At a headline glance it seems there is some calm returning to the financial markets. Equity markets are up 10% over the last month, sterling is back to around $1.25 and government bond markets are exhibiting some of their tightest ever-trading ranges in April. However, there remains gargantuan uncertainty ahead. Beyond the questions asked here of “Who pays?” there is also the growing changes in quality of data and markets.
Take inflation. It is not unreasonable to expect that the collapse of the economy will lead to deflation. We know toilet roll and hand gel cost more but to offset that package holidays will cost less. Yet what is the inflation (deflation) of a product that no one currently buys? And indeed, is the correct outcome to record a theoretical inflation number or a practical one? One of the premises of UK inflation is the manner in which products move out of, and into, our typical basket of goods. For example, we now account for smart phones rather than vinyl. How this changes will have implications on everything from next year’s season ticket to RPI-linked bonds’ coupon payments.
And take central bank corporate bond purchases. Each central bank has responded in a way they believe is appropriate. Whilst the Fed has proved most expansive (announcing last week the purchase of BB-rated bonds) investment grade assets are very much front and centre of what central banks will buy. In the UK, this is the third time the Bank of England has purchased corporate assets since 2009. Given we have a well-trodden path of bank support it is not obvious why any corporate would want to be rated A. The ECB is set to purchase up to half of their “eligible” corporate bond universe by year-end. Credit market concerns in 2018 around the increase in BBBs to 50% now seem rather quaint, but 50% is now more likely a floor for BBBs (as a % of the overall indices) as the economic impact of Covid-19 send ratings lower.
The quality of markets is relevant to government bonds too. And not just in the most obvious ratings way; Fitch downgraded the UK to AA- at the end of March and markets will be on tenterhooks to see how Italy’s current BBB negative outlook rating is treated by S&P next Friday (24th at 10pm) – remember, the ECB prefers investment grade debt. The quality of markets is an elusive term but captures the sense of a free and fair market. The Bank of Japan has intervened to buy 10-year government bonds if they drift north of 20 bps since 2018. The Bank of England is stepping up its ownership of gilts to beyond one third of GDP. The Fed has “infinite” capacity to purchase. Central bank policy – and details around that – are the key determinants of market value and the current aim is to crush volatility and see subdued rates for a long while to come.
These details and observations create different frameworks and value structures and do not detract from the immense monetary effort that has been corralled to deal with 15m unemployed in the US (as estimated by initial claims) nor the potential collapse in the size of the UK economy by one-third in the second quarter but will create differing rational responses – some of which we can only start to imagine.