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Coronavirus convexity

| June 26, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The path of the economy has rarely been less certain. Equity volatility remains high. Even indicators of press coverage of the economy reflect a wider-than-usual range of possibilities. But the impact on asset returns from swings above or below consensus does not look the same. Assets under the wing of the Fed should have a balanced downside and upside. Assets that have to make it on their own seem to have more downside than upside. It’s an issue to consider for any portfolio: coronavirus convexity.

The VIX as a benchmark for uncertainty about the economy is well off its 2020 peak but still more than double its 5-year median (Exhibit 1). The US Economic Policy Uncertainty index, built from text analysis of thousands of newspapers and other sources, is also well off its 2020 peak but almost three times its 5-year median. Dispersion in 1-year ahead forecasts of quarterly growth collected by the Philadelphia Fed’s Survey of Professional Forecasts is at 3.87, nearly three times its median since 1968. In contrast, the MOVE index of implied volatility in US Treasury rates is well off its 2020 peak and below its 5-year median. In the rates market, investors expect a narrower-than-usual range of possibilities.

Exhibit 1: Equity and economic uncertainty remain high, rate uncertainty low

Source: Bloomberg, Federal Reserve Bank of Philadelphia, Amherst Pierpont Securities

The International Monetary Fund this week updated its estimates for global growth and highlighted the upside and downside possibilities. The base case projected a 2020 drop in US GDP of 8.0% followed by a 2021 gain of 4.5%, a path more severe than both the Congressional Budget Office and the Federal Reserve. More interestingly, the IMF looked at a downside scenario with another COVID-19 outbreak in early 2021 and an upside scenario with more confidence in containment strategies and, consequently, less precautionary behavior and a faster recovery. The IMF did not break out numbers for the US but did show numbers for World GDP. In the downside, GDP in 2021 sank nearly 4.5% below the baseline. In the upside, it rose slightly more than 3.0%. Under the assumption that the two scenarios are equally plausible, the IMF projections argue the economy for now has more downside than upside.

 

Any scenario analysis these days has to layer in the potential responses of monetary policy. Central banks have been clear about their willingness to respond to the sort of sudden economic stop that came in March and April and to the possibility of a slow rebound because of continued social distancing and other containment strategies. The Fed has rolled out an extraordinary set of tools in this crisis. It includes extended zero-interest rate policy, QE in markets for Treasury debt, agency MBS, agency CMBS and investment grade corporate debt, and direct lending to states, local governments and businesses, although the lending programs have yet to launch. Fed policy would almost certainly limit the downside in the targeted securities market, helping balance asset downside and upside.

 

Assets outside the reach of most plausible monetary policy tools, including loans to the most highly leveraged businesses small and large, would likely be very negatively convex to the path of coronavirus and the economy. Return downside in a second COVID wave would likely be much larger than return upside to effective containment and faster growth.

 

It is also worth noting that more companies may eventually fall outside the bounds of Fed policy. Companies have loaded their balance sheets with cash in the last few months to help ride out an expected shortfall in revenues. However, the debt issued to generate the cash has raised leverage to levels that Fitch estimates could take two years to repair under consensus growth. A second COVID wave could keep earnings suppressed and raise leverage to levels beyond the Fed’s reach.

 

There is also the possibility of fiscal response, and the US fiscal response to coronavirus has been significant. It has stabilized household and small business balance sheets and damped fundamental risk to household and corporate credit. Fiscal response, is harder to predict, particularly if an initial rebound in growth convinces policymakers that no more fiscal stimulus is needed.

 

Fed policy will likely continue to squeeze spreads and limit returns on assets currently targeted by QE and other policy, and spreads on riskier substitute investments should compress, too. However, investors should consider the coronavirus convexity of assets outside the Fed’s reach. The reward for the risk in most cases is not there yet.

* * *

The view in rates

The June FOMC brought the Fed’s economic projections back and confirmed the market’s expectations that the Fed will keep rates near zero through 2022 or beyond. The current 0.64% rate on 10-year Treasury debt implies an average real rate of -70 bp and inflation of 134 bp. Real rates have generally continued to fall and Implied inflation has continued to climb since mid-March. That should keep pressure on the yield curve to steepen from 2-year to 10-year and from 5-year to 30-year. This is a replay of the rate impact of previous episodes of QE.

The view in spreads

Portfolio balances at the Fed, banks, and money market funds have slipped since early May although lately fixed income ETFs and mutual funds have sizable amounts of money to spend. Demand from these quarters for high quality assets should keep squeezing spreads tighter. As spreads tighten in the highest quality assets, investors will have to move to the next tier of higher risk to get sufficient spread, but it is likely to happen. Spread compression across rating categories or credit quality is highly likely. There is fundamental risk in the most leveraged corporate balance sheets, and only there might spreads continue lagging the rest of the market.

The view in credit

Prices on some sectors of leveraged loans, rating agency downgrades in leveraged loans and high yield and rising bank loan loss reserves signal a wave of distressed credit. Rising unemployment and delinquency rates in assets from MBS to auto loans show pressure on the consumer balance sheet. However, monetary and fiscal policies are both shoring up these fundamentals. The course of leveraged corporate and consumer credit also depends on renewal of CARES Act unemployment benefits and support for small businesses, along with moratoriums on eviction and foreclosure.

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