Einblicke
It’s All About the Virus
|
|
Global Fixed Income Bulletin
|
• |
Februar 29, 2020
|
It’s All About the Virus
|
Februar 29, 2020
|
It’s All About the Virus
It’s All About the Virus |
|
February marked a watershed in the evolution of the coronavirus (COVID-19) outbreak and its ramifications. Through February 19 (the day the S&P hit its all-time high), optimism reigned. The world thought this health crisis was likely to be contained to Asia, predominantly China, with a relatively small impact on the U.S. and European economies. It was a temporary supply shock, disrupting supply chains, but importantly, it would not materially affect 2020 cumulative economic performance, either in the U.S. or China. Lost output could be made up without lasting impact on demand. So much for wishful thinking! By the end of the month, the 10-year U.S. Treasury yield was at a record low, equities were down close to double digits and high yield had a negative return year to date.
The failure to contain the spread of the coronavirus to China (and Asia) changed the game. The world now faces an aggregate demand shock (above and beyond a short-term collapse in Chinese demand) on top of the original Asian supply shock. Economic growth will take a bigger hit (although there is nothing really evident in the data yet). The hit will last longer. It will be global. And, maybe worst of all, no one knows when it will end. The Brookings Institute has come up with SEVEN potential scenarios. There are probably a lot more than that! This uncertainty will weigh on economies and financial markets until there is evidence that infection rates are likely to have peaked. Recession is likely in countries already facing weak economic prognoses and weak policy frameworks. Other countries, probably the U.S., will escape recession but at the cost of a stagnating economy. Volatility will stay high; government bonds should continue to be well supported; risky assets should struggle (financial markets were not well positioned for the plethora of bad news delivered post February 19). Medium term, this crisis should pass and economies return to normal. When and how much pain is felt along the way will determine how low yields go and how wide credit spreads move. As long as the virus’s impact remains disruptive rather than destructive, we should be fine, eventually. Buckle your seat belts!
Note: USD-based performance. Source: Bloomberg. Data as of February 29, 2020. The indexes are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See below for index definitions.
Note: USD-based performance. Source: Bloomberg. Data as of February 29, 2020. The indexes are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See below for index definitions.
Source: Bloomberg. Data as of February 29, 2020. Note: Positive change means appreciation of the currency against the USD.
Source: Bloomberg. Data as of February 29, 2020. Note: Positive change means appreciation of the currency against the USD.
Source: Bloomberg, JP Morgan. Data as of Feb 29, 2020.
Source: Bloomberg, JP Morgan. Data as of Feb 29, 2020.
Fixed Income Outlook
February has been a match of two halves: Pre-February 19 the outlook was still optimistic, post February 19, goldilocks has been postponed, maybe indefinitely. Before the 19th, the outlook was a continuation of the steady recovery which characterized the end of 2019. Equities rallying and government bonds rallying, credit performing well in spite of some minor spread widening due to the tight levels at the end of 2019 and risks surrounding the coronavirus. By the end of February, markets had had their worst week since the 2008 financial crisis and the 10-Year Treasury Note hit historic lows, as the coronavirus continued to spread across the globe. By now it’s clear the coronavirus pandemic will have a meaningful impact on the global economy. While consensus had been that the worst impact would be felt in the first quarter and a recovery in the second quarter, this is now likely overly optimistic. We increasingly believe uncertainty is unlikely to be resolved until at least late in the second quarter.
Thus, thinking about the outlook for the next few months is tricky to say the least. The coronavirus creates a fluid situation for markets with no one certain about how long and far it will run. On the positive side, it appears to be receding in China, where it started, allowing the economy to start to recover; some other Asian economies – Japan, Singapore, and Taiwan – have been remarkably successful at containing the virus. On the negative side, infections outside of China, particularly in Europe, have been accelerating and are only just to pick up in the U.S. and many other countries. A public health failure in just one or two major economies could be severely disruptive to the entire global economy.
Fixed income markets have reacted to the increased risk sentiment with risk free duration rallying and credit spreads widening (investment grade, high yield and emerging markets). With government bond yields making new all-time lows in many advanced economies, it is not clear how much further they can fall, unless economies move into recession. Central banks have responded with emergency easing – rate cuts as well as measures to ease monetary conditions and keep liquidity flowing – but the market was quick to anticipate this response and significant rate cuts have been priced for every developed economy central bank.
Looking forward, the debate is whether the impact will merely be “disruptive” to the global economy, with a rebound in economic activity following the current slowdown, or “destructive,” with the timeline uncertain and longer term damage inflicted. Our base case is still for it to be disruptive with open questions over (1) the timeline to the peak in the infection rate, (2) the impact on consumer/business confidence and (3) the level where markets offer extreme value. The good news is that we are seeing both central banks and governments moving into action, with combined monetary and fiscal stimulus, but it remains to be seen if the response will be enough to calm markets.
While monetary accommodation is not a solution to a medical problem, and will have limited effect in cushioning the economy from a supply side shock, it can help prevent monetary conditions from tightening. The Fed’s surprise emergency rate cut (50 bps) in early March was extremely important in this regard. Moreover, we expect central banks and fiscal authorities to deliver on credit easing measures to support corporate/household cash flows and their access to credit.
