~Weekly Overview~

Virus Spread and Economic Impact

Welcome to the third blog entry of the Weekly Overview Series.

This week, the U.S surpassed China as the country with the most Coronavirus cases and this number is expected to increase rapidly to hundreds of thousands as the government response is slow; India is in the spotlight for a potential massive contagion due to a lack a prepared health system, overpopulated cities and poor hygiene and Central Banks continue to exhaust their last monetary tools. As well, we have seen the first fiscal responses by the US and the Eurozone.

In this entry, first I want to talk about credit markets and the importance of their evolution to the general economic situation. As with the dollar swap lines, credit markets are not in the headlines but still are essential to get a global view of future market prospects.

Credit Markets

From corporate bonds to mortgage debt and government bonds, credit markets are suffering the worst rout since the financial crisis.

Can credit markets stabilize to ease liquidity to both governments and companies?

The Quantitative Easing programs most central banks have implemented consist of massive purchases of bonds and asset and mortgage-backed securities to lower these assets’ yields and flood with money the economy. The Federal Reserve, for example, announced on Monday an unlimited QE program combined with other emergency facilities that boosted stocks on Tuesday.

However, is this applicable to corporate bonds?

There has been attempts to stabilize the corporate bonds market by the Fed announcing emergency funding facilities to purchase:

  • Commercial Papers (debt used for payrolls and other short-term liabilities)
  • Corporate debt from Primary Dealers (big banks licensed to trade with the Central Banks) 
  • Corporate debt from Money-Market Funds (invest in highly liquid assets such as cash or short-term bonds)

Nevertheless, companies are highly indebted and have distressed financial statements. Their capability to repay additional debt to avoid cash flow difficulties is questionable.

Credit market investors fear a wave of companies’ credit worthiness downgrades. Some examples include Boeing lowered from A- to BBB just two notches above ‘junk’ by Fitch or Occidental Petroleum and Delta Airlines cut to junk by S&P. A cut in credit worthiness is likely to mean a flight of investors from corporate bonds, a drop in its price and a spike in the yield. One evidence of these already happening is the measurement of the high-yield bond spreads.

The high-yield bond spread shows the yield premium (additional yield) investors seek to buy corporate bonds over government bonds. The gap is expected to continue widening if this exceptional situation lasts for longer. Therefore, companies will find more costly to issue more debt to fund its operations and stay in business.

Finally, I would like to shed light on investor sentiment in credit markets.

Credit Default Swaps (CDS) are a financial instrument that insures the buyer against a credit default of the companies the investor has bonds of.

The CDS took a main role in the 2008 financial crisis as they triggered the bankruptcy of large insurance companies that took the risk of subprime mortgage-backed securities. These mortgages were given to individuals with poor credit history.

The rise in the use of CDS again, with both investment-grade (e.g AAA) and junk companies, arises the past threats of the 2008 financial crisis. The cost of CDS have spiked to 2009 levels.

Source: FT
Source: FT

US Stimulus Package

This week, following Western Europe, the US has passed a $2 trillion stimulus package to reinforce the economy and avoid collapse. It is far higher than the $800 billion financial crisis one. The current situation requires fiscal policy.

In the 2008 crisis, companies went bankrupt at a low rate during an extended period. In this crisis, due to lockdown, many companies are on the verge of bankruptcy all at the same time.

On Thursday, filings for US jobless claims (seasonally adapted) jumped to 3.28 million last week, a historic record high from a half-century low the previous week of 221,000. To compare this, during the worst week of the 2008 financial crisis, 600,000 Americans lost their job. Expectations go further north for the weeks ahead with estimates of 4 and 5 million jobs lost every week.

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“This shows the severity of the downturn, and the speed of it,” said Michelle Meyer, head of U.S. economics at Bank of America Corp. “It speaks to the unusual nature of this recession — it is an abrupt plunge into recession versus prior downturns, where the shock has time to multiply. We could have very high numbers continue for the next few weeks.”

How severe could this recession in the U.S and the world be?

Following from the words of the head of U.S economics at Bank of America, the U.S Q2 GDP estimations are frightening.

Morgan Stanley, the most bearish big bank predicts an annualized U.S GDP fall from April to June of 30%. Goldman Sachs, for its part, projects a 24% annualized drop for the next quarter. They go even further to say that the world output is only expected to increase by 1%. JPMorgan, the most bullish, reduces its estimations to a 14% annualized fall.

That is how the GDP fall could compare with historical data:

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What’s in the $2 trillion stimulus package to face the virus crisis? Source: Bloomberg

The bill contains assistance for almost 94% of the Americans, most of the companies and besieged cities and states.

  • About $500 billion will be in loans and assistance to companies, state and local governments.
  • $17 billion in loans for companies deemed critical to national security. This is the main reason for the spectacular 50% surge of Boeing Co. in the last three days.
  • For airlines, $25 billion in grants that don’t need to be paid back and another $32bn in loans and grants to other participants of the aeronautic industry.
  • Small business aid sums up to $350bn with an obligation to retain workers.
  • Individuals earning less than $99,000 are eligible for checks up to $1,200, couples for checks up to $2,400 with an extra $500 for each child. The more income, the less money.
  • Unemployment claims will be increased by $600 weekly for four months and expanded to cover more workers.
  • Student loans payments can be deferred for six months.

This expansionary fiscal package has made the market to rally for three days. After an impressive drop from $345 to $95 and halting production for 14 days starting on 25th March, Boeing, has spiked 90% to 180$, for example.

However, Trump’s desire to restart U.S economy to be fully open by Easter without taking quarantine measures, could lead to a massive contagion and the need of a lockdown, worsening the economic implications of the outbreak.

In countries in current lockdown, a premature lift of the exceptional measures to contain the virus, could cause a second wave of spread.

If so, the government and central banks will have to go further north in the amount of money injected, that is huge already. The impact revisions on policies could have in the market is small as traders have accustomed to these money floods.

Therefore, stock markets could heavily drop again if a second wave happens.

As always, I leave here the weekly performance S&P500 map:

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