Week in Review

What We're Reading:

May 11, 2020

Global U.S. dollar shortage rises as emerging markets lose reserve. The pace at which emerging market economies are losing FX reserves is staggering. What is causing this collapse in reserves and rising dollar shortage? (BBN Times)

Internal Chinese report warns Beijing faces Tiananmen-like global backlash over virus. An internal Chinese report warns that Beijing faces a rising wave of hostility in the wake of the coronavirus outbreak that could tip relations with the United States into confrontation.  (Reuters)

Scientists say a now-dominant strain of the coronavirus could be more contagious than the original. Scientists have identified a new strain of the coronavirus that has become dominant worldwide and appears to be more contagious than the versions that spread in the early days of the COVID-19 pandemic. (Los Angeles Times)

Fearing political dangers, China spent years preparing for this economic crash. For China, this isn’t just any economic crash. It is one against which Chinese leaders have steeled the country for more than a decade. (Washington Post)

EU-Mexico trade deal prompts French farming backlash. The European Union signed a free trade agreement with Mexico on April 28, provoking strong reactions. (EurActiv)

Potential end of a Philippines-U.S. Security Treaty. The U.S.-Philippine alliance has been one of the key features of the U.S. defense infrastructure in the Asia-Pacific. With a Defense Treaty dating back to 1951, the Philippines has often been presented as one the members of the “San Francisco System,” one of America’s key Asia-Pacific allies, along with Japan, South Korea, Australia, Taiwan, Thailand and New Zealand. (Global Risk Insights)

Robo Treasury: Positives and pitfalls. Robotic process automation has the potential to be a powerful tool for treasurers, especially those looking for new ways to garner efficiency gains. What’s more, as a relatively easy-to-deploy technology, RPA can deliver significant value in a short timeframe. But is RPA really a silver bullet for treasury? (TMI)

The importance of establishing customer trust in uncertain economic time. Customers will lean toward companies they can trust during strained times like we’re going through now. To gain trust, companies must show consumers they respect their time and money. Companies need a culture that engages in transparent communication, is open to criticism and can deliver fast and efficient responses. (HSN)

The explosion in global government debt, in five charts. Protecting an economy from a pandemic isn’t cheap. (Quartz)

The pandemic won’t save the climate. Could the pandemic lay the foundation for more serious action to protect the environment—including on the greatest of all environmental problems, climate change? The short answer is: Probably not. (Foreign Affairs)

8 documents required for international shipping. You’ve heard people talk about how to do the sexy part of exporting—the research, the schmoozing, the travel, and all the marketing and sales stuff that people think about when they think about the glamour of international trade. This week, Shipping Solutions talks about the not-so-sexy part of exporting: documents required for international shipping. (Shipping Solutions)

Into the Dalgona coffee trend? Mmm, thanks trad. The “cloud coffee” phenomenon making the rounds on Instagram and TikTok is a prime example of how ingenious people leverage global trade to bring us ideas and products we never knew we needed, but that we now love. (Global Trade Magazine)

Over the last few years, it has become increasingly apparent that national unity has become a thing of the past. There is no nation on the planet that has been able to maintain any semblance of national purpose.

The divisions between citizens have contributed to substantial political and economic decline. Analysts believe there has been a long period without a true outside enemy to focus people’s attention on and that has allowed internal divisions to harden. Today, it can be argued there is a national threat. However, it has not unified; it has become yet another reason to divide.

One side of the divide holds that reacting to the virus must take priority, no matter the cost. Those who lament the damage to the economy are dismissed as “greedy capitalists” who care nothing for the suffering of others. The other side asserts the efforts to control the virus are government overreach and that the whole pandemic is a media-created hoax. The vast majority of the population falls in between these extremes and worries about both the virus and the impact on the economy. As one cartoon had it, “I have a balanced approach to this crisis—half the day I panic over COVID-19 and the other half of the day I panic over the coming depression.”

These divides are not unique to any nation—they are in evidence in Asia, Europe, the U.S. and now in Latin America, Africa, South Asia and elsewhere. The political leaders have been forced to react to these extreme positions. That has compromised strategy. There is no comprehensive quarantine in place and there is no resumption of normal patterns. The fear is that there will be a “worst-case” outcome as a result—a high rate of infection and death and a collapsed economy.

