Market Pulse
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February 12, 2020
The Coronavirus and Its Impact on the Global Market
 

Market Pulse

The Coronavirus and Its Impact on the Global Market

The Coronavirus and Its Impact on the Global Market

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February 12, 2020

 
 

Will the inevitable economic recovery take the shape of a V, U, Bathtub or L?

Global markets have reacted to the novel coronavirus (nCoVid19) outbreak in varying degrees of distress, increasing short-term volatility and leaving investors concerned over slowing economic growth in China, at least in the near-term. The outbreak, which started in Wuhan, one of China’s most populous cities, has resulted in over 48,000 confirmed cases across 26 countries, and over 1,300 deaths, as of this writing.1

For investors, we believe the question is what shape the eventual economic recovery - V, U, Bathtub or L – will take. We believe this is dependent on how quickly the markets recover; speed is of the essence. In our view, U.S. and Chinese central banks should react quickly if further damage is done to the global economy, and it is our view that China will, in fact, do “whatever it takes” to help.

But investors need to watch the clock. If the recovery is fast, all should normalize quickly. However, if the recovery lags and spills into the third quarter of 2020, watch out. We believe leverage stresses will increase and credit will take a hit. Financial conditions will tighten.

Investors also will need to keep an eye on the calendar for economic data, which we think is likely to be pretty bad over the next month. It is important to understand that poor economic data can lead to exacerbated headline risk encompassing the viral period. Of note:

  • China PMI data is expected out on February 28, although we expect most of the data to be delayed until early March based on the Chinese New Year.
  • In the U.S. the Philadelphia Fed data will be available February 20, developed market flash PMIs on February 21 and the Chicago PMI February 28. Based on the data, we expect market sentiment to drop, and some supply chain disruptions, especially in those manufacturing sectors more reliant on China.
 
 

The fundamental response has been OK, but the clock is ticking. . .

Global financial conditions are currently easy, as central banks across the globe have effectively enacted a “put option” policy for mitigating downside risk. We would question, though, whether a put policy is enough to right a listing global economy in rough waters. Rates are low, will likely remain low globally (not rise, as previously expected). We are not sure whether this is enough to offset weaker global demand, which some are hoping is merely delayed, not destroyed.

However, much of this depends on the length and depth of the coronavirus shock. In a scenario where earnings slow to or below a certain threshold, corporate leverage ratios will uptick and should negatively impact credit markets.

As mentioned, one key is the Chinese central bank. It is our expectation that the central bank will go big on stimulus programs, not unlike European Central Bank Chairman Mario Draghi’s “whatever it takes” mantra not so long ago. Possible outcomes of a stimulus program include an explosion of government spending above its current 14% of GDP level, an aggressive easing of the reserve ratio requirement and an onrush of liquidity injections. We also see China easing up on delevering programs as a credit stimulus, as well as enacting a series of tax, fee and regulation cuts. China will be fiercely determined not to let the epidemic bring down their economy.

 
 

Pricing: Rates and FX Relative to the Credit Markets

In general, rates and the U.S. dollar (USD) have repriced a global reflation trade that was the consensus prior to the nCoV, while credit and spread markets have not reacted as much. But this should change if the recovery takes longer than expected.

More specifically:

  • U.S. Treasury yields have reacted most dramatically, as the 10-year fell 40 basis points (bps) from a high of 1.92% on December 31, 2019.

o   If the coronavirus hits the U.S. in any meaningful way, we expect the rate cuts to be fast and furious.

o   We see fatter left tail (downside) on distribution of risks

  • The USD Index is up +2.5% YTD, a result of the unwinding of a global cyclical recovery trade versus the U.S. The USD is returning to near 2019 highs from Sept. peak trade war fear
  • Credit is experiencing marginal impact

o   Investment Grade currently sits at a 96 bp Option-Adjusted Spread (OAS), 3 bps wider YTD. The yield is currently 2.64%2

o   Cyclical themes we like include communications, gaming, financials, and select energy (pipelines)

o   There is a ton of supply out there

  •  High Yield is currently at a 356 bp OAS, 20 bps wider YTD, with a current yield of 5.28%2

o   Of interest are building materials, food and beverage, transportation and select retail

o   BBs are quite tight, while Bs – and some select CCCs – represent the best value

