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Recovery heralds a new era for global capital markets

By Toby Fildes
17 Dec 2020

The shock of coronavirus has changed markets — and society — forever. Toby Fildes picks out the key themes that will emerge from that upheaval in 2021. As 2020 has reminded everyone, the unexpected will happen — but markets can cope.

At the end of every year there is always an urge to look back at the highlights and look forward to the opportunities a new year brings. Only this year, most will want to forget 2020. 

The coronavirus has upended life as we know it. It’s been exhausting, stressful, difficult — the most challenging year of our professional and perhaps personal lives. The preference to look forward is therefore greater than ever — market participants are united in their hope for better, more normal days ahead.

Review 2020Yet so much was achieved in 2020 that capital markets can be proud of. Record volumes of debt and equity were issued to help stem the ravages of the crisis, often through deals of sizes hitherto deemed impossible. The money raised helped plaster over gaping holes in balance sheets, keep liquidity flowing and directly finance vast government schemes to protect jobs and prop up health services. Nearly all of this was done by people working from home, often in cramped conditions and with children needing attention.

Societies faced their biggest emergency since the end of the Second World War and capital markets stood up to be counted. 

Inevitably, much of 2021 will be spent clearing up the damage and mess caused by this crisis. Companies will seek to delever or refinance emergency cash injections. Banks will begin to feel the true economic impact of the crisis through a new vintage of non-performing loans and defaults. Governments will try to strike a balance between lowering their ballooning debt to GDP ratios and continuing to support citizens and businesses. 

So there will not be much opportunity to recuperate after 2020. Somehow, capital market participants will also have to find the energy to deal with the end of Libor (set for the end of December 2021), a new wave of M&A, a reinvigorated Europe determined to press on with Capital Markets Union, a new president in the White House and Brexit.

A way out of the debt? 

If 2020 was all about piling on the debt as governments around the world rushed to save their economies and societies, 2021 will be all about working out ways to reduce it — or at least sustain it. 

Uncomfortable questions about debt sustainability have so far largely been avoided, thanks to the vast (and in some still cases, still growing) quantitative easing programmes. But those questions will surely come. Developed countries’ debts have typically gone up by between 10% and 20% of GDP in 2020.

So what are the options? Apart from running a fiscal surplus (see next section), there are three main ones: economic growth, restructuring and inflation. 

Review 2020With vaccines on their way, growth will certainly bounce back. But, as Algebris Investments points out, over the last 20 years, developed economies’ excess of real growth to fiscal balances, while volatile, has averaged close to zero.  

Meanwhile, restructuring would be catastrophic for Europe’s capital markets — a fact that did not stop Riccardo Fraccaro, Italian prime minister Giuseppe Conte’s closest aide, from floating the idea of the European Central Bank cancelling debt issued during the pandemic.

Algebris highlights an alternative — governments issuing very long-dated or perpetual bonds with low coupons, using the proceeds to buy back higher coupon or shorter-dated debt. However, it says, while this could reduce the net present value of debt and perhaps lower interest costs, “ultimately it’s a kick-the-can approach, which won’t help reduce the debt burden materially”.

This leaves inflation, in the past the most consistent way of reducing indebtedness. But here Europe has a problem: its ageing population. As Lee Heathman, senior lead portfolio manager at BlackRock, says: “Longer term, as fiscal and monetary policy tapers and the economy gets back to pre-Covid levels, we will be looking at a Japanese-style low growth, low inflation reality, due to the overpowering forces of demographics.” 

So it looks like the debt is here to stay. Perhaps it’s time to redefine what is sustainable instead. Japan’s government debt, after all, has been larger than its GDP since 2000 and is heading for 200%. Can Europeans and north Americans learn to be Japanese?

A new social contract 

The short answer to making debt sustainable is to borrow less — or even, to repay debt. No one seems keen to talk about that at the moment. Even the International Monetary Fund has urged governments to borrow more, pointing out that interest rates are low and restarting the economy is paramount.

Not only are economists leaning towards fiscal expansion at the moment — politics require it.

The social contract is back in fashion in a big way. G20 economies have delivered fiscal packages worth over $10tr this year, via huge subsidies for employment, housing and healthcare. As McKinsey points out, in real terms this is about three times the support provided during the 2008 financial crisis and 30 times the size of the Marshall Plan, which helped rebuild Europe after the Second World War. 

