Euro Area
Unsurprisingly, European consumer confidence has declined sharply as a result of lockdown measures required to contain the spread of COVID-19. The GfK survey in Germany fell from 8.3 to 2.7, much worse than the consensus expectation of 7.1, and close to…
Highlights The pillars of dollar support continue to fall, but the missing catalyst is visibility on the trajectory of global growth. For now, we remain constructive on the DXY short term, but bearish longer term. Market internals and currency technicals have become supportive of pro-cyclical trades in recent days. There is tremendous value in the Norwegian krone, Swedish krona and British pound. Buy a basket of NOK and SEK against a basket of USD and EUR. Feature Markets are getting some semblance of calm after being flooded with vast amounts of monetary and fiscal stimulus. The DXY index, having breached the psychological 100 level, failed to break above 103, and is now in a volatile trading pattern of lower intra-day highs. The message is that the Federal Reserve’s injection of liquidity, along with generous USD swap lines for major central banks, has eased the funding crisis (Chart I-1).1 All eyes will now begin to focus on fiscal support, especially from the US. As we go to press, US leaders have agreed to a $2 trillion fiscal package. As we highlighted last week, a central bank cannot do much about an economy in a liquidity trap, but governments can step in and be spenders of last resort. While fiscal stimulus is a welcome catalyst, the impact on the economy is likely to be felt a bit later. More importantly, until the number of new Covid-19 cases peak, the global economy will remain in shutdown, and visibility on the recovery will be opaque (Chart I-2). This provides an air pocket in which the dollar can make new highs, especially if the slowdown is not of a garden variety, but a deep recession. Chart I-1A Shortage Of Dollars Chart I-2Some Reason For Optimism We continue to monitor the behavior of market internals and currency technicals to gauge a shift in market dynamics. Both liquidity and valuation indicators are USD bearish, but as a momentum currency, the dollar will benefit from any signs we are entering a more protracted slowdown. In this report, we use a simple framework for ranking G10 currencies – the macroeconomic environment, valuation and sentiment. There has been a tectonic shift in currency markets over the last few weeks which has uncovered some very compelling opportunities. This is good news for investors willing to stomach near-term volatility. In short, we like the pound, Swedish krona and Norwegian krone. Are Policy Actions Enough? Chart I-3The Dollar And Interest Rates Diverge There has been an unprecedented wave of monetary and fiscal stimulus announced in recent weeks.2 This should eventually backstop economic activity. Below we highlight a few key developments, along with our thoughts. USD: The Fed has cut interest rates to zero and announced unlimited QE. As we go to press, a $2 trillion fiscal package has been passed. This represents a much bigger monetary and fiscal package compared to the 2008 Great Recession. The near-term impact will be to boost aggregate demand, but the massive increase in the supply of dollars should lower the USD exchange rate. As a rule of thumb, lower interest rates in the US have usually been bearish for the currency (Chart I-3). EUR: The European central bank has announced a €750 billion package effectively backstopping the peripheral bond market. The good news is that the structural issues in the periphery are much less pronounced than during the 2010-2011 crisis. This is positive for the euro over the longer term, as cheaper funding should boost capital spending and productivity. GBP: The Bank of England has cut interests to almost zero and expanded QE. Meanwhile, there has been an intergenerational shift in the pound. The lesson from the imbroglio in British politics since 2016 is that cable at 1.20 has been the floor for a “hard Brexit” under normal conditions. This makes the latest selloff an indiscriminate liquidation of the pound. On a real effective exchange rate-basis, the pound is close to two standard deviations below its mean since 1965. On this basis, only two currencies are cheaper: the Norwegian krone and Swedish krona. AUD: The Reserve Bank Of Australia cut interest rates to 25 basis points and has introduced QE. The Aussie is now trading below the lows seen during the Great Financial Crisis. This suggests any shock to Aussie growth will have to be larger than 2008 to nudge the AUD lower. CAD: The Bank Of Canada has cut rates to 75 basis points and introduced a generous fiscal package. More may be needed if the downdraft in oil prices persists beyond the near term. We highlighted a few weeks ago how the landscape was rapidly stepping into one of competitive devaluations.3 We can safely assume that we are already into this zone. One end result of competitive devaluations is that as interest rates converge to zero, relative fundamentals resurface as the key drivers of currency performance. In short, the last few weeks have seen long bond yields converge in the developed world (Chart I-4). That means going forward, picking winners and losers will become as much a structural game as a tactical one. From a bird’s eye view, below are a few key indicators we are monitoring. Chart I-4The Race To Zero G10 Basic Balances Chart I-5CHF, EUR, AUD and NOK Are Supported The basic balance captures the ebb and flow of demand for a country’s domestic assets. Persistent basic balance surpluses are usually associated with an appreciating currency, and vice versa. This is especially important since the rise in offshore dollar funding has been particularly pernicious for deficit countries. Switzerland sports the best basic balance surplus in the G10 universe, followed by the euro area, Australia and then Norway (Chart I-5). Surpluses imply a constant underlying