credit Markets

The Big Question Still Has No Answer.

"The current crisis is more complex than the 2008 GFC".

We still haven’t answered the big question.

And perhaps that’s because it’s impossible to answer so soon after the lifting of lockdowns.

The imposition of new, limited/localized containment measures to combat rising infection rates in some locales complicates things further, even as it suggests a partial answer.

There are two ways of formulating the question. Expressing it in 30,000-foot terms is as simple as asking: “What does the post-COVID world look like?”

Earlier this week, in a note to clients, Deutsche Bank’s Aleksandar Kocic broke that question down into some of its (many) constituent parts. To wit:

Questions like which businesses would survive the crisis, how many people will lose their jobs permanently, how will they pay their rent, how much will they be willing to travel, consume, what services will they use, or how the banking sector will respond to all of that, still remain largely out of grasp.

That passage hints at the more narrow formulation of the question: “What does economic reality look like in the post-COVID world?”

Going by all-in borrowing costs for blue-chip American corporates, the answer is that things will be better than ever. The spread compression from March’s panic wides is nothing short of astounding, especially when you consider the Fed wasn’t actually buying anything (ETFs or otherwise) until early last month.

Of course, there’s something absurd about that. There are plenty of good arguments for why the post-COVID economic reality won’t be the dystopian nightmare some feared just two months previous. But it’s exceedingly difficult to imagine that the operating environment for corporates (as a group) won’t be considerably more challenging than it was pre-pandemic.

Sure, some companies will thrive in the new environment, but that’s always true. Some businesses and business models adapt to circumstances more easily than others, and sometimes it’s by accident. Although I know virtually nothing about the company, I imagine Peloton’s original pitch for expensive exercise bikes went well beyond a single slide featuring the word “pandemic” in 82-point font. And yet, that’s all they’d need now to make the case.

But just because the Fed has managed to wrestle corporate borrowing costs into submission doesn’t mean things are back to “normal”. In an expanded version of the note mentioned above, Deutsche’s Kocic illustrates a “structural shift” in credit.

“Equity/credit interaction, both during the peak of the pandemic as well as in the weeks of subsequent recovery, is pointing out at demand shock as the main culprit”, he writes, referencing the ongoing debate around the appropriate way to characterize the corona crisis (i.e., Will the supply disruptions dominate the demand shock creating long-run inflation or will the demand disruptions prove enduring, creating a semi-permanent disinflationary impulse?).

“The onset of structural shift is suggestive of latent risks waiting to be activated”, Kocic goes on to say, illustrating the point with the following visual.

(Deutsche Bank)

Before 2020, IG credit (the figure is CDX.IG spreads) and equities were tightly correlated. But, when the pandemic hit, “they begin to depart from their logical and historical commonality and their interaction develop[ed] a hysteresis during the peak in March [and] April”, Kocic goes on to say.

That hysteresis dissipated as the virus was brought under control (or what looked like “control” prior the last two weeks, anyway), but as Kocic notes, referencing the red points in the figure, “the markets emerged altered”.

We’ve witnessed what he calls “a semblance of recovery”, and yet, that recovery in credit has been only “partial”. “While high frequency dynamics of their interaction has been altered only slightly, when adjusted for equity levels, IG is trading 20bp wider than before”, Kocic writes.

What does this reflect? Well, as alluded to above, it suggests that the Fed’s efforts notwithstanding, credit markets may never fully normalize. Or, if they will, we cannot yet know when — there are simply too many embedded contingencies, all of which speak to the broader question about reality in the post-COVID world, as well as its more narrow formulation centered around prospective shifts in economic behavior. Kocic expands and refines his message from Monday. To wit:

Current crisis is more complex than the 2008 GFC. Its long-term effects on aggregate demand have not been sorted out yet, especially their influence on the corporate sector and credit. Questions like which businesses would survive the crisis, how many people will lose their jobs permanently, how will they pay their rent (and how will their landlords pay their liabilities), how much will they be willing to travel, consume, what services will they use, or how the banking sector will respond to all that, remain still largely out of grasp. It is possible, if not likely, that despite Fed’s protective maneuver, default rates might increase, which would affect rate of borrowing and credit spreads in general. Wider credit spreads could persist without revisiting their pre-corona levels even if the crisis subsides significantly.

Apropos of something, Nike on Thursday evening reported a 38% YoY decline in revenue.

Margins were down sharply, missing consensus by a mile. The company swung to a 51 cent/share loss versus expectations for a profit.

In a statement Friday, the company said it plans to “shift resources and create capacity to reinvest in [the] highest potential areas”.

That’s a euphemism for layoffs.

“We anticipate our realignment will likely result in a net loss of jobs”, Nike conceded.

“We will soon be forced to make some difficult choices”, CEO John Donahoe told employees, in an e-mail. “These decisions are exceptionally difficult because they impact friends and colleagues”, he added.


 

3 comments on “The Big Question Still Has No Answer.

  1. Yeah what exactly happens when we get closer to Q4 with these kinds of insane down spikes in revenue… as you have said… white collar is going to get hammered just as the unemployment bonus disappears… Congress did far too little to prop up the economy and now hard decisions are going to be made which will kick off a real second wave of revenue down trends as all the consumer purchasing power evaporates in August. We are going to need UBI immediately to prevent a downward spiral.

    • Yeah, I’m somewhat perplexed that Senate Republicans haven’t shown more urgency in pushing more stimulus. The longer they wait, the worse the damage will be going into November. I suppose they could be waiting until closer to November to pass more stimulus so it’s fresher in the minds of voters, but that’s a risky move and might be too little, too late. I know H has pointed how Mnuchin may be holding onto some of his ammo, but with the recent outbreaks, the second half of the year is shaping up to be a rough one.

      It almost makes me wonder if Senate Republicans aren’t too keen on the idea of another term for the President. If that is the way they feel, they are also putting some of their own necks on the line with all the close Senate races expected.

      For what it’s worth, I don’t believe for a second that most Senate Republicans are worried about the deficit/debt impact or people pocketing the stimulus dollars. No way their base cares beyond a few libertarian true believers and deficit concerns haven’t stopped them before.

      • Trump has changed the composition of “the base.” Not so long ago the Tea Party was, at least, a vocal portion of the GOP base. Now the base more resembles the George Wallace base.

        The GOP’s Southern Strategy has worked.

        I wonder if this is the outcome the Koch Brothers and the Adelsons paid so much for.

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