Review 2020In 2020 alone, governments in the European Union are expected to spend an additional $2,343 a person compared with 2019. In the US, spending will be $6,572 higher.  Never before, in most countries, have governments gone so far to protect citizens from economic contraction. Support for such measures has spanned the political spectrum from President Trump in the US to left-leaning governments in Italy and Spain.

It would take a brave — even foolhardy — president or prime minister to start hacking back at this new consensus. The terrible social and health costs from Covid-19 have not suddenly stopped at the emergence of a series of effective vaccines. The effects will be felt for years.

The Next Generation EU initiative — $750bn, most of which will be spent on “cohesion, resilience and values” — is billed as temporary. But, as economist Milton Friedman was fond of saying: “Nothing is so permanent as a temporary government programme.” 

The new social contract is here to stay. Public sector bond markets had better be ready.

EU’s bid for a safe asset

On their own, the sheer ambition and size of the EU’s Support to Mitigate Unemployment Risks in an Emergency (SURE) and NGEU coronavirus recovery programmes would be impressive enough. 

But their symbolism runs much deeper — they could well mark the beginning of a new era for the euro and European capital markets.

The €100bn SURE and €750bn NGEU schemes rely on the EU becoming a heavyweight bond issuer, a development that many believe could herald — at long last — the creation of a common European safe asset in the debt market. This is something diehard euro fans have wanted for almost two decades. Germany, and especially the Bundesbank, have argued against it for almost as long. 

But the severity of the Covid-19 pandemic and size and speed of response have effectively led to the Germans being overruled. 

However, creating this market will not be straightforward — a lot needs to happen in the right sequence. Just issuing a lot more bonds does not mean the job is done. As Alexander Lehmann of Bruegel, the think-tank, says, for EU bonds to become a safe asset and the foundation for more integrated and liquid internal capital markets, they will need more transparency and predictability. 

Only then, supporters argue, could the euro ultimately become a more significant reserve currency. And only then would EU bonds help to integrate national financial systems, reducing the risk of runs on national bond markets and of the destructive interaction between sovereign creditworthiness and bank solvency. 

There is much at stake and it will be a long and difficult journey. But the first steps have been taken.

Sustainable finance sweeps all before it

Far from being set back by the coronavirus, sustainable and responsible capital markets end 2020 more powerful and important than ever.

As the virus ran amok through Western societies there were concerns that the environmental, social and governance capital markets movement, which had gathered such strong momentum in recent years, would slip backwards as the survival instinct — both social and economic — would trump all else.

And for a while, the ‘E’ in ESG did take a back seat. But the ‘S’ — social — came to the fore, first through the creation of Covid-19 response bonds. Picking up on a Chinese idea, the International Finance Corp was the first Western issuer, with a $1bn deal. 

Review 2020According to Tanguy Claquin, head of sustainable banking at Crédit Agricole CIB in London, it is only a matter of time before a European sovereign follows Indonesia, Ecuador and Guatemala and issues a social bond. “If you look at the expenditures managed by a state, they are an obvious social bond issuer,” he says.

Led by public sector borrowers, social bond issuance has ballooned. It is expected to reach $140bn in 2020, more than twice as much as all previous issuance put together. Investors have been falling over themselves to play their part in fighting the pandemic, but it has served to mainstream the product, leaving a lasting legacy of demand and prompting the creation of new funds.

The biggest issuer by far was the EU, which raised €39.5bn for its SURE programme; some believe it could issue €170bn in 2021, transforming this asset class.

Although the social bond volumes stand out, 2020 was a crucial year for sustainable finance as a whole. The foundations for a broader and more useful market were set, including the first official guidance for transition bonds that emerged in early December, the endorsement of sustainability-linked bonds by the European Central Bank through its decision to buy them as part of its Asset Purchase Programme, and perhaps most importantly the completion, expected in January, of the EU’s Taxonomy of Sustainable Economic Activities. 

The use of proceeds green bond — the star of the sustainable finance show thus far — now finds itself having to share the limelight. It might even be upstaged.   G

By Toby Fildes
17 Dec 2020