Morgan Stanley: Coronavirus - Monetary and Fiscal Policy - Is the Kitchen Sink Enough?

Andrew Harmstone, Managing Director Global Balanced Risk Control Team

Manfred Hui, Managing Director Global Balanced Risk Control Team

Christian Goldsmith, Executive Director Global Balanced Risk Control Team

In our previous weekly updates, we highlighted effective monetary and fiscal policy as one of the four factors that will determine our move back into risk assets. Global policymakers, in particular the Fed and the US government, have certainly thrown everything at the economy to support it, including the kitchen sink. However, there are signs that the measures, despite being unprecedented, may be insufficient. We also have concerns about their implementation.

The US Paycheck Protection Program’s (PPP) $350bn provision for small business loans has already been exhausted¹, having only helped a little over 5% of US small businesses, according to our estimates². With an estimated three quarters2 of small businesses applying for the loans, there is a clear disconnect between the demand and amount available. 80% of applicants³ are still waiting and many will run out of funds imminently. This week, Congress approved a $310bn extension to the PPP’s provision for small business loans and whilst this is welcome, it is still not enough. Therefore, it is likely that bankruptcies and unemployment will escalate further, resulting in permanent damage to the economy and prolonging the global downturn.

The effectiveness of various fiscal and monetary policy measures is relevant to questions that we are receiving from clients on certain asset classes. In this update we provide our perspective on the main market events this week:

Investment Grade and High Yield Bonds

Initially, the Federal Reserve’s credit facility to support investment grade corporate bonds completely excluded high yield debt issuers⁴. Though recently extended to support fallen angels rated BBB prior to 22 March, there are still large segments of high yield at risk. Fundamental headwinds are likely to kick-start more prolonged fund flows out of high yield. In contrast, investment grade companies’ stronger fundamentals should help them weather the crisis better. High yield’s lack of support has further unintended consequences. As high yield downgrades increase, Collateralised Loan Obligations (CLOs)⁵ will need rebalancing to increase the credit quality of their tranches, potentially putting further pressure on high yield. We believe these factors justify our continued underweight to global high yield, whilst we remain neutral on investment grade bonds.

Mortgage-Backed Securities

In addition, Mortgage Service Providers (MSPs) must now allow householders with federally-backed mortgages, who have lost income due to the COVID-19 crisis, to suspend payments. Though MSPs would have to pay up to four months’ interest on those loans, beyond this they would not be obligated to pay. This puts a limit on losses, but MSPs may still be reluctant to issue mortgages.

Eurodollar⁶

A factor further complicating any recovery is the global supply shortage of dollars, triggered by the flight to safety and slump in global trade. Compounded by the recent oil supply glut and the US reduction in oil purchases, cheap oil means even fewer US dollars are flowing into the eurodollar market. Given the size of the market, this liquidity shortage is likely to have wide-reaching, structural effects. The impact is particularly great for those emerging market countries which normally rely on global trade to service USD-denominated debt. Depressed oil prices mean oil-exporting nations will also face challenges to meeting their budgets.

Oil crashes below zero

The consequences of oil oversupply at a time of significant shortfall of demand, escalated further this week. Traders faced the conundrum of either selling May’s existing WTI futures contract at a negative price, rolling over to the June contract at very unattractive spreads, or paying over the odds to find storage, itself in short supply. This caused oil prices to crash to below zero. Naturally, the repurcussions are extensive, hitting many, including retail investors who bought ETFs tied to oil futures, likely denting their risk appetite. There is unlikely to be any relief soon and oil volatility is likely to remain high, with significant downside risk.

Conclusion

We still believe that many investors are too optimistic over prospects for the global economy, as we still do not know the full extent of the likely damage. Typically when the market reaches the bottom, fear dominates greed, but we do not yet see sufficient evidence of this. The oil market’s behaviour could foreshadow a similar outcome for equity markets, and many investors do not appear to fully appreciate the likelihood of markets hitting further lows.

With respect to the fourth of the factors on which we focus to help determine the right time to move into risk assets, fiscal and monetary policy is largely in place in unprecedented size, but may still be insufficient to save all areas of the economy. Given our negative economic outlook, we still do not believe it is the right time to increase exposure to risk assets.

¹ U.S. Small Business Administration. As of 15 April 2020. Press release. Statement by Secretary Mnuchin and Administrator Carranza on the Paycheck Protection Program and Economic Injury Disaster Loan Program. www.sba.gov.

² GBaR estimate based on the overall average loan size of $206,000 reported in the SBA PPP Report as of 16 April 2020 www.sba.gov/document/report--paycheck-protection-program-ppp-report-through-april-16-2020-12-pm-est ; and the number of US small businesses being 30.7mn in 2019 as stated by the U.S. Small Business Administration Office of Advocacy.

³ National Federation of Independent Business (NFIB), new survey released 20 April. www.nfib.com/content/press-release

⁴ Federal Reserve announces extensive new measures to support the economy. Board of Governors of the Federal Reserve System. Press release 23 March 2020. www.federalreserve.gov.

⁵ CLOs are a form of asset-backed security, consisting of debt tranches of company loans of varying credit quality and equity tranches. They consist usually of low quality, leveraged loans, making them highly susceptible to downgrades.

⁶ US dollar-denominated deposits held outside the US.

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