Gauging the Fallout and Reasons for Optimism

Gauging the Fallout and Reasons for Optimism

March 25, 2020

Host: Hello and welcome to Talking Markets: exclusive and unique insights from Franklin Templeton.

Ahead on this episode: As uncertainty continues to grip markets, Sonal Desai, Chief Investment Officer, Franklin Templeton Fixed Income, gauges the fallout, and finds reasons to be optimistic. Here’s Katie Klingensmith with the interview.


Katie Klingensmith: It’s been now over a month since we have been pretty focused on the health fallout, the economic fallout, the financial market fallout from this pandemic, COVID-19. Sonal, you started out rather sanguine about the overall implications of COVID- 19, are you still somewhat optimistic?

Sonal Desai: I mean I would never characterize myself as sanguine, Katie, but having said that, I would say that I was more optimistic to start off with that we in many countries would be able to avoid the type of shutdowns that we have seen. Now given that we are seeing these shutdowns, it becomes critical to actually try and assess how long we think these shutdowns are going to last. Is this something that we’re looking at which, is it a matter of weeks or is it a matter of months? This becomes really critical. You cannot shutdown entire economies for months at a go. You know, we keep going back to the case of China and indeed a large part of China did close down for about six weeks.

Now if I look at different countries around the world, is it going to be four weeks? Is it going to be six weeks? It is still very different from three months. I think some of the more dramatic announcements that I see and when I hear a lot, not about recessions, but about big D word, which is a “Depression,” I still think that is somewhat wildly overstated. I’m happy to talk about that more.

At this stage, I would say it’s very clear that we are going to have a pretty bad first quarter though it’s only in the US, but it’s really towards March, this current month, and the latter three weeks of March that we will start seeing the impact importantly. And then I think, clearly, April is going to be quite ugly in terms of growth. And then as we go through the second quarter, as we arrive to the third month, the latter half of the second month of the second quarter, I think we’ll start seeing a recovery.

Now the shape of the recovery is something which is debated so much. Are we talking about an “L” which, to me, is the depression word or are you talking about, an extended “U,” or are talking about some form of “V.” To me, I still think I remain optimistic that some form of V is reasonable.

If I look at what countries like, ranging from Germany to especially the UK, how they have designed their fiscal packages, I actually remain relatively optimistic that we will get to a point where in the second half of the year we should see a reasonable rebound.

Katie Klingensmith: I think it’s reassuring to hear and any signs of optimism relative to some of what we have all been reading. I do want to go back to what you noted, I’m not quite sure exactly what letter it is, but your sense that we could see between a V and a U-shape. Does that depend on different scenarios? And how do we actually see the scenario playing out where we can see a recovery within 2020?

Sonal Desai: I’d say, actually, there is a combination of a demand shock and a supply shock and that is a part of the reason that people are particularly concerned because it’s a negative demand shock and a negative supply shock. I would note that there is also on the margin what will ultimately be a positive supply shock and that is on the front of oil. The oil shock is very negative for markets up front. It’s very negative for a whole host of emerging markets upfront, but exposed. When I say exposed, I mean as we come out of this period where nobody drives, nobody flies, but everyone is really very housebound exposed. That supply shock, that surge of a supply of oil and the complete collapse of a petrol crisis at the gas pump here in the US, we are talking about some states where the prices have already dropped to 99 cents a gallon, which we haven’t seen probably in a couple of decades.

And if we look at those prices exposed, that actually is not a negative supply shock, it’s on the margin positive, but yes, it’s not today’s business, nobody’s driving anywhere anyway. But okay, the question of the U and the V, how do I see that playing out? I think that does come down to how long we essentially shut the economy down. And what can fiscal and monetary policy do to what is a demand shock?

I would just respond in the following grades. If I look at demand shocks in general, certainly if the Fed or in the case of the UK where the central government is essentially, committed to paying 80% of the wage bill of private sector workers who are in virus affected areas in the sense of not regions, but in, for example, restaurant workers, etc., you committed to paying 80% of these workers’ wages for a limited amount of time. What does this do? The most important thing this does is that these workers, of course, apart from the humanitarian issue of not being out of a job at a time when clearly a restaurant which lives off two weeks of future earnings cannot afford to keep an entire waitstaff if nobody’s going to the restaurant, they have to be fired. If these workers know that as this comes to an end, there is a job waiting for them, more likely than not, that makes a big difference in how they behave in the intervening period.

