s less than $0.4. This is a global trend. Fiscal stimulus is acting like a sugar rush – it’s effective for a couple of quarters but starts to wane as too much debt and ageing demographics weigh on economic activity. In our view, this accumulation of debt will hasten the ‘Japanisation’ effect across the developed world with yields grinding ever lower.
As bond yields fall, we believe yield curves will continue to flatten. The 10-year US Treasury yield could well drift down to zero, perhaps even lower, while the 30-year bond yield could trade below 1.0%. This is supportive for government bond prices and that’s why we are bullish on medium- to long-dated US Treasuries. Australia is another market where we believe there are strong returns to be made in government bonds.
There has been a lot of excitement about a spike in money supply recently, but the velocity of money – the rate at which money is exchanged – is declining. In fact, it has been doing so for several decades in Europe, the US, China and Japan. Until this picks up, it’s unlikely we’ll see an increase in inflationary pressures.
In our view, we are still in a deflationary environment. The game changer would be more extreme policy innovation, such as Modern Monetary Theory (MMT). But we think that point is still one to two years away.
Dodging the landmines is just as important as picking credits that can thrive in this environment. While central banks may have prevented a liquidity crisis, an insolvency crisis is looming. In the US, the base case from Moody’s is for default rates in high yield to rise to about 14%, and up to 8% in Europe. These are levels not seen since the 2008 financial crisis.
That’s why we are focusing on companies with robust fundamentals. We are avoiding more cyclically exposed sectors, such as autos, industrials and some of the materials businesses, that we feel are extremely indebted, especially after accessing the emergency loans used to shore up liquidity during this crisis.
Q3 and Q4 reporting seasons will inevitably deliver a lot of negative surprises. The key to avoiding these, and to delivering strong performance during these periods, is thorough credit analysis.
In high yield, we are focused on the better-quality end of the market (BB-rated credits and high Bs) and avoiding low quality Bs and CCCs. We like through-the-cycle businesses with bonds that offer security against high quality collateral. Many of these are in the pharmaceutical, food and beverage, and TMT sectors and are seeing an improvement in their credit profile as a result of Covid-19.
Albertsons is a good example of a high yield business with an improving credit profile. The BB-/B2 rated US supermarket chain owns around 40% of its stores and its in-store pharmacy makes it a convenient one-stop shop. Our calculations tell us the company’s store portfolio, manufacturing plants and distributions centres are worth over $11 billion which equates to more than 1.6x their net debt, providing strong asset coverage and some downside protection for bondholders. Albertsons was already paying down debt ahead of its recent IPO, and with Covid-19 driving food sales up, deleveraging is accelerating meaningfully.
We expect that improving fundamentals should drive strong performance. We also think rating agencies are likely to upgrade Albertsons given its financial metrics are now approaching those of its investment grade rival, Kroger, which would act as another catalyst for spread tightening in the company’s bonds.
The rally continues to be driven by stimulus rather than economic fundamentals. We believe that an insolvency phase should be expected over the next year. We believe this is a credit-picker’s market and remain focused on finding companies with robust business models that can withstand the uncertainties ahead while offering attractive total return potential. With deflation likely to dominate proceedings for a while yet, a healthy allocation to government bonds, even at these low yields, also remains warranted.
Please note: Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the individuals mentioned at the time of writing are not necessarily those of Jupiter as a whole and may be subject to change. This is particularly true during periods of rapidly changing market circumstances.
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