Market Update March 2020

8 minute read

Given the significant turbulence currently gripping markets, we have prepared a summary of our views on the main asset classes.

Overview

  • Overall, we hold a neutral position in equities relative to bonds.
  • We remain neutral in equities, and within each underlying regional equity market.
  • We also hold a neutral position within risk-free assets and a structural underweight/neutral position within credit.
  • We expect to retain our positioning until the economic impact of the Covid-19 virus becomes clearer.

Fixed income

We have seen an unprecedented, rapid response from Central banks. The Covid-19 crisis has led the US Federal Reserve to reduced rates too zero and in the UK to 0.25%. Even if these moves make a difference, there's not much more to be done in interest rate policy- which explains why there was no change in the ECB deposit rate of -0.5%.

The effective closing down of economies requires cash and liquidity to reach bars, restaurants, taxi firms, hire care companies, train companies and airlines. To name but a few. We expect affected economies to fall into recession. Global GDP forecasts are headed from 3% at the start of the year towards zero. The UK will see negative GDP, likely in Q2 and probably Q3, leading to a recession. Exact detail on how deep and for how long the recession lasts will become clearer but credit markets are fearful of 'deeper and longer'. Central Banks are facilitating the flow of cash throughout the system's plumbing but getting that cash needs fiscal imagination, which is already being revealed in Europe and in the UK no doubt soon.

The backdrop for government bonds should remain supportive

As in the financial crisis of 2008 we anticipate quantitative easing to pick up the GDP slack, so we are unlikely to see an increase supply in bonds pushing yields higher. The volatility in government markets is a function of their relative liquidity and an unwinding of cross-border holdings, which is typical in periods of extreme market stress. We believe government markets are unlikely to move materially higher in yields and the backdrop remains supportive for this asset class.

Investment grade spreads are now trading at, or beyond, levels last seen in the Eurozone crisis of 2012. We increased liquidity in portfolios in January and February as valuations looked rich, and in times of stress we seek to maintain this liquidity wherever possible. Whilst valuations viewed in isolation are, in many cases, approaching distressed levels – most evidently in subordinated financial paper – there is little confidence that we have seen the bottom yet, even if banks have far sounder footings than in 2008.

The willingness of central banks to inject liquidity and ease monetary policy is proven but the ability of governments to get ahead of the inevitable economic slowdown and support consumer demand very much remains in question. The drawing down of credit lines by well-rated corporates – such as Boeing, IHG (Hilton hotels) is indicative of a real fear of credit markets seizing up and corporates being unable to access liquidity. There remains a tangible concern about the ability of companies to generate revenues over the next three to six months against a backdrop of economic activity grinding to a halt.

Investment grade is about avoiding names with evident cash-flow uncertainty

The most immediately vulnerable corporates will continue to be those exposed to, or operating within, consumer, leisure and hospitality sectors. Avoiding names with evident cash flow uncertainty and retaining a preference for the utility sector (along with selected TMT issuers) still seems very appropriate. Banks are without question in a much better place from a capital perspective than they were during the financial crisis, although the market's brutal treatment of subordinated (and callable paper) will put a renewed focus on the willingness of some institutions to call their debt at the first opportunity. However, the reality is that there is little or no differentiation in the pricing of credit risk. Indeed, as we have seen liquidity challenged in some government bond markets, exploiting relative value opportunities will be reliant on a period of normalised liquidity, which seems some way from investment grade markets today.

High yield valuations may look appealing, but spreads are likely to widen further

Likewise, the high yield markets have suffered, mirroring our investment grade comments, and have seen a significant sell-off globally in a very short space of time. On a spread basis, global high yield now offers a government OAS of 833 basis points (for an effective yield of 8.9%), which is wide of all long-term average spread levels, and broadly comparable with the spread offered on the market at the peak of the 2015/2016 energy-led sell-off.

The headline valuation picture is appealing but we would caution that the impact of the COVID-19-induced slowdown is poorly misunderstood at best at this point in time, so it seems plausible that spreads could widen further (especially when viewed through the lens of the peak financial crisis spread levels).