  • Emerging Markets (EM): The EMBI Global Diversified is 4.77%, 16 bps lower YTD, but also 16 bps wider2

o   In terms of USD denominations, we see opportunities in Ukraine, Egypt (based on an IMF package and reforms) and Nigeria (valuations)

o   In local currencies we have interest in Brazil, Russia, Indonesia and Mexico, as all these governments, and others, have plenty of room to cut rates

 
 

The Powell Testimony: The U.S. Economy is still “in a good place” BUT, we will do “whatever it takes” if and when necessary

U.S. Federal Reserve (Fed) Chairman Jerome Powell testified in front of the U.S. Congress on February 12. Our key takeaways include:

  • There were no surprises. He essentially recapped his remarks after the last FOMC
  • The economy really is in a good place. On February 11, the NFIM small business sentiment index rose from 102.7 to 104.3.

o   As a reminder, small business accounts for approximately 65% of job creation in the U.S. As importantly. . .

o   . . .Economics 101 reminds us that jobs create income, which in turn leads to increased consumption, which in turn represents approximately 70% of GDP

o   Almost all small business categories are performing well.

  • The big picture: Potential GDP in the U.S. is expanding, where the non-inflationary growth rate is nearing 2.25% or above.

o   The formula: Potential GDP = labor force growth + productivity growth

- Labor force growth is roughly 0.5%

- The average growth of Productivity (on a 4-quarter basis) has been  1.7% since 2016; the last data point we have is 1.8% year-over-year

- Contained Unit Labor Costs may also extend the cycle

o   Technology led Capital Expenditure (CapEx) is likely underestimating productivity, to the point where we expect CapEx/Business Investment to rebound after sings of weakness 2019

o   The Fed is willing to let the economy run hot. Ultimately its goal is to achieve  inflation symmetrical at 2%

o   Exogenous shocks related to the coronavirus will lead to aggressive action by Powell. The bar has been lowered for rate cuts, and multiple cuts if needed. In the end, Powell wants inflation core PCE at 2% and will act accordingly to get there.

In summary, there was a lot going on in the world before the coronavirus outbreak and we expect some short-term economic distress followed by a recovery. But the ultimate shape of the recovery - V, U, Bathtub or L – will be dependent on a number of factors outlined in this piece. In short, stay tuned!

 

1 The New York Times, February 12, 2020.https://www.nytimes.com/2020/02/12/health/coronavirus-cases-china.html

2 As of February 11, 2020. The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.  See Disclosure section for index definitions

 
 

Risk Considerations

There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks. 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. 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. 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. High-yield securities (“junk bonds”) are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. 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).

 
jim.caron
Managing Director
Global Fixed Income Team
 
 
 
 

Definitions

 

The Bloomberg Barclays U.S. Corporate High Yield Index measures the market of USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody's, Fitch, and S&P is Ba1/BB+/BB+ or below. The Index excludes emerging market debt. The Bloomberg Barclays U.S. Corporate Index is a broad-based benchmark that measures the investment grade, fixed-rate, taxable, corporate bond market. The US Dollar Index measures the value of the U.S. dollar versus a basket of foreign currencies. The JP Morgan Emerging Markets Bond Index Global Diversified Index (EMBIGD) tracks total returns for traded external debt instruments in the emerging markets, and is an expanded version of the EMBI+. As with the EMBI+, the EMBI Global Diversified includes US dollar-denominated Brady bonds, loans, and Eurobonds with an outstanding face value of at least $500 million. The diversified variant of this index has a distinct distribution scheme which allows a more even distribution of weights among the countries in the index, including limiting country weights to a maximum of 10%.

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