Cold hard truths
As the majority of us come to the end of our second month of remote working, it seems that some of the novelty is gone. For markets, too, the hard reality seems to have emerged. Last week, the S&P 500 fell to a three-week low. Markets appeared troubled by the latest round of poor economic data and the enormity of the mounting bill of stimulus and aid packages that aim to ease the pain of lost revenues.
This reality check in equity markets mirrored what we have seen in the fixed-income universe since the start of the crisis: a preference for lower-risk government bonds and a stark aversion to riskier high-yield credits, where spreads have soared.
The gap between S&P 500 dividend yields and US 10-year government bond yields has widened dramatically in recent weeks and is now eight standard deviations above its 14-year average (see figure 1).
Figure 1. Dividend and bond yields part ways
Source: Bloomberg, as at May 2020.
This is because dividends have remained consistent, while government-bond yields have fallen as investors seek them out as safe havens. However, this relationship may be on the brink of change as dividends and share buybacks come under pressure – something that could bode well for high-yield credit (read more about this in our recent piece, ‘When coupons are king: the case for global high-yield credit’).
Fixed income: the changing face of high-yield credit
Our Credit team notes that there has been a sustained focus by companies on raising liquidity in the face of heightened uncertainty and increased volatility. This mirrors the triage-type efforts in place among private lenders to ensure that borrowers avoid defaults and stay afloat until activities can resume.
Within public markets, the premium on near-term money led to a temporary inversion of investment-grade credit curves – although they have since normalised and returned to their typical gentle upwards slope.
Since then, issuance has reached record levels and the investment-grade market has returned to relative normality. Meanwhile, the high-yield market remains distorted and the number of fallen angels – or issuers downgraded from investment-grade status – that recently descended has raised the average credit quality of the asset class (read more about this in our Weekly Credit Insight).
While fallen angels have altered the composition of the high-yield index in the near term, the market has experienced even greater change over the past decade. Our Global High Yield capability recently reached its 10-year anniversary, which we used as an opportunity to consider how the market has changed in terms of breadth, underlying credit quality and its emphasis on sustainability.
Equities: a dispersion in outcomes
Our Global Emerging Markets team notes that the effect of the coronavirus pandemic has been highly variable across countries, with a relatively contained outbreak in Asian countries outside of China and a more severe scenario across certain Latin American countries like Ecuador and Brazil. There has been a subtle shift in the timeframes that investors seek to discount, as phase one (that is, the lockdown) is shifting to a more protracted and uneven phase two (when economies start reopening).
Our analysts build models that factor in the current disruption and anticipate a return to normal growth and trading conditions at a certain point in the future, which they believe could be 2021 or 2022. The recent suggestion by Federal Reserve Chair Jerome Powell that the US economy would not recover until the end of 2021 is further evidence that this date is being pushed further out. This will simply prolong the current period of uncertainty and make estimates less robust and prone to change.
Meanwhile, our Asia ex-Japan team notes that many companies are trading at lows last recorded during the 2008 financial crisis. Trailing dividend yields are a full standard deviation above the mean, while price/book valuations are one standard deviation below their 10-year average. Although investor risk aversion is high, this potentially presents an interesting entry opportunity for the asset class.