Developed Markets
Monthly Review
In February, yields fell to historic levels across the globe as markets braced for the social and economic impact of the coronavirus, as the virus continued to rapidly spread outside of China. Other geopolitical risks around the globe took a backseat as the coronavirus was the main driver of market moves, particularly at the end of the month. The OECD slashed its global growth forecasts for 2020 from 2.9% to 2.4%. 10-year global yields across the developed markets dropped, including 36 basis points on the United States Treasury, 25 basis points in New Zealand, and 17 basis points in Germany. The VIX closed the month at 40%, which was close to a 5-year high, signaling increased concern among investors of the impacts the coronavirus will have on the global economy. U.S. breakevens fell, with the 10-year breakeven ending the month at 1.43.1 The reinversion of the Treasury yield curve and collapse of real yields was also indicative of uncertainty about the economy.
Outlook
The global outlook is contingent on the coronavirus’ path and pace at which it spreads in the coming weeks. Expectations are that the virus spreads to the EU and U.S., posing serious disruptive risks to the regional and global economy, even if the Chinese economy is starting to normalize. If the situation continues to worsen, particularly in the U.S., the Fed is likely to deliver on additional rate cuts at its March meeting or soon after. The Fed could reset rates back at the lows seen after the global financial crisis. The Fed has promised to help stabilize financial markets, and is committed to being flexible regarding interest rate policy. If the spread of the virus slows, we believe there could be a sharp global rebound. The risk of a meaningful recession is unlikely if labor markets do not weaken.
Emerging Markets
Monthly Review
Emerging markets (EM) fixed income asset performance was negative in the month, as investors reduced risk due to the uncertainty surrounding the spread and economic impact of COVID-19. EM currencies weakened versus the U.S. dollar, while local bond returns were flat as bond yields failed to match the decline in Treasury yields. Inflows into the asset class ($4.4bn) continued for most of the month, primarily into hard currency strategies ($4.1bn), while local currency strategies gained $0.2bn. Many central banks cut rates or enacted other easing measures to combat the slowdown in economic activity.2
Outlook
We remain cautious on EM debt in the near term, on the back of a still fluid situation regarding the Covid-19 virus. The transmission of the coronavirus shock through the global economy is likely to come from different sources: the demand-side (as declining consumer confidence weighs on private consumption), the financial sector (an equity sell-off implies a negative shock to wealth, and thus consumption, whereas wider spreads translate into tighter financial conditions and thus reduced corporate investment), and from the supply-side, as quarantines and other emergency measures disrupt global supply chains. In our view, we think the demand/financial channel is the most significant one, and as a result, monetary/fiscal policy accommodation may prove effective in mitigating the shock and providing some needed stabilization to financial assets. Markets have already priced in over 100 bps of Fed easing in the next year, and other Central Banks are likely to follow suit with their own monetary policy easing. In addition, some countries affected by the virus have also announced small fiscal stimuli (for example, Italy), which could be expanded depending on the severity of the shock.
Credit
Monthly Review
Unsurprisingly, the key driver of credit spreads in February was the uncertainty surrounding the coronavirus and its impact on economic activity and market/business confidence. Additional weak economic data (started before the virus), Q4 2019 corporate results that were ahead of lowered expectations and the start of U.S. election news were all discussed, but were not material market movers.
Outlook
In February we continued to be conservative in our credit positioning, participating in a limited number of new issues while maintaining an unchanged risk exposure, long of credit but less long following sales in Q4 2019.
We see the coronavirus as a “fluid situation” for markets with new cases continuing to increase and more regions being impacted. Fixed income markets have reacted to the increased risk sentiment with risk-free duration rallying and credit spreads widening. Looking forward the debate is whether the impact will be “disruptive” or “destructive.”
Securitized Products
Monthly Review
As with the other sectors, coronavirus was the dominant story in February, with U.S. interest rates rallying sharply to new lows and equities selling off materially. In an ironic twist, the securitized markets had essentially an opposite reaction, where government guaranteed agency MBS was the worst performing asset class, while credit-oriented securitized assets performed well. While this sounds counter-intuitive, this market dynamic actually makes sense when one drills a little deeper. Credit-oriented securitized assets performed well during the month driven by the continued demand for yield, and also supported by continued strong fundamental market conditions. Agency MBS underperformed as lower rates increased prepayment concerns and limited how much agency MBS prices could rise.
Outlook
We are generally more cautious in the securitized markets as we enter March, given the potential economic consequences of the virus outbreak. We continue to add to our government guaranteed agency MBS positions, and are slowly reducing some of our credit exposures. We remain positive on mortgage and securitized markets overall from a fundamental perspective, but we believe that liquidity and volatility conditions could deteriorate, and markets could cheapen in the coming weeks as a result. Agency MBS has cheapened meaningfully over the past two years and now look attractive on a risk-adjusted relative value basis, while securitized credit opportunities have widened less than their corporate equivalents in recent weeks.
2
RISK CONSIDERATIONS
Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.