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The outbreak of the coronavirus falls under the study of complex systems. We are faced with reinforcing and rebalancing loops that occur in a continuous mode. Between January 20th and February 20th it was considered a Chinese problem. However, since last week it turned global as the virus spreads over Europe and the USA. If we listen carefully to medical experts, we learn that we should treat this outbreak as an influenza+ epidemic. But we aren’t. The culture of fear has been joined by another proponent: a biology (viral) one this time. The political, economic and climate related proponents were about to be given a better weight in the distribution of financial market risk premia. The COVID 19 virus has clearly pushed that agenda further into the future.
The culture of fear has only accelerated since the start of the millennium. The political establishment has given us all a master class over the past 20 years. Financial markets got fearful through the GFC of 2008/2009. Back then, it took almost two years to conquer the overall market rout. Central banks took the lead in stemming the liquidity and credit crunch as a balance sheet recession impacted households and companies. Highly activist global monetary policies were instrumental in pushing term premia into structural negative territory. This culminated in 10 year German rates hitting -70bp by the end of August 2019.
The COVID 19 episode has sent us back to square one i.e. the summer of 2019 in EMU government bonds. The difference today is that the US yield curve has caught up with US 10 year Treasuries dropping 80bp towards 1.12% since the start of 2020. So, what’s next ?
We expect that the market rout will be shorter than 2008-2009 alongside however a shallower recovery in risk assets. We do not expect central banks to play alongside the script of 2008-2009. The COVID 19 fear has pushed bond valuations to levels that call for a deep and global recession. We do not agree. We hold onto our call for monetary support expressed at the end of last year. We accept that central banks will alleviate for the tightening of financial conditions that occurred since the start of 2020. This translates into two policy rates cuts towards 1.00% by the US Fed in order to stem a modest US growth deceleration over 2020. For the ECB, we expect less action on rate cuts (due to the reversal rate which is not too far below current levels) and more action on balance sheet management. Balance sheet action might be reflected by increasing asset purchase program tilted towards corporate bond purchases or by increasing the multiplier on required EU bank reserves. The latter would insulate the banking sector in an unloved negative interest rate reality. Both should be spread supportive and at the margin push curves steeper and credit risk premia lower.
We essentially believe that central banks should refrain from taking the lead – by a US Fed for example cutting policy rates 4 times – as such behaviour might instil more financial market fear and instability. A supportive monetary response next to a responsible credible fiscal response is in order, as a means to support public and private investment initiatives. The coronavirus should act as a catalyst for more fiscal stimulus.
We observed a bull steepening of the US Treasury yield curve over the past week against a bull flattening tendency by the German yield curve. With a supportive but measured monetary response as our base case scenario, we expect that current valuations on core 10 year rates are not sustainable over H2 2020. Stickiness might be high over the next couple of months but growth fears might revert as swiftly as corona fears revert by April-May.
DPAM Fixed Income team remains agile and focused on portfolio robustness and smart diversification. A quick tour around the main areas of expertise provides the following summary:
EUR government bond witnessed a significant flight to quality dynamic, pushing core yields significantly lower and curves substantially flatter since early February 2019. Sovereign spreads took a beating due to pandemic fears from Covid19 on global growth and the lack of willingness/capabilities of markets to warehouse risk in the midst of the fastest equity sell-off on record. We have reduced the portfolio duration underweight in two steps during this period to limit the potential damage of a convexity/technical driven bund rally (as seen in Aug-19) and to incorporate the reduction in visibility on the type of recovery. In general, we feel that the recovery is certainly delayed but it is too soon to call it derailed. Our (market expectations-based) valuation models continues to indicate that core rates are both expensive and overbought. Hence we keep a (smaller) duration underweight going forward.
We remain positioned for a supportive EUR IG corporate bond environment that see tighter credit spreads on the back of supportive central banks that act in concert. Over the last week of February, we adhered to the prudence principle and reduced our UW duration. We turned the portfolio more defensive by purchasing Itraxx Main protection and by reducing our exposure to subordinated debt (insurance and LT2).
European and US high yield markets have been hit last week by an extreme sell-off. Both markets print negative YtD performances: European HY market by -2.08% and US HY by -1.38%. The European HY index is at the same level as it was in February 2019 and the US HY index close to the level it was at the start of the year 2019. Travel and automotive industries have been more affected than others by this risk-aversion. At current spread level, European HY is discounting a default rate of 29%, with a recovery rate of 40% for the next five years. This level corresponds to the market pricing a scenario like the 2000-2001 recession.
Global nominal and inflation linked bonds: medium to long term, we see rate convergence between higher rate markets (US, Canada, Australia, NZ, UK) towards lower rate markets (core of Europe, Japan). This convergence is likely to be more pronounced in risk-off markets. Hence, we overweight these markets versus core European and Japanese markets. In the short term, we see the potential for additional fiscal policy (combined with continued monetary effort) to boost growth and inflation. The COVID-19 impact is likely to increase the size of this fiscal stimulus and to bring it forward in time. So once the virus subdues, we can expect a recovery in rates, knowing that over the long term rates will remain subdued. We keep our short duration bias.
The tentative rise in inflation expectation over the past 6 months have been reversed to the low levels witnessed mid-2019. Investors are given another chance to increase inflation linked bond allocations at these attractive levels. Key risk scenario at the moment is that the COVID-19 impact stretches beyond a short-term problem and pushes the global economy towards a true recession (=credit and job destruction). This would put rates further down.
Emerging market government sector (Local Currency): the spike in risk aversion in February was pretty strong especially in EM FX. We acknowledge that some currencies have clearly entered oversold territories from a technical point of view. However it might be too soon to buy the dip as the virus is still spreading in Europe and the US. For now we keep our defensive stance and will wait for more clarity on demand and supply fallout before adding some risk. The EMD fund held up well thanks to its defensive positioning, meaning its exposure to high quality names and strong diversification.
Within our unconstrained global bond strategy, we were able to stick to our moderate duration profile around 5 years. Our long credit protection (Itraxx Crossover and US CDX HY) purchased early January and February dampened the late February shock. Across the board EUR strength versus DM and EM currencies and a revisit of break-even rates to summer 2019 levels brought us back to square one. Our longer term convictions are intact calling for higher inflation expectations as regionalization replaces globalization. Value increased in high quality AUD, NZD, CAD & SEK government bonds and a selection of carry rich EM government bonds. We stay put on our quality selection in financial and non-financial credit.
Within European convertible bonds, we discover a universe that is attractive in terms of implied volatility versus historical volatility after the equity sell-off. European convertible bonds performance has been resilient compared to the global convertible universe thank to a better credit quality. European equity valuation is attractive after the sell-off as the PE ratio came down to its 10 year average and very close to the PE of the end of 2018. Our convertible fund embeds an expected EPS growth of 6.6% for 2020. We include names that could attract M&A interests (Delivery Hero, Takeaway, Qiagen).
To conclude, we repeat that fear – translated as risk aversion within financial markets – has been a kingmaker for core government bond markets. We refrain from extrapolating such condition over the next cycle as central banks should take a backseat and give risk premia assessment back to financial markets. Markets evolve under the premise that the bond – equity correlation will remain deeply negative. Any correction in equity gets translated in higher price levels/lower rates in core bonds. This last episode might have brought us a step closer to the end of the negative correlation era. Entering a new era where episodes of positive correlation appear more often will require breaking the culture of fear.