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Before the Covid-19 crisis, many wondered if central banks had anything left in their toolbox to fight the next downturn. The US Federal Reserve (FED) and Bank of England certainly appear to. Both have shown a remarkable proliferation in the types of support they can offer markets and companies. In the US, the FED is working closely with the US Treasury to pump trillions of dollars into the economy and there could be more to come. This unprecedented central bank intervention has stabilised markets and improved liquidity conditions. We believe they will do more, given the extent of the economic shock. Even with the current level of intervention, we are very interested to see if the vast quantitative easing (QE) programmes will generate money supply growth on a scale that eventually causes a sustained uptick in inflation.
For us, this means that eventually we could even see a reverse in the current trend of paying up for global growth and a return to the fore of “old fashioned” value investing. Value investing (buying stocks that are currently unloved by the market) was a great style leading into the Great Financial Crisis, however since then markets have tended to favour buying more expensive growth stocks, in a low growth world, and have shunned taking a risk on cheaper stocks. They offer increased risk to an investor that they may be cheap for a reason – such as low cashflow, higher leverage and a strong competitor in their marketplace.
Another potential impact that we must consider is the exchange rate between the US dollar and the UK pound. Maintaining a near-zero interest rate and extraordinary levels of direct monetary expansion are designed by the FED to buy accelerating debt issuance by the US Treasury as it seeks to fund a higher domestic budget deficit. Until recently, US Treasuries offered investors a yield of over 2 per cent for one of the ‘safest’ assets in the world. This compared favourably to European government bonds yielding near-zero or negative rates, with a marginally higher risk profile. The dollar’s status as the world’s reserve currency - used in most cross-border trades - meant that the US could borrow freely and with little consequence, other than the odd hiccup when politicians squabbled over raising the debt ceiling. But as the interest rate differential has disappeared and total debt has pushed through $25 trillion, the bull case for the dollar has been diminishing.
In the near term, much reduced dollar/euro hedging costs for European investors compared to 2019 may sustain flows into the US currency; but that is likely to be transitory. Longer-term, the dollar could be entering a secular decline.
Flows have been returning to investment grade and high yield bond markets, which have seen a glut of new issuance. Initially, these issues were offered with big concessions, but have since become less competitively priced. Opportunities remain in fixed income, but it is important to be selective as the full extent of the economic damage is unknown and default risk has increased. As a result, we have been making some changes to our own portfolios this week, increasing our exposure to active management in the bond market to manage quality and liquidity risk.
This week, the Bank of England joined the FED in discussing possible negative interest rates, although there are concerns for the challenges this will present banks and the broader money markets. Instead, we may see the FED use its balance sheet to create a similar effect. FED chairman Jerome Powell has made it clear there is no limit to the central bank’s balance sheet growth. This, alongside the US Treasury borrowing to support the real economy, is taking US debt to eye-watering levels.
The FED balance sheet has risen by around $2.7 trillion to $7 trillion in the last two months alone and is set to expand further. The US Treasury is seeking to borrow $3 trillion to fund Covid-19 bailout packages. Previously, the FED was buying up to $75 billion of Treasuries a day at the height of the crisis. Now it is back to buying $30 billion a week. To help absorb the avalanche of US debt coming through and avoid yields backing up, the FED will have to ramp up purchases again.
While inflation remains a possibility over the medium to longer term, at present, the world is focused on the deflationary shock from a collapsing global economy and widespread job losses. With this in mind, we are not yet changing from our focus on global growth stocks, but we are starting to consider when this focus may need to change. There are a few things to watch: how fast supply chains and productivity levels can recover; how forthcoming solvency issues are repaired - and the degree to which the monetary explosion stays within the system. But this will be an 18-month, if not multi-year, process. So, it is too early to be too definitive, but we do expect a change to come.
As we enter the bank holiday weekend, we are pleased to hear better news on infection / mortality rates in the UK, and indeed around Europe, but remain mindful of the risks that remain. Please do stay safe and well.