The financial stress caused by Covid-19 is far from over. Investors should be prepared for nonpayments to spread far beyond the most vulnerable corporates and sovereign borrowers, in a calculation that threatens to drive prices down.
There is still time to get ahead of this trend. Rather than buying assets at valuations surprisingly decoupled from underlying business and economic fundamentals, investors should think much more about the salvage value of their assets and adjust their portfolios accordingly.
So far, despite signs of mounting stress on corporate and government balance sheets, defaults have been largely confined to some hard-hit segments.
But the feeling that the worst has not happened has fueled complacency among investors on all sides. A new generation of retail investors has emerged, helping stocks on their relentless march higher.
Contrast investor optimism with corporate circumspection. While many central governments are focused on reopening economies that have been locked down to contain the spread of the virus, most businesses have remained cautious. Many are still looking to cut spending further.
Distrust has been encouraged by the resurgence of infections around the world. In the United States, a majority of states have now chosen to stop or reverse their lockdown easing plans. And companies and investors have every reason to be cautious. Health experts are warning us against being overoptimistic about a vaccine and, judging by the worst affected areas, too many people have yet to properly consider the threat of infection and align their behavior with the risks facing society.
Such a weak and uncertain economic environment reduces the willingness and ability of borrowers to meet their contractual obligations. This is particularly the case in vulnerable sectors such as hospitality and retail, and in developing countries with less financial cushion and limited room for policy flexibility.
The worrying signs are already numerous: a record rate of business bankruptcies; job losses moving from small and medium enterprises to larger ones; longer payment terms for commercial real estate; more households falling behind on their rents and continuing to defer credit card payments; and a handful of developing countries delaying debt payments.
Yet judging by a range of market indicators, investors are not showing sufficient concern. Some continue to expect a strong V-shaped recovery in which a vaccine, or a build-up of immunity in the population, will allow a rapid resumption of normal economic activity. Others count on more support from governments, central banks and international organisations.
But supportive actions from policymakers have already been significant, including payment deferrals, direct cash transfers, covenant relief, lowest interest rates and corporate bond purchases. The G20 group agreed on a “debt service suspension initiativefor the poorest developing countries.
While notable, these measures will not prevent investors from sharing some of the capital losses, whether due to corporate failures or to developing countries needing more than exceptional funds from bilateral sources. and multilateral. Many have already made it clear that they expect ‘private sector involvement’. This will likely mean, at a minimum, the short-term suspension of interest and principal payments.
Given that neither a rapid revenue recovery nor more financial engineering is likely to avoid an increase in delinquencies, the best that can be hoped for in a growing number of cases may well be orderly, voluntary and collaborative restructurings. , like the one announced last week in Ecuador.
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The complicated negotiations between Argentina and its creditors demonstrate that such agreements are far from easy, especially given the lack of cohesion among creditors. But the alternative – a disorderly default – destroys even more value for debtors and investors.
The potential damage is not limited to financing. Disruptions in capital markets could also undermine the already sluggish economic recovery by making consumers more frugal, worried about their job prospects, and encouraging businesses to postpone investment plans pending a clearer economic outlook.
The investment challenge may well change in the coming months, from an exceptional wave of liquidity, which has driven virtually all asset prices up, to a general correction in prices and complex individual delinquencies.
No wonder, then, that an increasing number of asset managers are raising funds in the hope of deploying a dual investment strategy.
The first is to wait for a correction to buy rock-solid companies trading at bargain prices. The second is to engage in well-structured bailout financing, debt restructurings and secured lending as countries, and some bankrupt companies, seek to reorganize and recover.
Liquidity-driven rallies are deceptively attractive and tend to lead to excessive risk taking. This time, retail investors are at the forefront. But it is the next step that we must already think about. This requires much more scrutiny from investors than the past few months have demanded.
The writer is chief economic adviser to Allianz and president-elect of Queens’ College, University of Cambridge.