The biggest casualties so far have been in lower-rated credits, and in the energy and cyclically-exposed sectors such as travel and leisure, but in truth no part of the market has been spared. The technical situation is very negative at this point in time, because although supply has been suspended for an indeterminate period of time, outflows from the asset class continue apace, and liquidity is being hoarded where possible by investors. Bid-side liquidity is therefore very much at a premium, and investors are in many cases opting to sell what they can, rather than what they would like. This leads to somewhat indiscriminate price action in the market that can potentially offer some opportunity at the correct moment in time. We are cautious on the market though and happy to bide our time here.

Securitized credit

As a consequence of the coronavirus outbreak we expect temporary volatility in the European ABS market on the back of substantial weakness in broader financial markets. We expect most pricing pressure on CLOs and CMBS, and to a lesser extent consumer ABS. From a fundamental perspective we expect the impact on our European ABS fund holdings to be limited.

CLOs will likely bear the heaviest impact of all structured credit sectors, however the investment-grade-rated tranches are well protected. Our European CLO holdings are mostly allocated to the senior part of the capital structure (AAA), with some holdings across the capital structure down to BBB. The underlying portfolios are well-diversified across countries and sectors. Having said that, broader and prolonged economic stress would eventually become visible in the portfolios. The sectors that are currently most exposed to weakness are airlines, oil & gas and hotels, gaming & leisure. Airlines are typically not present in CLOs and oil & gas only via companies not directly exposed to the oil price (such as gas station chains). Hotels, gaming & leisure is hence the only sector present in CLOs that we expect to be heavily impacted by the current coronavirus crisis. The current exposure to this sector in the portfolios of our CLO holdings is less than 7%. A typical BBB CLO holding can withstand very serious levels of stress, considerably beyond what could be expected even if the European economy for shut-down for a few months.

Our European ABS holdings have some exposure to Pan European CMBS. Our CMBS holdings are well diversified over both countries and regions. The majority of our investments are in the most senior tranche. As such, our CMBS investments have two layers of protection. The first is provided by the equity brought into the deal by the sponsor of the loan, and the second layer is credit enhancement provided by all tranches below our senior tranche.

This leads to very limited credit risk in our CMBS investments. Currently we have a very small allocation in CMBS-backed by Italian retail assets, which are again well diversified over the country. The coronavirus outbreak in (Northern) Italy is not expected to trigger immediate credit events, but we will keep a close eye on the scenario of a prolonged lockdown across Europe. However, in any such event we do not foresee any losses on our CMBS holdings.

Our European ABS holdings have a high allocation to consumer ABS (RMBS, Credit Card ABS etc.). Fundamentally for consumer ABS, we expect the impact of the coronavirus outbreak to be limited. We would foresee a rise in arrears as borrowers face temporary difficulties due to sickness or - temporary - unemployment. The extent of the rise will depend on the severity of the outbreak, which differs per geography; currently the impact will be largest in (Northern) Italy. We expect that the rise of delinquencies will lead to a reduction in excess spread but will by no means lead to losses on our investments.

Currencies

US dollar

The USD has recently experienced a sharp appreciation verses G10 currencies, the main reason for this was due to volatility in the money markets, which lifted USD carry, thereby raising the cost of dollar shorts. With limited liquidity in the market, investors are scrambling around for dollar assets, which in turn has supported the currency. The US Federal Reserve has attempted to alleviate the dollar funding stress, with a $700bn quantitative easing plan followed by establishing a commercial paper funding facility. We remains constructive on the USD in broad terms. However, safe-haven currencies with current account surpluses like JPY or CHF could strengthen against USD as the greenback loses the benefit of elevated interest rates

Sterling

Sterling has recently had a difficult time, as the currency has been the main casualty of the blow out in the FRA-OIS spreads (FRA-OIS spread is the difference between 3 month Libor (the inter-bank lending rate) and the overnight index rate (risk free rate set by central banks). The coordinated actions by global central banks and enhanced provision of liquidity should alleviate the pressure on GBP which has been disproportionality pressured recently. As such there is potential for GBP to bounce, although this is only tactical as it does not in any way represent any unwavering belief that the Brexit trade negotiations will be smooth. However, the overarching concern with sterling is the UK has a large current account deficit, and as such the currency is vulnerable in this environment.