demand for these currencies - either for domestic goods and services or for investment into portfolio assets. The UK and the US rank the worst in terms of basic balances. As for the UK, the basic balance deficit explains why the recent flight to safety hit the pound particularly hard. Net International Investment Position Both Switzerland and Japan have the largest net international investment positions. These tend to buffet their currencies during crises, since foreign assets are liquidated and the proceeds repatriated home. This is at the root of their status as safe-haven currencies. There has been structural improvement in most G10 net international investment positions, especially compared to the US (Chart I-6). Should the returns on those foreign assets be sufficiently high, this will lead to income receipts for surplus countries, providing an underlying boost for their currency. Chart I-6Structural Increase In G10 NIIP Interest Rates The race to the zero bound has pushed real interest rates into negative territory for most of the developed world. This has also greatly eroded the yield advantage of the US dollar against its G10 peers (Chart I-7). Within the G10 universe, the commodity currencies (Aussie, kiwi and loonie) have become the high yielders in real terms. This yield advantage should help stem structural depreciation in their currencies. Chart I-7Most Of The G10 Has Negative Real Rates Valuation Models One of our favored valuation models for currencies is the real effective exchange rate. The latest downdraft in most G10 currencies has nudged them between one and two standard deviations below fair value (Chart I-8A and Chart I-8B). According to the BIS measure, the Norwegian krone and Swedish krona are currently the cheapest currencies, with the krone trading at more than three standard deviations below its mean fair value. Chart I-8ASome G10 Currencies Are Very Cheap Chart I-8BSome G10 Currencies Are Very Cheap Most importantly, despite the recent rise in the US dollar, it is not yet very expensive. The trade-weighted dollar will need to rise by 8% to bring it one standard deviation above fair value. This was a definitive top in the early 2000s. This rise will also knock the euro lower and push many pro-cyclical currencies into bombed-out levels, making them even more attractive over the long term. Chart I-9NOK and SEK Are Deeply Undervalued Other valuation measures corroborate this view: Our in-house purchasing power parity (PPP) models show the US dollar as only slightly overvalued, by 7%. These models adjust the CPI baskets across countries so as to get closer to an apples-to-apples comparison. The cheapest currencies according to the model are the SEK, NOK, AUD and GBP (Chart I-9). The yen is more attractive than the Swiss franc as a safe-haven currency. Our intermediate-term timing models (ITTM) show the dollar as fairly valued. The main ingredients in these models are real interest rate differentials and a risk factor. On a risk-adjusted return basis, a dynamic hedging strategy based on our ITTMs has outperformed all static hedging strategies for all investors with six different home currencies since 2001. According to these models, the Australian dollar and Norwegian krone are the most attractive currencies, while the Swiss franc is the least attractive. Our long-term FX models are also part of a set of technical tools we use to help us navigate FX markets. Included in these models are variables such as productivity differentials, terms-of-trade, net international investment positions, real rate differentials, and proxies for global risk aversion. These models cover 22 currencies, incorporating both G10 and emerging market FX markets. According to these models, the US dollar is at fair value (mostly against the euro), but the yen, the Norwegian krone and the Swedish krona are quite cheap. In a forthcoming report, we will show how valuation can be used as a tool to enhance excess returns in the currency space. For now, the universal message from our models is that the cheapest currencies are the NOK, SEK, AUD and GBP. Speculative Positioning Chart I-10Speculators Have Been Taking Profits Our favorite sentiment indicator is speculative positioning. More specifically, positioning is quite useful when it is rolling over from an overbought or oversold extreme. Being long Treasurys and the dollar has been a consensus trade for many years now (Chart I-10). According to CFTC data, this has been expressed mostly through the aussie and kiwi, although our bias is that the Swedish krona and Norwegian krone have been the real victims. The key question is whether the unwinding of dollar long positions we have seen in recent days reflects pure profit-taking, or represents a fundamental shift in the outlook for the greenback. Our bias is the former. Net foreign purchases of Treasurys by private investors have reaccelerated anew. Given the momentum of these purchases tends to be persistent over a six-month horizon, it is too early to conclude that dollar gains are behind us. That said, speculative positioning has also uncovered currencies in which investor biases are lopsided. This includes the Australian and New Zealand dollars. Currency Rankings And Portfolio Tweaks The depth and duration of the economic slowdown remain the primary concern for most investors. Should the world economy see a more protracted slowdown than in 2008, then more gains lie ahead for the greenback. This is on the back of a currency that is not too expensive, relative to history. That said, there have been a few currencies that have been indiscriminately sold with the global liquidation in risk assets. These include the Norwegian krone, the British pound and the Swedish krona, among others. To reflect the fundamental shift in both valuation and sentiment indicators, we are buying a basket of the Scandinavian currencies against a basket of both the dollar and euro. Finally, our profit targets on a few trades were hit, and we were stopped out of a few. Please see our trading tables for the latest recommendations. Appendix Table I-1 Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “The Dollar Funding Crisis”, dated March 19, 2020, available at fes.bcaresearch.com. 2 Please refer to Appendix Table 1. 