The world’s attention has been focused on day-to-day updates about COVID-19: the number of positive cases and fatalities, questions about ending lockdowns, and news about vaccine development. All of these factors have translated into enormous swings in the market. A key part of the story is global credit conditions, which were already at the 14th percentile before the crisis started. Getting a handle on potential future defaults is dependent upon understanding the weaknesses that the virus crisis exposed.

These are indeed extraordinary times. The Federal Reserve bought $1.3 trillion of treasury debt in a single month. Everyone knew the Fed would come to the rescue, but how much rescue is needed and how much will create moral hazard? How much does intervention stabilize the markets and how much does it mask risk? Answers to these questions will emerge later. Our goal now is to examine the current metrics with a forward-looking bias so that we can anticipate and quantify the risks to come.

The Kamakura Troubled Company Index® stabilized with a small decline of 0.89% to 31.30% and remained at the fourth percentile of historical credit quality as measured since 1990.

The index continued to be highly volatile, ranging during the month of April from 25.69% to 32.4%. The index reflects the percentage of 40,500 public firms that have a default probability of more than 1%. An increase in the index reflects declining credit quality, while a decrease reflects improving credit quality.

At the close of April, the percentage of companies with a default probability between 1% and 5% was 22.38%, a decrease of 0.27% over the month. The percentage with a default probability between 5% and 10% was 4.81%, a decrease of 0.52%. Those with a default probability between 10% and 20% amounted to 2.7% of the total, a decrease of 0.1%; and those with a default probability of over 20% amounted to 1.41%, unchanged from the prior month.

Among the 10 riskiest-rated firms listed in April, nine were in the U.S. and one was in Luxembourg. The riskiest-rated company in Kamakura’s coverage universe was Entercom Communications Corporation, with a one-year KDP of 66.55%, up 11.65% over the past month.

Six of the 10 riskiest companies were in the energy sector. There were 15 defaults, with 10 in the U.S. and one each in Australia, Chile, Luxembourg, Singapore and the UAE. The breadth of the failures shows the global ramifications of current market conditions.

The Kamakura expected cumulative default curve for all rated companies worldwide narrowed slightly, with the one-year expected default rate decreasing by 0.62% to 3.47%, while the 10-year rate decreased by 0.69% to 21.46%. The expected 10-year cumulative default rate has been higher than the prior peak during the credit crisis for two consecutive months.

“An important part of the current credit story is not the increase in the Troubled Credit Index or the expected cumulative default curve,” said Martin Zorn, president and COO of the Kamakura Corporation. “These tools have been flashing yellow warning signals for some time. Rather, the COVID-19 pandemic is the pin that has pricked the credit bubble building for the past several years. Concern was masked by the low one-year default probability, narrowed spreads and a robust refinancing market that allowed firms to pretend and extend without defaulting.”

Zorn went on to comment that the “current crisis is the trigger event. … Government intervention is creating a short-term floor for adverse economic consequences, but one of the unintended consequences may be masking longer-term risk in some cases.”

The impact that the COVID-19 crisis is having on corporates has been underlined by two new publications this week. Firstly, business confidence in the U.K. has seen its largest quarterly fall on record, according to Deloitte’s latest CFO survey. This reversal comes after the Q4 2019 survey showed the largest increase in sentiment in the wake of the general election.

The Deloitte CFO survey for Q1 2020, which gauges sentiment amongst the U.K.’s largest businesses, took place after the U.K. was placed into lockdown between April 8 and 22. A total of 104 CFOs participated in the latest survey, including CFOs of 23 FTSE 100 and 43 FTSE 250 companies. The combined market value of the U.K.-listed companies that participated is £418bn, approximately 21% of the U.K. quoted equity market.

Optimism, revenue and risk appetite

In Q1 2020, 84% of CFOs report that they are less optimistic about the prospects for their company than they were three months ago. This is the lowest business confidence reading on record and, in stark contrast to Q4 2019, where a majority (53%) of CFOs said they were more optimistic about the financial prospects of their company.

Business sentiment around revenues has fallen markedly. In Q1, 97% of CFOs say they expect U.K. corporates’ revenues to decrease in the coming 12 months. CFOs expect their own businesses’ revenues to be 22% lower on average this year than estimated in their pre-COVID-19 plans.

CFO perceptions of external uncertainty have risen to the highest level in the history of the survey. The majority of CFOs surveyed (89%) now feel there is a high or very high level of uncertainty facing their business, a sharp increase compared to 34% in the previous quarter.

