The ECB pulled out the big guns last week, including an extension to its quantative easing programme to encompass corporate bonds. The impact on the investment grade market has been immediate and dramatic, increasing fund flows, lowering spreads and creating record demand. But even amidst this renewed passion for Eurobonds, one issue got left behind and we wonder how long this new central bank inspired romance will last. Eventually, investors return to fundamentals and there is always the potential for a correction if valuations run up too far. It’s obvious to say it, but what the world really needs now is growth – including earnings growth – and it feels increasingly like monetary policy has less and less to give in this regard.
No-one could accuse the ECB of under-delivering against market expectations this time around and corporate bonds have been one of the main beneficiaries. The investment grade market was liquid and cheap already, but its promised inclusion in the ECB’s QE programme has taken this to another level. Flows into Eurozone corporate bond ETFs have broken records in the last week. The average yield on Eurozone investment grade bonds has dropped below 1% for the first time in nearly a year. Financial groups sold €6.3b of bonds on Tuesday, the heaviest day of issuance since January 2015. A bond from Valeo, French auto parts maker, was 11 times oversubscribed.
But will this increasing investor desire for investment grade debt last? Recent ECB interventions have tended to produce a passion for assets that burns bright at first, but which fades as reality bites. Investment grade bonds might have run up quickly on promised ECB demand, but eventually investors will want to see improving fundamentals to stay invested at this level. That could be a problem. Economists are still cutting their growth forecasts – including the ECB itself. Morgan Stanley recently commented that “European corporates are trapped in a profits recession.” European companies have just experienced their worst earnings season since the financial crisis and analysts have cut their full-year earnings per share growth forecasts to their lowest level since 2009.
This is also a world of ‘radical uncertainty’ – not a new term, but one that’s gaining more use in these unpredictable times. This isn’t the same as quantifiable risks, but the uncontrollable, the unquantifiable and the unknowable. Even though we know EU Referendum is coming, there are too many moving parts to plot what might happen beyond the summer – BREXIT or not. Uncertainty, but especially shocks, tend to focus the mind of investors very quickly on fundamentals. A rapid – and artificial – run up in asset prices adds to the risk of rapid corrections if those fundamentals disappoint.
Just to make it clear, we’re not talking about some kind of catastrophic crash. Recent studies from Moody’s and the FCA have found limited risk of a complete market shut down in investment grade markets. We still expect markets to remain relatively cheap and liquid. Our latest EY Private Placement Market Investor Survey also highlights the increasing availability of alternative finance, which provide an additional source of liquidity. But there remains a risk of brief spikes of illiquidity in the event of shocks and significant corrections for individual assets.
Just to underline how companies really cannot count their chickens – even in these markets – one deal failed to get away on Tuesday. And there remains some question mark over how much the ECB can buy of the c. €500b eligible investment grade market without significantly distorting it and if this will help improve supply and demand in the long term. The cost and availability of finance is only one consideration for banks and companies when deciding whether to offer or take out credit or not. At least as important is the strength of the underlying economy – which brings us back to growth.
Loose talk and low growth
It’s continuing concerns over growth – and inflation – that made this another central bank dominated week. The ECB and Fed have grabbed most of the headlines, but we’ve had all the major and many of the minor central banks pronouncing. Most have loosened policy – or at least created expectations of looser policy. The Bank of Japan held rates, but suggested it could cut interest rates to minus 0.5%. The Bank of England voted 9-0 to hold with their downbeat statement pushing expectations of the first increase well into 2017. The Fed held, but its statement and dot chart pushed expectations of the next increase out to September. Looking beyond the ‘big 4’, Norway’s central bank its main policy rate again and also suggested that it could move into negative territory. The South African Reserve Bank raised its benchmark rate 0.25% to 7%, but in response to commodity-related currency pressure rather than a position of economic strength.
There seems to be no way out of this pattern without growth and there is – as we’ve noted before – increasing concern that ultra-loose monetary policy could be a hindrance as a well as a cure. It’s tough for anyone to make firm predictions in this area, since we’re certainly uncharted waters. But, the increasing spread of NIRP (negative interest rate policy) contains risks of unintended consequences in bank margins, in unprofitable investment and potentially in central bank confidence – if investors feel the move signals that central banks are running out of road.
It’s also difficult to escape this global pattern without concerted, co-ordinated effort. The former Governor of the Bank of England, Mervyn King, recently highlighted central banks’ “prisoner’s dilemma”. If any of them were to raise interest rates, they would risk a slowing of growth, possibly another downturn. He too is concerned about the potential for disequilibrium in the world economy from low interest rates and low returns. Meanwhile, growth expectations remain grounded and weak in areas that monetary policy cannot easily reach. The IMF’s solution is for governments to join the fight, building on monetary policy with expansionary fiscal measures and structural reforms to increase falling productivity – a topic that framed this week’s UK Budget. As the EY ITEM Club highlighted, the OBR’s GDP forecast for 2020 has fallen by 1.5% since November primarily due to a more pessimistic view of UK productivity growth.
We agree it will take a concerted effort to address this decline in UK growth. Global capex fell by 2% in 2015 even in non-energy/materials sectors, according to S&P. They only expect it to increase by 2% in 2016 – which they call ‘thin gruel’ for “a global economy struggling to maintain upward momentum”. They put this weak rise down to overcapacity and the simple fact that earnings are weak and uncertainty is high. Cheap debt can only do so much in this regard. We expect to see companies maintain the measures we’ve seen for the last few years: portfolio reviews to identify sectors and geographies to address and build upon; M&A to drive synergies and meet the challenge of disruptive influences; and a strong focus on operational and capital resilience because it’s increasingly difficult to know what’s around the corner.