3 Please see Foreign Exchange Strategy Weekly Report, titled “Are Competitive Devaluations Next?”, dated March 6, 2020, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been negative: The Markit manufacturing PMI dropped to 49.2 while the services PMI tanked to 39.1 from 49.4 in March. Initial jobless claims hit 3.3 million, a record high, in the week ended March 20. Nondefense capital goods orders, excluding aircraft, shrank by 0.8% month-on-month in February. The DXY index depreciated by 2.6% this week. The US Senate passed a $2 trillion economic relief package, which is now pending approval by the House. The bill includes direct payments to individuals, US$350 billion in loans to small businesses and investments in medical supplies. The Fed has created a backstop for investment grade bonds by vowing to purchase as many securities as needed to prop up the market. Report Links: The Dollar Funding Crisis - March 19, 2020 Are Competitive Devaluations Next? - March 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative: ZEW economic sentiment crashed to -49.5 from 10.4 while consumer confidence fell to -11.6 from -6.6 in March. The Markit manufacturing PMI decreased to 44.8 from 49.2 while the services PMI tumbled to 28.4 from 52.6 in March. This pulled the composite index down to 31.4 from 51.6 in March. The current account increased to EUR 34.7 billlion from EUR 32.6 billion while the trade balance fell to EUR 17.3 billion in January. The euro appreciated by 2.4% against the US dollar this week. ECB President Lagarde argued for the one-off issuance of “coronabonds,” a shared debt instrument among member economies that pools risk and lowers lending costs for the more indebted nations affected by the pandemic. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanse Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: The Jibun bank manufacturing PMI fell to 44.8 from 47.8 in March. The coincident index increased to 95.2 from 94.4 while the leading index fell to 90.5 from 90.9 in January. Imports shrank by 14% while exports shrank by 1% year-on-year in February. The Japanese yen appreciated by 0.9% against the US dollar this week. As expected, the Tokyo Olympics were postponed, striking a further blow to economic activity and the tourism sector. The government is considering a JPY 56 trillion stimulus package that includes cash payments to households and subsidies for small businesses, restaurants and other tourist-related sectors. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been negative: The Markit manufacturing PMI declined to 28 from 51.7 while the services PMI collapsed to 35.7 from 53.2 in March. Retail sales contracted by 0.3% month-on-month in February from an increase of 1.1% in January. Headline CPI grew by 1.7% year-on-year in February. The public sector net borrowing deficit shrank to GBP 0.4 billion from GBP 12.4 billion in February. The British pound appreciated by 4.3% against the US dollar this week. The Bank of England (BoE) left rates unchanged at 0.1% and decided to continue purchases of UK government bonds and nonfinancial investment grade bonds, bringing the total stock to GBP 645 billion. The BoE has stated that it can expand asset purchases further if needed. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been negative: The Commonwealth bank manufacturing PMI decreased slightly to 50.1 while the services PMI plunged to 39.8 from 49 in March. The house price index grew by 3.9% quarter-on-quarter from 2.4% in Q4. Unemployment decreased slightly to 5.1% in February. The Australian dollar appreciated by 5.1% against the US dollar this week. The government pledged an additional A$64 billion package, bringing total stimulus to 10% of GDP. The package includes assistance for individuals and small businesses impacted by the virus. Prime Minister Morrison said that more stimulus, including direct cash handouts to households, is likely to be announced over coming weeks. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Exports increased to NZD 4.9 billion, imports shrank to NZD 4.3 billion and the monthly trade balance showed a surplus of NZD 593 billion. Credit card spending grew by 2.5% in February from 3.7% the previous month. The New Zealand dollar appreciated by 4.2% against the US dollar this week. The RBNZ turned to quantitative easing and announced the purchase of up to NZ$30 billion of government bonds, at a pace of NZ$750 million per week. The government announced fiscal stimulus of just over NZ$12 billion that includes wage subsidies for businesses, income support, tax relief and support for the airline industry. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: Headline CPI grew by 2.2% year-on-year in February. Retail sales excluding autos fell by 0.1% month-on-month in January, compared to growth of 0.5% the previous month. Wholesale sales grew by 1.8% month-on-month in January from 1% the previous month. Jobless claims soared to 929 thousand in the week ended March 22, representing almost 5% of the labor force. The Canadian dollar appreciated by 2.8% against the US dollar this week. The government approved a C$107 billion stimulus package that includes payments of C$2,000 per month to individuals unemployed due to Covid-19 and C$55 billion in deferred tax payments for businesses and individuals. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: Producer and import prices contracted by 2.1% from 1% year-on-year in February. ZEW expectations sank to -45.8 from 7.7 in March. Imports fell to CHF 15.7 billion from CHF 16 billion while exports fell to CHF 19.2 billion from CHF 20.7 billion in February. The Swiss franc appreciated by 1.6% against the US dollar this week. The Swiss government proposed stimulus worth CHF 32 billion, bringing total stimulus to 6% of GDP. The package will largely consist of bridge loans to small- and medium-sized businesses, social insurance and tax deferrals. The SNB also set up a refinancing facility to provide liquidity to banks. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: The trade balance declined to 18.3 billion from 21.2 billion in February. Norwegian unemployment soared to 10.9% in March, the highest level since the Great Depression. The Norwegian krone appreciated by 7% against the US dollar this week. The Norges Bank cut rates from 1% to a record low of 0.25%, citing worsening conditions since the 50 basis point cut on March 13. Parliament approved loans, tax deferrals, and extra spending worth NOK 280 billion. The government expects private-sector activity to contract by 15-20% in the near-term. The government will likely need to draw on its sovereign wealth fund to finance spending. Report Links: Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: The producer price index contracted by 1.2% year-on-year in February, deepening from 0.4% the previous month. Consumer confidence dropped to 89.6 from 98.5 in March. The trade balance grew to SEK 13.2 billion from SEK 11.8 billion in February. The unemployment rate rose to 8.2% from 7.5% in February. The Swedish krona appreciated by 3.5% against the US dollar this week. The Swedish government bucked the lockdown strategy, choosing to keep businesses open during the pandemic. In addition, the government announced stimulus measures of up to SEK 300 billion, which includes relief for employees that have been laid off or taken sick leave. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights The pandemic has a negative impact on households and has not peaked in the US. But a depression is likely to be averted. Our market-based geopolitical risk indicators point toward a period of rising political turbulence across the world. We are selectively adding risk to our strategic portfolio, but remain tactically defensive. Stay long gold on a strategic time horizon. Feature I'm going where there's no depression, To the lovely land that's free from care. I'll leave this world of toil and trouble My home's in Heaven, I'm going there. - “No Depression In Heaven,” The Carter Family (1936) Chart 1The Pandemic Stimulus Versus The Great Recession Stimulus Markets bounced this week on the back of a gargantuan rollout of government spending that is the long-awaited counterpart to the already ultra-dovish monetary policy of global central banks (Chart 1). Just when the investment community began to worry about a full-fledged economic depression and the prospect for bank runs, food shortages, and martial law in the United States, the market rallied. Yet extreme uncertainty persists over how long one third of the world’s population will remain hidden away in their homes for fear of a dangerous virus (Chart 2). Chart 2Crisis Has Not Verifiably Peaked, Uncertainty Over Timing Of Lockdowns Chart 3The Pandemic Shock To The Labor Market While an important and growing trickle of expert opinion suggests that COVID-19 is not as deadly as once thought, especially for those under the age of 50, consumer activity will not return to normal anytime soon.1 Moreover political and geopolitical risks are skyrocketing and have yet to register in investors’ psyche. Consider: American initial unemployment claims came in at a record-breaking 3.3 million (Chart 3), while China International Capital Corporation estimates that China’s GDP will grow by 2.6% for the year. These are powerful blows against global political as well as economic stability. This should convince investors to exercise caution even as they re-enter the equity market. We are selectively putting some cash to work on a strategic time frame (12 months and beyond) to take advantage of some extraordinary opportunities in equities and commodities. But we maintain the cautious and defensive tactical posture that we initiated on January 24. No Depression In Heaven The US Congress agreed with the White House on an eye-popping $2.2 trillion or 10% of GDP fiscal stimulus. At least 46% of the package consists of direct funds for households and small businesses (Chart 4). This includes $290 billion in direct cash handouts to every middle-class household – essentially “helicopter money,” as it is financed by bonds purchased by the central bank (Table 1). The purpose is to plug the gap left by the near complete halt to daily life and business as isolation measures are taken. A depression is averted, but we still have a recession. Go long consumer staples. Chart 4The US Stimulus Package Breakdown Table 1Distribution Of Cash Handouts Under US Coronavirus Response Act China, the origin of the virus that triggered the global pandemic and recession, is resorting to its time-tried playbook of infrastructure spending, with 3% of GDP in new spending projected. This number is probably heavily understated. It does not include the increase in new credit that will accompany official fiscal measures, which could easily amount to 3% of GDP or more, putting the total new spending at 6%. Germany and the EU have also launched a total fiscal response. The traditionally tight-fisted Berlin has launched an 11% of GDP stimulus, opening the way for other member states to surge their own spending. The EU Commission has announced it will suspend deficit restrictions for all member states. The ECB’s Pandemic Emergency Purchase Program (PEPP) enables direct lending without having to tap the European Stability Mechanism (ESM) or negotiate the loosening of its requirements. It also enables the ECB to bypass the debate over issuing Eurobonds (though incidentally Germany is softening its stance on the latter idea). The cumulative impact of all this fiscal stimulus is 5% of global GDP – and rising (Table 