At that stage, it’s not an issue of getting the workers to go out to a closed restaurant, of course the restaurants are closed, people can’t go out to shop in malls, if the malls are closed, this is a given. However, you give them enough cash that they can pay their rent, pay their mortgages, pay their utility bills, not destroy their credit, it does mean that when this comes back, you’ve given them a bridge. That’s what I would say. We are in a space where we need to give small- and medium-sized enterprises, people, and large corporates. And here I’m talking about the airlines for example, or multinational hotel chains, all of them need a bridge. They don’t need a traditional bailout. They need a bridge to get from this side to the other side.

And after that we can deal with how this gets paid back. And that’s how, to me, you deal with the demand shock. The demand is gone. Here’s the thing, today’s demand, the fact that if somebody was eating at a restaurant once a week every week, and then for three weeks they are at home. I’m not suggesting that on the fourth week they’re going to go out and eat four times in a restaurant, they are not. That three times a week restaurant level loss, it’s lost. The point is the week after, if they go back because they have the cash to eating once a week in a restaurant, you have seen a big pickup in growth rates. Will we see a much longer period of time for the level GDP to pick back up? Yes. But I do hope that if you have an appropriately designed fiscal, together with monetary policy, you can actually hope to have growth rates pick up in a much more speedy fashion. And that’s important.

Katie Klingensmith: I think there’s a lot of eyes from the central banks and on the central banks around the world. Before we take a look at their responses, can you just lay out briefly what has happened in bond markets, so government bond markets and the big sectors within the global fixed income space?

Sonal Desai: I’ll start with the Fed because I think the Fed has done an exemplary job. I would note that I have been fairly strong critic of Fed policy over the last couple of years, but I equally have to completely grant to the Fed that when it was in true crisis, it very much stood up and delivered. And you know, I think, honestly it will be economic historians, which will look back at the last few years to determine where the Fed policy was too easy, too tight, what went on. Right now, I think that there’s very little doubt that the Fed is being enormously proactive in a way that is remarkable. So, for example, just last week I was actually speaking to someone in the press and I mentioned that I thought that potentially the Fed could, they said, “well, has the Fed used every tool in its toolbox?” Because if you remember the Fed did this dramatic cutting of interest rates and launching close to $700 billion of QE. And people said that, well now the Fed has nothing left in its toolkit, the Fed can never do what the ECB does, which is to buy investment grade corporates because it isn’t allowed. It has to go to Congress. So what did the Fed do? It essentially used the exchange stabilization mechanism. So essentially it’s created a special purpose vehicle using funds which don’t need to go through Congress. These are essentially funds which are used on occasions for things like the swap lines for example, that the Fed extended to central banks around the world and it essentially put equity into a special purpose vehicle. And the New York Fed can buy IG corporates into that. So, it’s sidestepped the whole issue of the dysfunctionality in Washington DC currently on the political front, to carry out what it needed to do in terms of trying to get markets functional again. So, it looked at the ECB and said, “wow, we need to do something with investment grade corporates.” And then it went further because these are short term, so less than five years IG corporates, it went further, it looked at Japan, the Bank of Japan buys ETFs and the Fed is buying ETFs right now in again IG corporates and these ETFs have majorities across the entire curve.

Now I think that these central bank actions show a remarkable desire and ability to actually gauge what is working and what is not working within markets. And I do think this is going to have an impact. Nonetheless, European policy makers are stepping up in a very important way by essentially going out there and saying, we are getting pretty close to the idea of issuing common bonds of some form or the other. Essentially you look at Germany, Germany is issuing close to $600 billion. It’s 10% of German GDP in terms of increasing the size of its fiscal deficits, Italy—which is clearly the worst impacted country in Europe—has only been able to talk about $25 billion. And in part that is because it needs to have the ability to issue. I think we are getting this. So that’s the optimistic take on the eurozone. What the impact is, again, I would say there are two layers of impact. There’s the near term where you really want to prevent this from spiraling. I don’t for a moment want to say that this could not become a depression. Clearly, it could if bankers and if fiscal authorities did not take steps, I would note that both bankers and fiscal authorities are being enormously proactive in taking steps. And this is a large part of the reason that I think we should be able to avoid something which could be far more catastrophic given the degree of disruption that we are seeing in the global economy.

So, I actually do give European policy makers relatively high marks, with particularly high marks to the fiscal authorities and the central bank authorities in the UK, less so perhaps clearly at a political level. But I’m just talking now about the fiscal package and I’m talking about what the Bank of England did. So, I think that global advanced economies are doing a lot. I think the concern, correctly, needs to be at the area of emerging markets, which have not yet been massively impacted. And here, we can only truly hope there may be some seasonality to the virus because the hope has to be that we find either palliative care or a vaccine before it takes over huge emerging markets such as, for example, India or countries in Africa or large parts of Latin America where there is going to be much greater difficulty in getting testing done on the scale that has occurred, for example, in Asia or at the scale which will happen in the US or in Europe.

