As the coronavirus spreads throughout the global population, it has also infected global asset markets. Risk assets have seen a significant correction, with both US and European stocks dropping more than 10% in less than two weeks. Last week alone it erased US$6 trillion in equity market cap, while the defensive bid has pushed long-end US Treasury yields to all-time lows.
Given only the guarantee of uncertainty, what we do know is that the damage being done has created the launch pad for the next up-wave once the virus is defeated. Preserving capital in the downdraft to enable participation on the recovery will be vitally important.
When analyzing the effect of exogenous macro shocks like this, it is imperative to focus on two key elements: 1) the environment at the starting point and 2) the magnitude of the impact of said event.
The starting point consisted of relatively limited downward revisions to global economic growth, with expectations of growth to hover around 3% this year. But in coming weeks, the predictions of local and even of a global recession may gain traction. The world is now facing an economic shock; a combination of disrupted trade and manufacturing flows, a drop in global business and leisure travel, and the possibility of a decline in consumer spending and business investments. We are seeing more tangible effects as we trade one uncertainty, trade in 2019, for another, supply chain issues related to the coronavirus. Numerous companies have already made negative revisions to their financial guidance. The growing risk is one of a global shut-in (i.e., health fears negatively affects personal and corporate activity that retards aggregate output).
In terms of quantifying the magnitude of effect, current economic forecasts must be heavily discounted and are changing by the day. Hard data released by governments is virtually meaningless at this point because it lags and thus, doesn't contain any of the virus-induced pullback in activity. Thus, the focus turns to more timely soft data like surveys and company updates. If perception becomes reality, then any meaningful trough in the plunging sentiment could start a bottoming-out process. Until then, a defensive posture towards risk is likely to remain.
Longer term, given that the main catalyst of current market events is an exogenous shock rather than a systemic imbalance, we believe that the more economic activity is suppressed, the larger the eventual rebound. To that point, we acknowledge the growing possibility that our 1.8% US GDP forecast for 2020 will prove too high and our 1.6% US GDP forecast for 2021 too low. For the eurozone, we expect the coronavirus will push growth below 1%, as it is most vulnerable to trade disruptions, while the major economies Germany and Italy are close to a technical recession with two quarters of negative or near-zero growth.
As fears of the coronavirus manifested themselves with equity markets selling off in one of the most rapid declines in history, US Treasury yields fell dramatically and market expectations grew for the Federal Open Market Committee (FOMC) to step in. It did so by cutting its benchmark rate by half a percentage point. This is the first time since 2008 that the Fed has cut rates before its monthly meeting. Ten-year Treasury yields are currently hovering around 1.03% and two-year yields are around 0.75%. Although the timing of this cut was a bit of a surprise, the market had already priced in a 50 basis point reduction in the federal funds rate by April, and another 50 by the end of the year.
We are starting to see a response from monetary and fiscal authorities to avoid a further deterioration of the economic outlook. The ECB will find it more difficult to come up with a new stimulus plan before its next meeting on March 12. It is currently busy with reassessing its inflation target and now has to scramble to come up with a proper answer to the crisis. Cutting the official rate further below zero will probably do more damage than it will help the eurozone economy. We also believe it will take more time for Lagarde to gather support within the board for other measures, such as increasing the existing QE program.
Besides more rate cuts from central banks globally, we expect considerable support through expansive fiscal policies. China is leading the way and has ample opportunities to extend its stimulus program. It is still an open question whether the eurozone will follow the Asian example. The European Commission and the ECB would certainly like to see a major spending spree from (Northern) European countries as well as an expanding European Union budget. Thus far, such plans have been vetoed by the Northern European block, but once the coronavirus crisis starts to hurt these countries, we should expect a turn of the fiscal stance of these countries as well.