2). Governments will be forced to provide more cash on a rolling basis to households and businesses as long as the pandemic is raging and isolation measures are in place. Table 2The Global Fiscal Stimulus In Response To COVID-19 President Trump has signaled that he wants economic life to begin resuming after Easter Sunday, April 12. But he also said that he will listen to the advice of the White House’s public health advisors. State governors are the ones who implement tough “shelter in place” orders and other restrictions, so the hardest hit states will not resume activity until their governors believe that the impact on their medical systems can be managed. Authorities will likely extend the social distancing measures in April until they have a better handle on the best ways to enable economic activity while preserving the health system. Needless to say, economic activity will have to resume gradually as the government cannot replace activity forever and the working age population can operate even with the threat of contracting the disease (social distancing policies would become more fine-tuned for types of activity, age groups, and health risk profiles). The tipping point from recession to depression would be the point at which the government’s promises of total fiscal and monetary support for households and businesses become incapable of reassuring either the financial markets or citizens. The largest deficit the US government has ever run was 30% of GDP during World War II (Chart 5). Today’s deficit is likely to go well beyond 15% (5% existing plus 10% stimulus package plus falling revenue). If authorities were forced to triple the lockdown period and hence the fiscal response the country would be in uncharted territory. But this is unlikely as the incubation period of the virus is two weeks and China has already shown that a total lockdown can sharply reduce transmission. Chart 5The US's Largest Peacetime Budget Deficit Any tipping point into depression would become evident in behavior: e.g. a return to panic selling, followed by the closure of financial market trading by authorities, bank runs, shortages of staples across regions, and possibly the use of martial law and curfews. While near-term selloffs can occur, the rest seems very unlikely – if only because, again, the much simpler solution is to reduce the restrictions on economic activity gradually for the low-risk, healthy, working age population. Bottom Line: Granting that the healthy working age population can and will eventually return to work due to its lower risk profile, unlimited policy support suggests that a depression or “L-shaped” recovery is unlikely. The Dark Hour Of Midnight Nearing While the US looks to avoid a depression, there will still be a recession with an unprecedented Q2 contraction. The recovery could be a lot slower than bullish investors expect. Global manufacturing was contracting well before households got hit with a sickness that will suppress consumption for the rest of the year. There is another disease to worry about: the dollar disease. The world is heavily indebted and holds $12 trillion in US dollar-denominated debt. Yet the dollar is hitting the highest levels in years and global dollar liquidity is drying up. The greenback has rallied even against major safe haven currencies like the Japanese yen and Swiss franc (Chart 6). Of course, the Fed is intervening to ensure highly indebted US corporates have access to loans and extending emergency dollar swap lines to a total of 14 central banks. But in the near term global growth is collapsing and the dollar is overshooting. This can create a self-reinforcing dynamic. The same goes for any relapse in Chinese growth. Unlike in 2008 – but like 2015 – China is the epicenter of the global slowdown. China has much larger economic and financial imbalances today than it did in 2003 when the SARS outbreak occurred, and it will increase these imbalances going forward as it abandons its attempt to deleverage the corporate sector (Chart 7). Chart 6The Greenback Surge Deprives The World Of Liquidity Chart 7China's Financial Imbalances Are A Worry The rest of emerging markets face their own problems, including poor governance and productivity, as well as the dollar disease and the China fallout. They are unlikely to lift themselves out of this crisis, but they could become the source for credit events and market riots that prolong the global risk-off phase. Bottom Line: It is too soon to sound the all-clear. If the dollar continues on its rampage, then the gigantic stimulus will not be enough, markets will relapse, and fears of deflation will grow. World Of Toil And Trouble Political risk is the next shoe to drop. The pandemic and recession are setting in motion a political earthquake that will unfold over the next decade. Almost all of our 12 market-based geopolitical risk indicators have exploded upward since the beginning of the year. Chart 8China's Political Risk Is Rising These indicators show that developed market equities and emerging market currencies are collapsing far more than is justified by underlying fundamentals. This risk premium reflects the uncertainty of the pandemic, but the recession will destabilize regimes and fuel fears about national security. So the risk premium will not immediately decline in several important cases. China’s political risk is shooting up, as one would expect given that the pandemic began in Hubei (Chart 8). The stress within the Communist Party can be measured by the shrill tone of the Chinese propaganda machine, which is firing on all cylinders to convince the world that Chinese President Xi Jinping did a great job handling the virus while the western nations are failing states that cannot handle it. The western nations are indeed mishandling it, but that does not solve China’s domestic economic and social troubles, which will grow from here. Of course, our political risk indicator will fall if