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The phoney war in markets


Patrick Kelliher

In my previous blog [1], I warned of a looming crisis in corporate bond markets as a result of the Covid-19 pandemic and intrinsic weaknesses in corporate bond fund liquidity. Sure enough, US investment grade corporate bond spreads rose from just over 100bps in mid-February to a peak of 401bps on the 23rd March [2] as the Covid-19 pandemic took hold in Europe and the US. With liquidity in the market evaporating, corporate bond ETFs started to trade at a discount to NAV [3].

This was linked with a wider market rout with both the S&P500 and FTSE100 falling by 1/3rd in the month to 23rd March. As investors fled to safety, 10-year yields on US Treasury Bonds fell from ca.1.6% p.a. to just over 0.5% p.a. by early March [4] with short-term Treasury bills even going negative for a short while [5]. Worryingly for the UK, long standing concerns over its reliance on overseas investors and the impact of Brexit lead to the pound collapsing from £1:US$1.31 to £1:US$1.15 [6] in a worrying echo of the Bank of England’s recent scenario exercises involving a loss of investor confidence in UK plc [7].

However, on the 23rd March, the US Federal Reserve acted decisively to stem the crisis. Amongst other measures, it pledged to extend its Quantitative Easing (QE) program without limit to support market functioning, with QE now covering not just Treasury Bonds and mortgage-backed securities but investment grade corporate bonds [8]. Shortly after, QE was extended to fallen angels (formerly investment grade bonds downgraded to junk status) as well as junk bond ETFs. This stemmed the rout in corporate bond markets, with US investment grade spreads falling back to 160bps by the end of June.

Coupled with other central banks monetary stimulus, and governments announcing various fiscal stimulus programs to tackle the economic impact of Covid-19, this led to a wider recovery in markets. Having fallen to under 5000, the FTSE100 rose by 22%+ to over 6100 by the end of June, while the S&P500 rose by nearly 40% in the same period. Meanwhile, swap lines provided by the US Federal Reserve helped allay fears of a dollar funding shortage in overseas banks and allowed currencies to recover, with sterling rising to £1:US$1.24.

Meanwhile, in the real world, economies have continued to tank. In its June 2020 economic update [9], the IMF revised their global growth forecast for 2020 down to -4.9% (compared to -1.9% in their April forecast), with developed economies forecast to shrink by 8% on average and with the UK economy forecast to shrink by more than 10%. Even this does not allow for a second wave of infections globally which is a distinct possibility.

The OECD forecasts the unemployment rate in the OECD to be 9.4% in Q4 2020, exceeding all the peaks since the Great Depression, and still 7.7% in 2021 – again assuming no global second wave in 2020 [10]. Too many retailers, hotel chains and other firms haven’t been able to survive the lockdown, and their competitors are too weak to take up the slack in the labour market. While government furlough schemes may have preserved some jobs, unemployment is likely to rise when these schemes end, depressing demand and leading to further insolvencies and redundancies.

This downturn in the real economy is reflected in downgrades and defaults. S&P recorded 132 issuer defaults in the year to 9th July [11a], partly due to the collapse in oil prices. By way of perspective, this is more than the 127 defaults in all of 2008, though below the 2009 full year total of 175. In addition, S&P downgraded over 1,000 bonds in the first 5 months of the year, and placed a further 1,350 are on negative watch [11b].

The rise in defaults is in line with IMF warnings of the sustainability of corporate debt in their October 2019 Global Financial Stability Report [12]. Then they estimated that even in a mild slowdown, about half as severe as that suffered during the Global Financial Crisis of 2007/09, debt owed by firms unable to service the interest could rise to US$19 trillion, or 40% of total corporate debt in major economies. Given that the contraction in GDP and record unemployment forecast due to Covid-19, this could well be an underestimate of the difficulties facing corporate borrowers.

Worse, as the IMF notes in its June 2020 Global Financial Stability Update [13], while banks have so far been able to cope due to improved capital and liquidity buffers built up in the aftermath of the 2007/09 Global Financial Crisis, further corporate defaults plus higher unemployment leading to increased individual defaults will place a strain on bank balance sheets. This is particularly the case for Eurozone banks which have struggled with the aftermath of the 2007/09 crisis and low profitability.

It is notable how many banks and other financial institutions are currently rated BBB-, just one level above junk status [14]. Were they to be downgraded to junk status, this could lead to severe funding difficulties for these banks and could trigger a seizure in wider interbank funding markets with negative consequences for other markets.

Unsurprisingly given the economic conditions and looming defaults, the IMF notes in its June 2020 Global Financial Stability Update a disconnect between the recent gains in markets and the deterioration of conditions in the real economy. It notes that market valuations appear stretched and that any number of factors could trigger a loss of investor confidence and fresh market falls. As well as a global second wave of Covid-19, it also notes that market expectations of continued central bank stimulus may be too optimistic; that trade tensions could increase; and/or that social unrest could arise due to increased inequality. In the UK context, it may be added the potential impact of a hard Brexit at the end of the year, given that the UK has not requested an extension to transition arrangements by the 30th June deadline for such requests despite the urgings of business for such an extension.