Katie Klingensmith: What do you expect for bond sectors, where you do find value right now and others that you might avoid?

Sonal Desai: I don’t know around the world how much focus there has been on this particular sector. In some ways, there has been more focus in recent times, than there used to be. And in some ways it was a somewhat sleepy sector within the US and that is the US municipal bond sector. And what has happened over the past several years has been a desire on the part of many asset managers to deliver more exciting returns from muni bonds, taxable and nontaxable muni bonds to achieve this. Because I will say upfront that muni bonds, the return is not necessarily going to be a very exciting return unless you leverage a lot. And I think that many asset managers have leveraged a lot. But I would say that these are investment grade style return, which are being sold off massively as the leverage is being unwound in other parts of the muni asset space. Our team is finding some enormous value there and so that would be one thing I would throw out there as being truly very, very interesting.

I think that as the coming weeks continue including other areas where we would have to start looking at quite seriously, though the Fed may take a little bit of the juice out of the market would be places like investment grade corporates where an investment grade high yield, we entered this year thinking that valuations were enormously stretched. It was very difficult for us to actually get excited about these sectors beyond the fact that we have to be invested in several of them for our multi-sector funds. But I would say that to some extent we are beginning to see value emerge and it is going to be a good time going forward to try not to buy the sector, not to buy the asset class, not to buy the index, but to find those specific pockets of value. I think the value of being active is really showing itself in this period.

Katie Klingensmith: And Sonal, we have, I think, a lot of people eager for your views on many different markets, I’ll just throw out a couple and see if you have anything specific you want to add some questions on REIT markets, leverage loans and CLOs.

Sonal Desai: The REIT market is extremely distressed right now. It’s under enormous stress that is very slow. There is intrinsic leverage there, there is stress there, and here I would say we do need to see what the Fed is going to do about these markets because otherwise they will stay a little bit distressed for a little while longer. There is intrinsic leverage there.

If you look at the leverage loan market, again, I think early this year we moved to better quality leveraged loans and that was an entirely, it was consciously done because we did realize that there was a lot of, I think, and to be honest, for the market as a whole, I think a lot of loans got made which probably shouldn’t have gotten made, which reflect more the Fed’s policy over the past several years when money was super easy. And so, a lot of money went to corporates, and they really should not have. So, I do think we will see some stress points in that market.

Separately on CLOs, I think that here we are waiting to see because the highest quality CLOs should not get us to a stage of extreme stress. Once again, we do have the Fed talking about actually allowing CLOs to be used with the AAA tranche within its repo facilities and so on and all of this is so recent. Some of these facilities still need to be put into place. So, I see stress, these are three very stressed pieces of the market. All of them have one thing in common and that’s leverage. I do think that the CLOs within these different groups, the CLOs, we should hopefully see fewer outright defaults, but we will see lack of liquidity. I think that’s a given, but we will not necessarily see defaults there.

On the leverage loan space, I think it’s a much trickier space and everything really depends on the individual names that we are looking at. Because some corporates in that space should not have gotten loans and they probably did. And then if you look at the REIT space, I would wait to see what, if anything, the Fed does here because again it would be out of, they’ve started talking about commercial CNBS, but REITs, again BOJ does operate in the REITs market, the Fed has historically not, so it will be interesting to see if they determine at some stage they need to.

Katie Klingensmith: Sonal, I hear a couple of important themes today. I think in part you see that if the right path between fiscal and monetary is taken, there is the opportunity for this to be somewhat of a V or at least a finite period of economic contraction, so those policy responses are really important. And I also hear the theme of you really noting the importance of active management and given the dislocation is so particular in each bond market I want to see if there’s anything else you want to make sure our listeners focus on in particularly what signs you might see in the real economy or in the pandemic or in financial markets that would give you hope going forward.

Sonal Desai: So what I would be looking for is indeed emergent signs that reasonably we can scale down the level of what I would consider extreme social distancing that they are seeing today. So it might still be that people work in teams, it might still be that restaurants have to operate at 50% occupancy. But do we get ourselves back to the spot that we were at around three weeks ago in the next few weeks? And I think that’s going to be very important and that’s what I’m going to be looking at almost more than everything else.

Katie Klingensmith: Thank you so much, Dr. Sonal Desai, the Chief Investment Officer at Franklin Templeton’s Fixed Income platform, for all of your insights. And I’m sure that we will continue to rely on them as we move forward in what is an unprecedented set of events.

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