Chinese equities rally more enthusiastically than Chinese state banks expand credit as the economy normalizes. But this would suggest that markets have gotten ahead of themselves. By contrast, if China surges credit, yet equity investors are unenthusiastic, then the market will be correctly responding to the fact that a credit surge will increase economic imbalances and intensify the tug-of-war between authorities and the financial system, particularly over the effort to prevent the property sector bubble from ballooning. China needs to stimulate to recover from the downturn. Obviously it does not want instability for the 100th birthday of the Communist Party in 2021. An even more important reason for stimulus is the 2022 leadership reshuffle – the twentieth National Party Congress. This is the date when Xi Jinping would originally have stepped down and the leading member of the rival faction (Hu Chunhua?) would have taken over the party, the presidency, and the military commission. Today Xi is not at risk of losing power, but with a trade war and recession to his name, he will have to work hard to tighten control over the party and secure his ability to stay in power. An ongoing domestic political crackdown will frighten local governments and private businesses, who are already scarred by the past decade and whose animal spirits are important to the overall economic rebound. It is still possible that Beijing will have to depreciate the renminbi against the dollar. This is the linchpin of the trade deal with President Trump – especially since other aspects of the deal will be set back by the recession. As long as Trump’s approval rating continues to benefit from his crisis response and stimulus deals, he is more likely to cut tariffs on China than to reignite the trade war. This approach will be reinforced by the bump in his approval rating upon signing the $2 trillion Families First Coronavirus Response Act into law (Chart 9). He will try to salvage the economy and his displays of strength will be reserved for market-irrelevant players like Venezuela. But if the virus outbreak and the surge in unemployment turn him into a “lame duck” later this year, then he may adopt aggressive trade policy and seek the domestic political upside of confronting China. He may need to look tough on trade on the campaign trail. Diplomacy with North Korea could also break down. This is not our base case, but we note that investors are pricing crisis levels into the South Korean won despite its successful handling of the coronavirus (Chart 10). Pyongyang has an incentive to play nice to assist the government in the South while avoiding antagonizing President Trump. But Kim Jong Un may also feel that he has an opportunity to demonstrate strength. This would be relevant not because of North Korea’s bad behavior but because a lame duck President Trump could respond belligerently. Chart 9Trump’s Approval Gets Bump From Crisis Response And Stimulus Chart 10South Korean Political Risk Rising We highlighted Russia as a “black swan” candidate for 2020. This view stemmed from President Vladimir Putin’s domestic machinations to stay in power and tamp down on domestic instability in the wake of domestic economic austerity policies. For the same reason we did not expect Moscow to engage in a market share war with Saudi Arabia that devastated oil prices, the Russian ruble, and economy. At any rate, Russia will remain a source of political surprises going forward (Chart 11). Go long oil. Putin cannot add an oil collapse to a plague and recession and expect a popular referendum to keep him in power till 2036. The coronavirus is hitting Russia, forcing Putin to delay the April 22 nationwide referendum that would allow him to rule until 2036. It is also likely forcing a rethink on a budget-busting oil market share war, since more than the $4 billion anti-crisis fund (0.2% of GDP) will be needed to stimulate the economy and boost the health system. Russia faces a budget shortfall of 3 trillion rubles ($39 billion) this year from the oil price collapse. It is no good compounding the economic shock if one intends to hold a popular referendum – even if one is Putin. For all these reasons we agree with BCA Research Commodity & Energy Strategy that a return to negotiations is likely sooner rather than later. Chart 11Russia: A Lake Of Black Swans However, we would not recommend buying the ruble, as tensions with the US are set to escalate. Instead we recommend going long Brent crude oil. Political risk in the European states is hitting highs unseen since the peak of the European sovereign debt crisis (Chart 12). Some of this risk will subside as the European authorities did not delay this time around in instituting dramatic emergency measures. Chart 12Europe: No Delay In Offering 'Whatever It Takes' Chart 13Political Risk Understated In Taiwan And Turkey However, we do not expect political risk to fall back to the low levels seen at the end of last year because the recession will affect important elections between now and 2022 in Italy, the Netherlands, Germany, and France. Only the UK has the advantage of a single-party parliamentary majority with a five-year term in office – this implies policy coherence, notwithstanding the fact that Prime Minister Boris Johnson has contracted the coronavirus. The revolution in German and EU fiscal policy is an essential step in cementing the peripheral countries’ adherence to the monetary union over the long run. But it may not prevent a clash in the coming years between Italy and Germany and Brussels. Italy is one of the countries most likely to see a change in government as a result of the pandemic. It is hard to see voters rewarding this government, ultimately, for its handling of the crisis, even though at the moment popular opinion is tentatively having that effect. The Italian opposition consists of the most popular party, the right-wing League, and the party with the fastest