I share the IMF’s concerns. To my mind markets have not fallen enough in relation to the damage done to the real economy, which looks to be on a par with, if not more severe than, the damage caused by the Global Financial Crisis. Back then, we saw peak to trough falls in the FTSE100 of 48% and 57% in the S&P500 [15] while US investment grade corporate bond spreads reached 641bps in November 2008. UK house prices fell by 18% between Q2, 2007 and Q1, 2009 [16]. Admittedly, this was driven by a banking crisis which we have avoided (so far!!), but if we consider the real economic damage, in the aftermath of the Global Financial Crisis, UK unemployment rose to 2 million in 2009 and 2.5 million in 2010. With the current pandemic, unemployment could exceed 3 million before the year is out [17].

Back in October, the IMF thought US equities were overvalued. The fact that the S&P500 is currently above its level back then [18] despite the pandemic strikes me as unrealistic even with the Federal Reserve pumping in money. While the FTSE100 has fallen by-18% since February [19], this is modest in the context of the sharp fall in GDP and rising unemployment. While current corporate spreads are higher than before the crisis, they are in line with historic averages. It seems like the markets have not fully priced in the impact of the current wave of Covid-19, let alone the risk of a second wave and/or some other shock such as a trade war between US and China, or a hard Brexit.

To use a historical analogy, I think current markets are like the phoney war that existed between the Allies and Germany in the aftermath of the latter’s conquest of Poland in 1939. After the initial shock and recovery, the FTSE100 has generally bounced around 6000-6300 with the S&P500 broadly trading in the range of 3000-3200, not really going anywhere, like the Allies in the months before 10th May 1940 when the Germans attacked. When the attack came, the Allied front collapsed in a matter of days with the British being evacuated from Dunkirk before the month was out. In the same way, I think an initial shock will produce a complete market rout as investors realise that current valuations are not supported by the reality of recession and mass unemployment.

Further blows could follow with reduced investor appetite and higher defaults possibly leading to a banking crisis. I also believe a reckoning is coming in the commercial property sector: there were already gaps in the High Street before the pandemic put large numbers of retailers out of business, and I think retail property values will be decimated. Meanwhile, the future of offices could be threatened in the long-term by the growth of home working.

In short, I really fear for what is coming next in markets. By way of disclosure, I already had my savings in cash before the pandemic struck as I was nervous about trade tensions and the risks in the bond market. While I bought some equities close to the bottom in March, I sold these when the FTSE100 went above 6000, which I thought was too a recovery too far. I also invested in US T-bonds as I believe there is a risk that yields on these could go negative (like US$15 trillion worth of other highly rated government and other bonds), while I also fear a hard Brexit could lead to the pound falling to parity with the Euro, if not the US dollar.



[2] ICE Bank of America Merrill Lynch US Corporate Master index of investment grade bonds (C0A0), retrieved from FRED, Federal Reserve Bank of St. Louis, July 14, 2020 – see

[3] “Credit Trends: How ETFs contributed to Liquidity and Price Discovery in the Recent Market Dislocation”, S&P, 8th July 2020

[4] Board of Governors of the Federal Reserve System (US), 10-Year Treasury Constant Maturity Rate [DGS10], retrieved from FRED, Federal Reserve Bank of St. Louis, July 13th 2020 - see

[5] Board of Governors of the Federal Reserve System (US), 3-Month Treasury Bill: Secondary Market Rate [DTB3], retrieved from FRED, Federal Reserve Bank of St. Louis, July 13th 2020 - see

[6] Board of Governors of the Federal Reserve System (US), U.S. / U.K. Foreign Exchange Rate [DEXUSUK], retrieved from FRED, Federal Reserve Bank of St. Louis, July 13th 2020 – see

[7] See for example “Stress testing the UK banking system: key elements of the 2019 annual cyclical scenario”, Bank of England, March 2019, available at

[8] “Federal Reserve announces extensive new measures to support the economy”, US Federal Reserve press release, March 23rd 2020 – see

[9] “June 2020 World Economic Outlook Update”, IMF – see

[10] “OECD Employment Outlook 2020 - Worker Security and the Covid-19 Crisis”, OECD at

[11a] “Default, Transition, and Recovery: The Oil and Gas Sector Leads 2020 Corporate Defaults”, S&P, 9th July 2020

[11b] “Credit Trends: Potential Downgrades Reach Another Record High Amid COVID-19 Stress”, S&P, 10th July 2020

[12] “Global Financial Stability Report – Lower for Longer”, IMF, October 2019 - see

[13] “Global Financial Stability Update”, IMF, June 2020 - see

[14] “Credit Trends: The potential Fallen Angels tally reaches a new high at 126”, S&P, 17th June 2020

[15] Looking at the period from the 30th June 2007 to 31st March 2009, the minimum value of the FTSE100 was 3512.1 on 3rd March 2009 compared to a maximum for the period of 6730.7 on 12th October 2007. In the same period, the S&P500 fell from 1565.15 on 9th October 2007 to 676.53 on 9th March 2009.

[16] The Nationwide quarterly all houses price index fell from 9738.6 in Q3, 2007 to 7981.0 in Q1, 2009

[17] “UK unemployment set to surge to 3.5 million this year, business leaders forecast”, Independent article by Ben Chapman, 2nd July 2020 at:

[18] The S&P500 was just above 3100.29 at the end of June 2020 compared to 3046.77 at the end of October 2019.

[19] The FTSE100 had recovered from a trough of 4993.84 on 23rd March to 6169.75 at end June, compared to 7534.37 on the 12th February before markets started to fall.


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