Jim McDonald | Perspective - May 15, 2020
The rapidity of declines in both equity and credit markets over the last month has been of record pace, as investors have grappled with the uncertainty surrounding the economic impact of COVID-19 (coronavirus). In addition, the surprise oil price war between Saudi Arabia and Russia has pressured oil prices and the related energy company bonds and equities. Containment efforts look to be succeeding in the countries hit first (including China and South Korea), but Europe and the U.S. are now seeing an acceleration in cases and implementing containment efforts that will cause a sharp, but shortterm, hit to economic growth. The health risk of the coronavirus appears much worse than the seasonal flu, but also much less fatal than the prior coronavirus episodes of SARS and MERS. Our current expectation is to see an acceleration of cases across Europe and the U.S. for the next couple of months, with the potential for a plateauing by July or August.
We are focused on the upcoming policy responses from monetary, fiscal and health authorities. Monetary policy has been first out of the gate, with interest rate cuts and liquidity programs from the U.S. Federal Reserve and aggressive action from the Bank of England. The European Central Bank has been more measured in its actions so far, but monetary policy by itself won’t resolve this situation. Fiscal action to “bridge the gap” is necessary, and initial signs are forming of a response in the U.S. where neither party can afford to be obstructionist. Additionally, the European Commission is readying to suspend budget rules that would allow fiscal stimulus.
This leaves us with health policy as the final input, and developments will move quickly on this front. The U.S. has granted accelerated approval to new testing capabilities and it appears a potential vaccine may be going into testing in several weeks. Improved testing can help manage the current case load, while an effective vaccine will reduce the risk of a return next year. The next several months will deliver a lot of new information pertaining to the outlook, making significant portfolio moves at the present risky. In our global policy model, we modestly reduced exposure this month to developed ex-U.S. and emerging market equities, reallocating toward high yield and investment grade bonds. For our Goals Driven Wealth Management clients, we have activated portfolio reserves to fund current spending needs out of risk control assets. In the months ahead, we will pay special attention to policy actions (fiscal, health) and market action (credit spreads, asset price reaction to bad news) as we assess the outlook for risk-taking over our tactical horizon.
March has seen rapid declines in U.S. Treasury rates with some steepness reintroduced to the yield curve as the Fed made the surprise decision to cut policy rates by 0.5% in early March. Compounding the virus outbreak, the oil price war sent rates on government bonds to all-time lows with the yield on the benchmark 10-year Treasury briefly falling below 0.4% and the 30-year briefly hitting 0.7% – leaving the whole U.S. yield curve below 1% for the first time in history. Amid deeply unsettled markets, strong demand for central bank liquidity and massive demand for Treasuries led the Fed to increase the size of its repo operations.
As the virus intensifies, risk remains tilted to the downside and Treasury yields are likely to continue to rally. European government bond yields, already in negative territory, declined further with many reaching historic lows. Germany’s 10-year yield decreased 15 basis points (bps) to -0.8%, its 8th straight decline and lowest yield on record. Britain’s 10-year yield dipped seven bps to 0.1%, reaching its lowest on record with its 15th straight decline. The Bank of England made an emergency 0.5% cut in response to the virus. Central banks across the globe are pledging to do whatever is necessary to limit economic pain. Despite lower rates, we still like duration in this environment.
On March 9, the high yield market experienced its second largest decline in 15 years (-3.1%), alongside a nearly 8% decline in the S&P 500 and a $10 drop in the price of oil as an oil price war erupted between Saudi Arabia, Russia and U.S. shale producers. The high yield market widened nearly 100 bps on March 9, driven by the largest one-day widening on record for the energy sector. Issuer performance in this sector will continue to be idiosyncratic and security selection will be crucial.
The past two weeks have been incredibly volatile. As the graph shows, four of the six largest daily spread widenings of the credit cycle have occurred in this period. The market spread is now nearly double what it was at the beginning of the year. Based on the market liquidity premium and expectations for the future default rate, it appears the market is now wide of fair value, which may be supportive of risk assets. The market now offers investors a multi-year high of roughly 7.25% yield with a backdrop of coordinated global monetary policy, expected fiscal response to combat the impact of the coronavirus and a default rate (ex-energy) that is expected to stay below the long-term average. For these reasons, we increased the high yield allocation in our global policy model this month.
Global equities have retreated sharply over the past month as COVID-19 expanded its reach globally, leading to containment responses that threaten economic activity. Initial supply chain disruption in China and concerns about slowdowns for travel-oriented industries has evolved into a broader disruption of supply and demand. The uncertainty has led to few attempts to quantify the impact by companies and Wall Street analysts. As a result, consensus earnings expectations globally have barely budged despite now being unrealistic. Our new base case for 2020 earnings results in an 11% negative revision to the Street consensus, equating to a 5% decline versus 2019 – somewhat better than we expect outside the U.S.
The chart shows our sector-level framework for the U.S., including significant negative revisions in commodities and financial services (lower interest rates). We do believe a portion of the 2020 decline is a deferral of activity rather than a new baseline of earnings, suggesting 2021 earnings shouldn’t necessitate the same level of cuts. Near-term forecasting is challenging, but the resiliency of the U.S. economy, combined with monetary and fiscal support, should serve to limit further downside if the duration of the disruption is limited to a couple of quarters.
Global oil markets had already been pressured by demand issues related to COVID-19. And they saw another massive leg down as Saudi Arabia initiated a price war after being unable to agree to production cuts with Russia. Saudi Arabia – benefitting from a lower marginal cost of production – moved its production target to 13.0 million barrels/day from the prior target of 12.3 (and actual production levels of 9.7). Effectively, Saudi Arabia is signaling that if Russia doesn’t want to participate in deeper production cuts, the Saudis are willing to do whatever is necessary to make Russia feel the pain.
We believe the pressure on Russia to come back to the table and seriously talk about production cuts is rising, but slowly. Saudi Arabia does not appear willing to wait and do nothing, and will press the issue by unleashing a flood of oil by letting the OPEC-plus agreement expire on April 1. The volume of new crude coming to market over the next one-to-two quarters is estimated to be as high as 5 million barrels/day, which would more than offset possible buying for strategic petroleum reserves in the U.S. and China. An agreement could take the pressure off oil prices, but it is difficult to see prices rising back above $50/barrel given the demand overhang from COVID-19. We remain underweight natural resources as a result.
-Jim McDonald, Chief Investment Strategist
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