Prepare for pain, hope for relief

This week’s record-low yield for the most liquid barometer among global sovereign bonds, the 10-year Treasury note, illustrates the fear animating financial markets. The risk of a pronounced global economic shock is on the rise as more countries face a demand-and-supply hit, trampling all over an initial view that the coronavirus was pretty much a China problem.

After a bout of hefty selling in recent days, global equities found some stability on Tuesday. European equities pared early losses with the continent-wide Stoxx 600 closing flat, while Wall Street’s opening jump of 1.5 per cent faded after more warnings of greater disruption from US and German officials. Sovereign bond yields remain within sight of recent lows, led by the US 10-year benchmark, which touched a fresh low and briefly fell below 1.30 per cent for the first time. 

Here’s the latest tale of the tape for asset classes since the coronavirus outbreak in mid-January. 

The bigger picture suggests that haven buying in government bonds and gold, alongside the selling of cyclical sectors in equities, amounts to preparing for the worst-case scenario — ie, the coronavirus developing a substantial global footprint. The hope in the back of all minds is that such grim expectations are not fulfilled, paving the way for a reversal in havens and a rebound in the equity and credit markets that have endured the most pain. 

Here’s Paul O’Connor at Janus Henderson Investors:

“Given recent trends in the virus, and the general unpredictability of its future progress, it seems right to emphasise capital preservation and defensive strategies until the fog of uncertainty begins to lift, or until markets have repriced sufficiently to offer better risk/returns opportunities. This may take quite some time yet. Prepare for the worst — hope for the best.”

In order to call a floor in government yields and risk assets, investors will have to keep an eye on the rate of infections outside of China, as shown here via the CSSE at Johns Hopkins University. 

Now there is a twist should the coronavirus spread a lot faster through Europe and the US. While China can lock down entire cities via its authoritarian government and contain the spread of infections, current market anxiety reflects the difficulty of applying such methods in western countries. In turn, the pressure on risk assets has scope to feed on itself and knock broader confidence among businesses and consumers. 

As Oxford Economics warns:

“Tightening financial conditions have added a new dimension to the coronavirus outbreak. The economic impact to the US and global economy was believed to be mostly contained last week, but rising volatility, plunging stock prices, and a strengthening dollar will likely exacerbate the economic shock on the US economy.”

Its analysts add: 

“Assuming the pandemic scenario doesn’t unfold, our upcoming baseline will feature 2020 US GDP growth of 1.5% and Q1 growth of only 0.3%.”

Alan Ruskin at Deutsche Bank highlights the fallout from a dual demand-and-supply shock: 

“Just-in-time global supply chains will present unique production challenges. Work place disruption, trade interlinkages, business uncertainties, profit warnings, inability to pay, and capacity to service credit are all related supply-side issues that, in turn, generate demand effects on employment/hours worked, disposable income, wealth and confidence effects.”

Some, such as Nouriel Roubini, believe the worst is yet to come for risk assets, writing in the FT that “investors are deluding themselves about how severe the coronavirus outbreak will be”. 

From a long-term perspective, buying a 10-year Treasury is hardly compelling value unless you really think an Ice Age is coming for the global economy. Yields can fall further for a while yet, with additional equity sell-offs seen by traders pulling the 10-year Treasury yield below 1.20 per cent.

That region could well mark the floor in yields before hope registers. It’s worth noting that key equity benchmarks such as the S&P 500 and Europe’s Stoxx 600 are within sight of a 10 per cent decline from recent peaks, usually the kind of pullback that does attract buyers, as seen in early 2018. 

Trevor Greetham at Royal London Asset Management says they are buying the dip in equities and notes: 

“As longer-term investors we find it usually pays off to look on the bright side when others are panicking. Virus disruption is very unlikely to force the world economy into recession. We expect to see a large but temporary hit to economic activity followed by a bounce back later in the year that additional stimulus could make stronger than it otherwise would be.”

As Brad Bechtel at Jefferies reminds us:

“If and when the virus issue passes we are going to end up in a world with a lot more liquidity in it than we had even just four months ago. Central banks and governments are going to throw everything they can at this one.”

Also on the hope side of the ledger is how US inflation expectations for the next decade are not hitting new lows. The US 10-year break-even inflation rate is currently around 1.55 per cent, still above October’s low of 1.47 per cent and the China growth scare of 2016, when this measure plumbed 1.20 per cent. A deflationary shock is not driving the decline in US Treasury yields; this is really about investors selling equities and credit, and piling instead into liquid haven assets for now.

But that only highlights the importance of China not allowing its renminbi to weaken much beyond its current area of Rmb7 per dollar. If Beijing holds this line, it will not provoke the US via a weaker renminbi (in light of the recent trade deal) or prompt the risk of capital flight at such a delicate time for China’s economy.

But as China’s trade partners gain a currency edge, a steady renminbi will also act against Beijing’s stimulus efforts. A weaker renminbi in the coming weeks would raise the prospect of a deflationary shock beckoning for the global economy and in turn drive US and other government bond yields lower. 

That risk and further downward price pressure on credit markets, oil and commodities will test equity sentiment. The good news for now is that global equities remain some 8 per cent above last summer’s lows when bond yields were previously sending a recession warning. The US and China trade deal and expectations of a firmer global economy in 2020 triggered quite a rally from October.

As Nick Colas at DataTrek notes, one question for the market when assessing the extent of losses for the S&P 500, is whether the coronavirus cancels out the hope that flowered late last year: 

“If one assumes that the global economic effects of Covid-19 are a wash with the US and China signing a phase-one trade deal (the cause of Q4’s global equity rally), then US large-cap stocks still have 5% further downside since Q3 2019’s S&P 500 close was 2,977.Also, lower rates are not likely to help valuations in the near term because they discount the very real possibility of recession.”

Quick Hits — What’s on the markets radar

Relegation battles are not just a challenge for football clubs, with the UK’s FTSE 100 blue-chip equity index is set for a quarterly shuffle of its constituents. 

Russ Mould at AJ Bell notes:

“NMC Health is already doomed to demotion” while “travel agent Tui, retailer Kingfisher and grocer Morrisons are teetering on the verge of the drop into the FTSE 250”.

Russ says others are not safe from entering the drop zone:

“With markets looking volatile, last-minute changes ahead of the reshuffle deadline on 3 March could also put recent entrant Just Eat, Takeaway.com, Hikma, Centrica, Meggitt and even profit-warning plagued Pearson in danger.”

The Korean won has depreciated to its weakest level versus the US dollar since 2016. The country’s central bank meets on Thursday when “they are expected to cut rates 25bp to a record low 1.0% as a result of the coronavirus”, notes Brown Brothers Harriman.

Alongside the Australian dollar, Korea’s currency is a barometer of the outbreak. As such, a rebound in the won would be among the all-clear signals, given that the country plays an integral role in the global supply chain.

Source: Economy - ft.com