Is there an end of volatility in sight, or should we expect a second wave?

As lockdowns following the Covid-19 outbreak are easing, we see some cautious optimism about a beginning economic recovery. But there’s no doubt that this crisis will take its toll on growth in 2020 and beyond. In a report released last month, the OECD outlined two equally probable - and equally gloomy - scenarios for the world economy. In the “single-hit scenario”, a second wave of coronavirus pandemic is avoided. Global economic activity would fall -6% in 2020, with unemployment rates jumping to 9.2%, up from 5.4% in 2019. In the “double-hit scenario”, a second wave of infections hits before year-end, triggering a return to lock-downs. In this scenario, world economic output would plummet -7.6% this year, before climbing back 2.8% in 2021.

Across the globe, central banks have stepped up to help stabilize financial markets and keep business afloat. In an attempt to rescue their economies from collapse, central bankers have embarked on unprecedented strategies in order to keep credit flowing. Despite public support measures though, corporate defaults are forecast to rise significantly over the coming months. Coface expects a one-third increase in insolvencies across the globe between now and 2021 compared to 2019, and this trend should affect all of the main mature economies: United States (+43%), United Kingdom (+37%), Japan (+24%), France (+21%), Germany (+12%). For many emerging economies (+44% in Brazil, +50% in Turkey) the picture looks even bleaker. 

And this is only the tip of the iceberg. There is a growing army of zombie companies that earn too little to even make interest payments on their debt. Latest estimates put the number of zombie companies in the US at a whopping 20 percent.  

Despite credit risk skyrocketing since the Covid-19 outbreak, we have seen an impressive number of issuances in global bond markets. Euromoney reported recently that global debt capital market volumes from April 1 to May 26 totalled $1.5 trillion - a 35% increase compared to the same period in 2019. Remarkably, investment grade corporate issuance has more than tripled, in both European and US markets. In the US, high yield has nearly doubled; whereas in Europe it has fallen to just a third of last year’s figure.  

For investors around the globe this has been an extraordinary couple of months. So, are we finally entering calmer waters? In our view, volatility in capital markets will persist for the foreseeable future. Whilst we have seen a slight reduction in corporate credit risk over the past month, after hundreds of downgrades in March and April, still a quarter of issuers in our Scorable universe face a significant rating downgrade risk. Risk levels will remain heightened - compared to pre-Covid 19 -  for the foreseeable future.    

A cause for concern for institutional investors in particular is the significant amount of corporates that could lose their investment-grade rating. Currently, almost a third of the companies we analyze are rated BBB- or BBB, and out of those, 16% are at substantial risk of a rating downgrade in the next 12 months - increasing the number of fallen angels a lot.

Whilst this time of volatility may also open up new investment opportunities, it is more important than ever to look at every issuer and their specific risk profile in detail.