Recessions are typically caused by either tightening of monetary policy, tightening of fiscal policy, bursting of a credit or debt bubble, bursting of a housing or asset price bubble, and/or a banking crisis. The risk of any of these was low heading into 2020. While the risk of a cyclical downturn driven by an exogenous shock (for example, global trade uncertainty) was moderate as “Black Swan” events aren’t taken into forecasting.
The spread of Covid-19 has broadened to more geographies and will have a pronounced impact on global growth in 2020. While a collapse in stock markets and emergency interest rate cuts inevitably lead to comparisons to the 2008 Global Financial Crisis (GFC), the situations are far different. The GFC was a balance sheet recession. Housing price bubbles inflated and then burst, materially impairing household balance sheets and forcing a shift towards saving rather than spending in developed market economies. The developments exposed vulnerabilities in a highly-leveraged global banking system. Bank counter-party confidence collapsed and the financial plumbing froze, resulting in a material reduction in global demand. In contrast, the exogenous shock posed by the coronavirus affects both the supply and the demand sides of the economy, as supply chains are disrupted and the consumer service sectors are faced with prospect of a sudden decline in consumer demand due to increased social distancing. The GFC triggered a deep recession followed by an extremely slow recovery as households and financial institutions repaired their balance sheets. The Covid-19 shock is likely to trigger large falls of output in the affected economies over the next quarter (and possibly two) but, provided that the virus fades, activity should rebound as supply constraints are lifted. Of course, this outlook is unusually uncertain and the geopolitical situation that has resulted in the collapse in oil prices has further complicated the calculus, but our “base case” is that this is will be a short, sharp shock to global growth.
Financial market reaction has been historically swift and severe, driven by a sudden and material downgrade in global growth and corporate profitability. If impacts are transitory in nature we believe that the high-quality segments of the credit market could largely recover — at least from a fundamental basis — after the virus impact subsides. Does a 6-month delay in realized earnings for a technology company with a high-investment grade credit rating matter to the long term credit story of that company? Probably not, given the strength of said company’s underlying fundamental credit profile prior to the delay. It’s the companies or issuers that are not strong enough to navigate a quarter or two of significant revenue disruption that will face material credit profile degradation. The leveraged- or high yield-type segment of the corporate credit universe can be materially impacted by sudden and unexpected economic shocks. In the investment grade space, we are less concerned about transitory challenges in the near-term. However, the duration and scope of the economic impact from this exogenous shock will determine how transitory impacts will be for high-quality, investment grade credit. Covid-19 is the second successive shock to hit the global economy, coming in the wake of trade tensions. Extended disruption (i.e.: into 2H of 2020) would heighten corporate credit risks and inflict more damage on the credit cycle.
The ability of a debt issuer to be able to absorb an unexpected economic shock, without materially and immediately impacting its fundamental credit profile, is a standard our Cash Credit Research team has always held for issuers on our approved credit list. As such, immediate adjustments to our approved credit list were not necessary as the Covid-19 news evolved in recent weeks. However, our team uses multiple risk levers, including maturity/tenor restrictions for approved issuers, as part of our standard policies and procedures. Adjustments to the approved credit list will be made based on the tangible impacts the virus has on the economy and on estimated impacts on individual issuer business profiles. Maturity/tenor restriction reductions will be more prevalent than “freezing” issuers, at least in the medium-term.
As the State Street Global Advisors’ Global Cash investment universe is more concentrated in debt issued by large banks and financial institutions, we always consider the condition of the credit cycle in that context. Heading into 2020, we considered the risk that trade tensions via weakened global growth trajectories and aggressive central bank easing will negatively impact banks’ earning capacity, thus the same consideration is relevant given this “Black Swan” event. While earnings are a more important consideration for equity analysts and investors, the ability of banks’ to organically accrete capital through earnings is an important factor in fundamental credit assessments. Slower economic growth and lower interest rates are negative for bank earnings, especially if lower rates do not spur demand for private credit. Given the persistence of low and negative rates in Europe and Japan, earnings capacity in those sectors are particularly challenged, which weakens the first line of defense against bank balance sheet devaluation in the event of weaker global growth. Strong operating income levels help absorb higher credit losses, preventing the erosion of its balance sheet’s book value. With regard to the global shortend credit markets, we have consistently identified the European and Japanese banking sectors as the most vulnerable to the end of the credit cycle, and as such these are the sectors that are most impacted by the initial negative economic developments from Covid-19.
The role the monetary and fiscal policy in mitigating Covid-19 impact is unclear at this stage. We expect central banks to continue to try to prevent further tightening of financial conditions.
We also believe that governments will attempt to provide immediate relief to affected sectors (airlines, tourism, etc.) and its workers, while also introduce measures so that small businesses which have been disrupted will not face immediate challenges in meeting their financial obligations (likely via targeted fiscal measures). Regulatory forbearance may help to mitigate any strains in banking sectors, but the speed of recovery will depend in large part on how the virus spreads and when the containment measures are lifted.
Consistently, over the last few years, we have reiterated that we broadly view the global banking sector as a source of strength in mitigating macro-economic impacts when the credit cycle ends due to the significant evolution of banking regulations since the GFC. These regulations, especially as they pertain to systemically important banks in all global regions, assure that bank capital buffers are materially higher and funding and liquidity conditions are more stable. Indeed, when the cycle does end and the most leveraged areas of the corporate credit markets suffer material degradation, we believe that the strength and soundness of the reformed banking system will prevent systemic impacts and broader contagion. Credit events are more apt to be idiosyncratic or industry-specific than systemic, in our view. Notably, the idiosyncratic and industry-specific focus points most immediately related to Covid-19 have generally been focus points at various times over the course of this credit cycle. For example, the energy sector and global bank loan portfolios with exposure to the sector) went through acute stress during 2015 and 2016, and many global banks reduced exposures during, and after, that episode. While the prolonged macroeconomic malaise in Europe, and its impact on the European banking system, has been a periodic source of stress since the GFC, the capacity of the European banking system to absorb such shocks has greatly improved. Since 2009, the common-equity Tier 1 ratio (CET1) of European banks has increased from 9.0% to 14.6%. 1 The UK’s stress test three months ago modeled a global recession more severe than the 20007–2008 crisis. Even at the low point of this stress test, UK banks’ CET1 is more than twice its pre-Crisis level.2
For the last two years, our Credit Research team motto has been: “Don’t worry about the end of the credit cycle: be ready for it.” For us that has meant continuing to select cash investment counterparties that are best-equipped to maintain their fundamental credit profiles when a downturn inevitably occurs.