Putting the 'K' in capital markets
The coronavirus crisis will continue to lead to divergence in economic fortunes, and that will play out in European capital markets as well.
The idea of a 'K-shaped' economic recovery, where some parts of the economy rebound and others decline, is apt for many aspects of the coronavirus crisis.
On an individual level, those in cramped living conditions or in poorly paid jobs are more likely to have been exposed to the virus — unless those in the latter have lost their jobs entirely. It will not be an easy recovery for them.
Many office workers, on the other hand, have not only kept their jobs and stayed safe, but also ended up with plenty more savings to splurge when they next get an opportunity.
Entire countries have also diverged, including within Europe, meaning some have further to climb in the recovery stage.
Analysis from Bruegel shows that the economic shock from the crisis within the EU varies from Croatia at 13.4% of GDP to Sweden at 6.5%, with differences between countries correlated to the strictness of lockdown measures, the share of tourism in the economy and the quality of governance.
The so-called "frugal four" countries — Austria, the Netherlands, Denmark and Sweden — which were most resistant to a generous EU recovery fund, were all among the seven least affected.
Both the EU and the UK are struggling to get to grips with an autumn wave of coronavirus infections, with winter looming. People are not quite sure whether they should talk about being in recovery yet or still being in the crisis. In part, the confusion is because of the undulating nature of the virus, but in part it is because of the K model.
This applies to the capital markets, too. Investment banking fees have swelled despite early jitters about liquidity and working from home, and equity and bond valuations recovered a long time ago. Meanwhile, despite the economic woes, European Central Bank activity has so far suppressed the spread between different eurozone government bond markets.
However, at the industry level, what is known in typography circles as the leg of the K becomes more visible.
S&P warned last week that while sectors like tech, consumer staples and homebuilders had barely been affected by the pandemic, for others — like airlines and hotels — "the credit damage will go well into 2023."
The ratings agency warned that "we can't rule out episodes of volatility and constrained access to financing" and that virus waves and more lockdowns could lead to "a wave of business failures among more affected sectors, notably for SMEs".
And as the last point makes clear, company size matters as well as industrial sector. Back in August, Tirupam Goel and José María Serena at the Bank for International Settlements wrote that banks appeared to be more cautious about lending and CLO investors about investing, meaning that the bond market became a more prominent source of funding compared with syndicated loans.
Larger firms have better access to the bond market than smaller ones. They may have more experience of issuing, have an existing relationship with underwriters, and have already incurred the fixed costs of issuance. Investors, meanwhile, may find it more efficient to deploy the fixed costs of research on an issuer that will print at greater size.
The authors warned: “Dominance in bond-based borrowing by large firms could crowd out mid-sized firms, which are also creditworthy and may exhibit significant liquidity needs.”
Also on the sliding slope of the K are European banks, facing asset deterioration from the crisis and the prospect of low interest rates stretching beyond the horizon. They have even been prevented from paying dividends, a decision that made the short-term outlook for eurozone bank equities "almost comically dire", according to Claus Vistesen at Pantheon Macroeconomics.
M&A is one way for banks and other companies either to move to the ascender of the K, or to take advantage of being there in the first place.
According to Willis Towers Watson research for the third quarter, in Europe the share price performance of the acquiring party of an M&A deal has beaten a regional index by 20 percentage points on average.
It is difficult to make sense of these markets: for some guidance, think about the K — at least it suggests only two outcomes to worry about, even if it is not so clear who will be on what slope.