Japanese Yen

We continue to think the yen will outperform as uncertainty remains elevated, the currency is cheap on various valuation measures and safe-haven demand will ultimately dominate. Even if risk stabilises or rebounds, there has been a fundamental change in the outlook, driven by shifts in monetary policy that will profoundly affect the behaviour of Japanese investors. With the Federal Reserve recently cutting interest rates to near zero, this means Japanese investors hedging costs will dramatically come down. Starting in mid-April the Japanese Life Insurers will publish investment plans for the full-year 2020-21. Given the cost of hedging has been cut, we expect to see a shift in behaviour from taking hedges off to putting hedges back on to overseas bond holdings, which will support the yen.

Euro

For some time the euro has been the main funding currency for emerging markets. As COVID-19 has increased volatility, investors have unwound their emerging market exposure and the euro has been the beneficiary. The ECB's decision not to cut deposit rates and to make TLTRO III highly accommodative is positive for the EUR. In addition the chances of a credible and aggressive fiscal response in Europe is rising, particularly given the market response to the ECB's failure to deliver a 'wow' factor on 12 March. Whilst these are all positive developments for the euro there risks remain against the US dollar, for example further widening in core versus non-core Eurozone sovereign spreads, which leads the market to price systematic risk. Secondly Fed actions fail to alleviate potential USD funding stress.

Global equities

Markets have been reeling from an unprecedented shock from the Coronavirus. Intervention from central banks and governments have had limited effect to date and been unable reduce the risk-off sentiment. Major US indices have suffered their largest one day declines over recent days as there are no clear indications that the outbreak can be controlled over the short-term.

The extent of damage to markets and global growth will depend on the speed of resolution to this issue and the level of global shut-down. Against this extremely challenging backdrop, expectations are being re-rated lower and an economic downturn by Q3 appears likely.

Nevertheless, we expect continued monetary and fiscal easing to help support the global economy and revive sentiment. Furthermore, the recent oil shock could boost balance sheets and consumptions once the outbreak subsides. We believe that now, more than ever, investing in companies with strong balance sheets and recurring income streams will be critical.

Regional markets

The US Federal Reserve cut interest rates to near zero at the start of the week whilst also announcing a fiscal stimulus package of around $7bn. Further intervention is expected with the US having no reached the peak of the virus yet. The US has been the most expensive equity market on a relative basis and the recent indiscriminate sell-offs do provide an opportunity for investors to rotate back into fundamentally strong businesses at more attractive valuations. This is particularly true at the mid-cap end of the market.

Coronavirus and oil will dominate fundamentals in the UK over the near term. Combined demand-destruction and supply-shock from coronavirus containment policies put significant downside risk to growth expectations. Prior to the virus outbreak, economic data had been showing signs of encouragement, with soft data such as PMIs and confidence surveys rebounding following the election. However, indicators are likely to weaken materially from here. Nonetheless, we take a positive view of the UK's coordinated fiscal and monetary policy response to the crisis.

We expect the eurozone to enter a recession but it is likely to take several months before this passes. Economic activity will be severely suppressed during that period, with fear and uncertainty resulting in a postponement of investments and consumption. Ultimately, we do not believe the short-term outlook is supportive for risky assets.

Sentiment remains negative for Japanese equities, with the country now in a recession. The economy contracted during Q4 and, given the current climate, is expect to contract further this quarter. Compared to other central banks, the Bank of Japan's response to the Coronavirus has not been viewed favourably. The economy is geared towards an increase in global growth and trade and is therefore in a precarious position.

With respect to emerging markets, GDP revisions have gone through major changes due to virus-related shocks. The market is fearing an economic recession alongside debt defaults, forced liquidations and policy error across the region. Sentiment has turned negative sharply in EM after a period of strong flows, but hasn't reached contrarian levels yet in our view. In terms of positives, China, South Korea and Taiwan – the biggest EM weight countries - have started to control the outbreak, whilst the recent oil price fall benefits Asian countries.

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