The COVID-19 crisis has taken a heavy toll on economic activity. In Q1, 94% say they are unwilling to take risk onto their balance sheets. This is the second-lowest reading for risk appetite on record, the lowest level having been observed during the 2008 financial crisis.

Despite policy action to support corporate financing, CFOs from the survey’s panel of large businesses reported the sharpest squeeze in credit conditions on record, with a marked deterioration in the availability and cost of debt in the last three months.

Almost all CFOs (98%) expect U.K. corporates to reduce capital expenditure in the next 12 months, in contrast to 38% anticipating an increase in Q4 2019. Hiring expectations are also significantly more pessimistic, with 98% of CFOs expecting a slowdown in hiring in the next year. In the previous quarter, 27% of CFOs predicted hiring would increase over the year.

COVID-19 and the economy

Amid the COVID-19 pandemic, 53% of CFOs are expecting the U.K. economy to see a deep and prolonged economic downturn that lasts until the end of 2020.

Most CFOs expect demand in their own sectors to start to revive later this year. However, over half (53%) do not expect demand to recover to pre-pandemic levels until after Q2 2021.

Looking ahead to the long-term impact of COVID-19, 97% of CFOs believe the crisis will lead to an increase in pandemic planning, while 89% believe it will lead to a diversification and strengthening of supply chains. CFOs believe the post-COVID world will see a greater role for the state and higher levels of corporate and household taxation.

“The COVID-19 pandemic has seen business confidence drop from an all-time high to an all-time low in just three months," commented Ian Stewart, chief economist at Deloitte. "CFOs expect the lockdown to ease in May and June and demand in their own sectors to start recovering later this year. But there is no expectation of a quick snap back in activity, with most CFOs assuming revenues will not return to pre-crisis levels for at least a year.”

Strategy and spending

The Deloitte CFO survey shows that CFOs are focusing on more defensive strategies than at any time since the survey began, with 76% rating reducing costs and 68% rating increasing cash flow as strong priorities.

CFOs are also taking specific actions to address challenges posed by the COVID-19 pandemic. Almost all CFOs (99%) have introduced or are planning to introduce alternative working arrangements such as flexible and remote working, 59% are furloughing employees, 52% are reducing output or shutting down factories and 30% have or intend to access the Bank of England’s COVID Corporate Financing Facility.

“Finance leaders are facing the toughest challenges in decades but most expect demand to start to come back this year," said Richard Houston, senior partner and chief executive of Deloitte North and South Europe. "Leaders are already thinking beyond the downturn and how to adapt and prosper in a changed world. Almost all finance leaders believe that flexible working will gain ground in the wake of this crisis. We have an opportunity to re-think the future of work in a way that boosts opportunity and innovation.”

Are interest rate hedges effective?

Elsewhere, an article on the Bloomberg website written by Demetri Papacostas, the company's head of corporate and commodity specialists, suggests that corporates may need to validate the effectiveness of their interest rate hedges.

The awakening of market volatility has come quickly and across all asset classes. Of particular note is the increased volatility for interest rate instruments. Papacostas says that this is impacting the rigor, transparency and the flexibility to run analytics on demand.

The article notes that corporates may be asked by their auditors to run regressions to re-check effectiveness. This is for a company’s interest rate swaps, and even on a company’s own bonds outstanding. Whereas in the past, companies used rudimentary tools to see how their bonds reacted to rate/credit changes, Papacostas says that auditors are now often demanding solid tools with rigorous scenario and regression capabilities to estimate the risk inherent in the current very unpredictable environment.

In addition to the lack of rigorous analysis, Papacostas makes the point that corporate treasury effectiveness may also be constrained by the lack of transparency and flexibility. Often, auditors do not need just a valuation, but also solid proof of how the number was derived, including the underlying models and assumptions.

Finally, the article comments that given the speed of change in the financial markets, month-end or quarter-end valuations may not suffice. Papacostas notes that the preferred access is to be able to see on demand how market values have changed to generate scenario analysis based on the new environment and potentially amend hedges to reflect the new reality.

Papacostas concludes by saying that, ideally, companies want to be able to generate a scenario analysis that reflects real-time moves, create a sophisticated regression that gives a sense of the magnitude of exposure, and when their auditors demand to see how they arrived at those numbers, they can generate the supporting documentation at the press of a button.

Reprinted with permission from CTMfile.

 Week in Review Editorial Team:

Diana Mota, Associate Editor and David Anderson, Member Relations