The uncertainty associated with the virus has sidelined the US primary market, and pushed spreads in the secondary market significantly wider. Investment grade credit spreads are wider to levels seen last October. Until we see stabilization in the market, the primary calendar is likely to continue to build, making the eventual return even busier and possibly requiring bigger concessions. In the secondary market, according to the Bloomberg Barclay's US Credit Index, we have seen a sell-off in credit spreads. The last twelve month (LTM) range of option-adjusted spreads (OAS) is 89-122 basis points. This sell-off has taken spreads from the recent tights to the middle of the range at 110 OAS. The sectors impacted the most have been those most closely tied to the global growth recovery, such as the energy and automotive sectors. Investors have been discouraged from buying into weakness thus far as US dollar prices overall haven't sold off much due to the collapse in US Treasury yields.
US high yield was hardly immune from the broader risk-off move. After holding in early on, fears about the lingering effects of the coronavirus and its ultimate influence on economic disruption lead to bond prices moving aggressively lower by the end of last week. High yield spread levels have widened materially with higher-quality credit holding in modestly better than lower quality. Yields have pushed higher as well with the yield-to-worst moving from near 5% to 6%, according to the Bloomberg Barclays US High Yield Index. The significant move lower in rates has helped limit the move higher in yields. Sectors under the most pressure include a number of consumer-related areas (automotive, leisure and gaming), airlines and transportation service, and most notably, energy. With the significant move lower in West Texas Intermediate crude pricing, the sector as a whole has seen some of the most dramatic price moves. The primary market was closed last week with a handful of deals getting pushed until the market sees some stabilization.
Private label securitized—asset-backed securities (ABS), commercial mortgage-backed securities (CMBS), non-agency residential mortgage-backed securities (RMBS)—sectors were not immune to the risk-off environment, but spreads held in relatively well compared to broader risk assets. Credit curves steepened across sectors and spreads widened more materially in sectors most directly impacted by the coronavirus such as aircraft asset-backed securities. We expect overall activity to increase somewhat over the coming weeks, but continued volatility could lead to a build-up on the issuance calendar. Given the more severe spread widening in markets away from securitized, the relative value offered in the securitized market is less apparent. But we continue to expect securitized to outperform other asset classes during periods of increased volatility as well as through the next downturn given the underlying fundamentals and strong deal structures.
We have three main views which we believe are worth watching that emanate from the coronavirus: direct linkage through trade, the impact to commodity prices, and the threat of general aversion to riskier assets. Fortunately, much of the emerging market debt (EMD) investments in the Asian region consist of high-quality investment grade credits. Sub-investment grade EMD, especially the property sector, is expected to have a more difficult outcome and is a segment in which we urge caution.
Regarding commodity prices, specifically oil, we believe it will likely remain a difficult environment for oil exporting sovereigns/corporates. Many were boosted by the jump in oil prices in January following the attack on Soleimani in Iraq; however, the buildup of stocks due to the growth concerns, as well as the supply imbalance, are expected to keep prices low during this period.
The markets are likely to express general caution around the growth impacts. The likelihood that the coronavirus warnings will increase should be viewed with caution. While EMD has held up reasonably well, aided by the flight to quality in US Treasurys, the risk of further spread widening is possible if the virus is upgraded to a pandemic.
Overall, we have seen USD-denominated EM corporates hold up better than USD-denominated EM sovereigns, which is leading to a potential opportunity. EM FX could likely be the most opportune investment, but again, entry is likely not now, but upon further weakening or more clarity on the spread of the virus.
As mentioned, global equity markets went through a rough patch in the last two weeks as investors liquidated positions. In the last two quarters, equity markets rose to new records as the initial trade deal between China and the US was sealed, and the Fed continued its loose monetary policy. As a result, equity valuations were becoming a potential issue, especially technology stocks. The market correction helps mitigate these valuation concerns, but we note that earnings growth will take a big hit in the coming quarters. Central bank stimulus will continue to support equity markets, but we might see a further drop in coming weeks if the news on the virus worsens and investors panic.
Once the coronavirus is under control, we may see a significant rebound in economic activity. It will take time for monetary and fiscal policies to add to growth, but once it does, we contend that it will strengthen the economic rebound further. Ironically, the dissipating effect of the virus in combination with such measures might result in a global economic growth level higher than before we were hit with the coronavirus. We may even see a classic V-shaped recovery of the world economy after a short period of depressed economic numbers. In the meantime, volatility will remain elevated on financial markets as investors respond to the virus headlines.
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