rising popular support, which is the right-wing Brothers of Italy. So the likely anti-incumbent effect stemming from large unemployment would favor the rise of an anti-establishment government over the next year or two. The result would be a clash with Brussels even in the context of Brussels taking on a more permissive attitude toward budget deficits. This will be all the worse if Brussels tries to climb down from stimulus too abruptly. Our political risk indicators have fallen for two countries over the past month: Taiwan and Turkey (Chart 13). This is not because political risk is falling in reality, but because these two markets have not seen their currencies depreciate as much as one would expect relative to underlying drivers of their economy: In Taiwan’s case the reason is the US dollar’s unusual strength relative to the Japanese yen amidst the crisis. Ultimately the yen is a safe-haven currency and it will eventually strengthen if global growth continues to weaken. Moreover we continue to believe that real world politics will lead to a higher risk premium in the Taiwanese dollar and equities. Taiwan faces conflicts with mainland China that will increase with China’s recession and domestic instability. In Turkey’s case, the Turkish lira has depreciated but not as much as one would expect relative to European equities, which have utterly collapsed. Therefore Turkey’s risk indicator shows its domestic political risk falling rather than rising. Turkey’s populist mismanagement will ensure that the lira continues depreciating after European equities recover, and then our risk indicator will shoot up. Chart 14Brazilian Political Risk Is No Longer Contained Prior to the pandemic, Brazilian political risk had remained contained, despite Brazilian President Jair Bolsonaro’s extreme and unorthodox leadership. Since the outbreak, however, this indicator has skyrocketed as the currency has collapsed (Chart 14). To make matters worse, Bolsonaro is taking a page from President Trump and diminishing the danger of the coronavirus in his public comments to try to prevent a sharp economic slowdown. This lackadaisical attitude will backfire since, unlike the US, Brazil does not have anywhere near the capacity to manage a major outbreak, as government ministers have warned. This autumn’s local elections present an opportunity for the opposition to stage a comeback. Brazilian stocks won’t be driven by politics in the near term – the effectiveness of China’s stimulus is critical for Brazil and other emerging markets – but political risk will remain elevated for the foreseeable future. Bottom Line: Geopolitical risk is exploding everywhere. This marks the beginning of a period of political turbulence for most of the major nation-states. Domestic economic stresses can be dealt with in various ways but in the event that China’s instability conflicts with President Trump’s election, the result could be a historic geopolitical incident and more downside in equity markets. In Russia’s case this has already occurred, via the oil shock’s effect on US shale producers, so there is potential for relations to heat up – and that is even more true if Joe Biden wins the presidency and initiates Democratic Party revenge for Russian election meddling. The confluence of volatile political elements informs our cautious tactical positioning. Investment Conclusions If the historic, worldwide monetary and fiscal stimulus taking place today is successful in rebooting global growth, then there will be “no depression.” The world will learn to cope with COVID-19 while the “dollar disease” will subside on the back of massive injections of liquidity from central banks and governments. Gold: The above is ultimately inflationary and therefore our strategic long gold trade will be reinforced. The geopolitical instability we expect to emerge from the pandemic and recession will add to the demand for gold in such a reflationary environment. No depression means stay long gold! US Equities: Equities will ultimately outperform government bonds in this environment as well. Our chief US equity strategist Anastasios Avgeriou has tallied up the reasons to go long US stocks in an excellent recent report, “20 Reasons To Buy Equities.” We agree with this view assuming investors are thinking in terms of 12 months and beyond. Chart 15Oil/Gold Ratio Extreme But Wait To Go Long Tactically, however, we maintain the cautious positioning that we adopted on January 24. We have misgivings about the past week’s equity rally. Investors need a clear sense of when the US and European households will start resuming activity. The COVID-19 outbreak is still capable of bringing negative surprises, extending lockdowns, and frightening consumers. Hence we recommend defensive plays that have suffered from indiscriminate selling, rather than cyclical sectors. Go tactically long S&P consumer staples. US Bonds: Over the long run, the Fed’s decision to backstop investment grade corporate bonds also presents a major opportunity to go long on a strategic basis relative to long-dated Treasuries, following our US bond strategists. Global Equities: We prefer global ex-US equities on the basis of relative valuations and US election uncertainty. Shifting policy winds in the United States favor higher taxes and regulation in the coming years. This is true unless President Trump is reelected, which we assess as a 35% chance. Emerging Markets: We are booking gains on our short TRY-USD trade for a gain of 6%. This is a tactical trade that remains fundamentally supported. Book 6% gain on short TRY-USD. Oil: For a more contrarian trade, we recommend going long oil. Our tactical long oil / short gold trade was stopped out at 5% last week. While we expect mean reversion in this relationship, the basis for gold to rally is strong. Therefore we are going long Brent crude spot prices on Russia’s and Saudi Arabia’s political constraints and global stimulus (Chart 15). We will reconsider the oil/gold ratio at a later date. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Joseph T. Wu et al, "Estimating clinical severity of COVID-19 from the transmission dynamics in Wuhan, China," Nature Medicine, March 19, 2020, and Wei-jie Guan et al, "Clinical Characteristics of Coronavirus Disease 2019 in China," The New England Journal Of Medicine, February 28, 2020. Section II: Appendix : GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Section III: Geopolitical Calendar
