Via Wolf Street

European Market Regulator flags big issues, including the “decoupling of financial market performance and underlying economic activity.”

By Nick Corbishley, for WOLF STREET:

The European Securities and Markets Authority (ESMA) warned of a “prolonged period of risk to institutional and retail investors of further – possibly significant – market corrections and very high risks” across its jurisdiction.

“Of particular concern” is the sustainability of the recent market rebound and the potential impact of another broad market sell-off on EU corporates and their credit quality, as well as on credit institutions.

The “decoupling of financial market performance and underlying economic activity” — the worst economic crisis in a lifetime — is raising serious questions about “the sustainability of the market rebound,” ESMA says in its Trends, Risks and Vulnerabilities Report of 2020.

Beyond the immediate risks posed by a second wave of infections, other external events, such as Brexit or trade tensions between the US and China, could further destabilize fragile market conditions in the near term.

From a long-term perspective, the crisis is likely to affect economic activity permanently, “owing to lasting unemployment or structural changes, which might have an impact on future earnings.” The increase in private and public sector debt could also give rise to solvency and sustainability issues.

In corporate bond markets, spreads have narrowed but they remain well above pre-crisis levels, owing to heightened credit risk and underlying vulnerabilities related to high corporate leverage. There was also a wide divergence across sectors and asset classes in April and May. Across non-financials, the automotive sector suffered the largest decline, followed by the energy sector.

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In one of the report’s rare positive notes, central counterparties (CCPs) proved resilient throughout the period, despite the surge in clearing activity coupled with the sharp rise in initial and variation margins. That said, there’s still a high risk of a further deterioration in credit quality, which is likely to spark a fresh round of credit downgrades.

The risks of “fallen angels” remain high, and securitized products (e.g. Collateralized Loan Obligations (CLOs)) could also be affected. “The COVID-19 crisis is disrupting markets in ways that were impossible to predict when CLO ratings were assigned before the epidemic”, ESMA notes.

This raises the likelihood of further credit downgrades as the crisis evolves. Recent developments in the leveraged loan market attest to (emphasis added) “a deterioration in loan documentation, a widespread decline of financial covenants and increased use of accounting techniques by borrowers to reduce their apparent financial leverage.” Taken together, these “magnify the risk” that when defaults occur, they are more likely to occur together – clustered across firms and sectors.

“The COVID-19 turmoil has also highlighted the risks of market-wide stress” for investment funds due to the “interconnectedness and spillovers in the EU fund industry,” the report said.

In the midst of the turmoil, some asset managers decided to suspend redemptions, including most property funds, because of “valuation uncertainty” and the intensity of outflows (run on the fund) that couldn’t be met through sales of these illiquid assets, indicating, as ESMA says, “that funds exposed to less liquid asset classes are more likely to be affected by shocks originating in other markets than funds invested in more liquid assets.”

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In its report, which analyzes the period from late February to the end of June, ESMA saw the financial market go through three different stages:

  1. A liquidity and volatility period (mid-February – end-March) during which markets, investment funds and infrastructures faced inordinate levels of stress. Huge volumes of money poured out of management funds and high-risk assets. Redemptions from bond funds reached record highs in March, resulting in outflows of 4% of their net asset value (NAV) in 1Q20.
  2. A rebound period (early to end-April) in which markets rebounded swiftly on the back of hugely accommodative monetary and fiscal policy actions, which continue to this days. Outflows from funds slowed and eventually gave way to net inflows, as investors flooded back into the market. By the end of April around half of the fund outflows had been reversed.
  3. A differentiation stage (starting early May) during which credit and solvency risk came to the fore, as investors began differentiating between issuers and asset classes amid ongoing deterioration of economic fundamentals.

In the second quarter as a whole, as volatility receded and liquidity improved, European equity markets enjoyed their best quarterly performance since 2015, with a rise of 20%. They are now up around 40% since the trough reached in mid-March, and are almost back to pre-crisis levels. But the performance of European stock markets has been wildly uneven:

  • By far the best performer, Germany’s DAXK index, which strips out the effects of dividends that are included in the DAX, has rebounded 48% and has come close to recapturing its pre-Covid highs.
  • France’s CAC has bounced back 32% and Italy’s FTSE Mbe, 30%
  • The continent’s two major laggards, Spain’s IBEX 35 and the UK’s FTSE 100, have respectively risen by just 14% and 13% off their March lows.
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Italy and Spain were both locked down longer and more severely than Germany and are also hugely dependent on tourism, so it makes sense that their markets haven’t rebounded as much. More striking is the divergence between Spain’s index and its French and Italian counterparts, suggesting that investors are particularly worried about the Spanish economy. As for the UK, investors are skittish about what additional turmoil could occur if it were to leave the EU without a deal at the end of this year. By Nick Corbishley, for WOLF STREET.

“Valuation uncertainties” were citied once again. And the trail of the Windhorst bonds. Read… €22Bn Hedge Fund H2O, Majority-Owned by Natixis, Ordered to Freeze Funds. Fishy Smells Emanate

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