Highlights Market Turmoil: The combination of accelerating global cases of COVID-19, a surging US dollar and elevated market volatility has wreaked havoc on financial markets. A sustainable bottom in global risk assets (and, potentially, bond yields) requires a reversal of all three of those trends. Fed & ECB: Central bankers on both sides of the Atlantic are now committing to provide liquidity backstops for both government bonds and corporate debt by promising “unlimited” purchases. This effectively removes the left tail of the return distribution on debt of more questionable quality that has seen significant spread widening, like US BBB-rated corporates and Peripheral European sovereign debt. Fixed Income Strategy: Upgrade US investment grade corporates to overweight from neutral, and upgrade Italian government bonds to overweight from underweight, on both a tactical (0-6 months) and strategic (6-12 months) basis. Buy What The Central Banks Are Buying Chart of the WeekAre These Market Stress Points Turning? The COVID-19 outbreak has become a full-blown global health crisis, with country after country imposing lockdowns on their populations to control the spread of the disease. The economic ramifications are now obvious: a certain deep global recession, but one of indeterminate length. The investment implications are also now clear: bear markets in global equities, credit and growth-sensitive currencies and commodities. There is a new bull market, however, in pessimism. Economic forecasters are tripping over themselves to offer up the most shocking estimate of the severity of the downturn. The IMF is now expecting a recession in 2020 “at least as bad” as during the global financial crisis. Wall Street investment banks are forecasting double-digit declines in US GDP growth during the second quarter. St. Louis Fed President Fed James Bullard wins the prize for the most gloomy prediction, suggesting that we could see a 30% US unemployment rate and a -50% (!) decline in US GDP growth in Q2. Investors have seen few positive headlines on the spread of the virus, resulting in a de-risking “dash for cash” that has impeded liquidity across equity, fixed income and currency markets. Global policymakers have responded with trillions of dollars of monetary and fiscal policy announcements designed to calm nervous markets while ensuring liquidity provision for temporarily shuttered businesses, of all sizes, facing painful layoff announcements. Chart 2Get Ready For Shockingly Weak Global Economic Data Have we seen enough stimulus to stop the market turmoil? In our view, three things must all occur for a sustainable bottom in global risk assets, and potentially bond yields, to unfold (Chart of the Week): Slowing growth in new COVID-19 infections outside China. As long as the global spread of the virus shows no signs of slowing down, it will be impossible for markets to ascertain the full hit to global growth from the outbreak. A cooling off of the surging US dollar. The greenback has soared 8% since March 9, and is wreaking havoc on global borrowers who have significant USD-denominated liabilities. Global financial market volatility must peak. Volatility spikes across all major asset classes have forced investors to de-risk portfolios; lower volatility will have the opposite effect. Of late, the news on all three fronts is tentatively more positive. The US DXY dollar index is off from the peak, the VIX index of US equity volatility is off the extreme highs and the number of new cases of COVID-19 in virus-ravaged Italy has declined for the past two days. While it is still early to call a lasting peak in these measures, it is potentially a sign of optimism coming at a time when economic confidence measures like the ZEW surveys are back to 2008 levels and a China-like collapse in activity is now expected in the US (Chart 2). We now think it is time to pick through the ashes of the global market rout and begin to add back some risk in global bond portfolios. We now think it is time to pick through the ashes of the global market rout and begin to add back some risk in global bond portfolios. After seeing the policy announcements of the past week, however, we are choosing to dip our toes back into the water in assets that now have direct central bank liquidity backstops – namely US investment grade corporates and Italian sovereign debt. The Fed Is Now Truly The Lender Of Last Resort … To Corporates The Fed unloaded their biggest of bazookas yesterday, expanding existing stimulus programs while introducing new initiatives that reach into parts of the US economy and financial markets previously untouched by the central bank. Specifically, the Fed did the following: Announcing unlimited quantitative easing (QE) for US Treasuries and agency mortgage-backed securities (MBS) Increasing the size of money market and commercial paper liquidity programs announced last week, and expanding the range of eligible assets Adding commercial MBS (CMBS) to asset purchases, which was never done even in 2008 Reviving the 2008 crisis-era Term Asset-Backed Loan Facility (TALF) to make loans directly to companies, while introducing a new “Main Street Business Lending Program” that will fund small businesses directly (details are yet to be determined) Most significantly for bond investors, the Fed will begin buying corporate bonds, in both primary and secondary markets, while also providing direct lending to eligible companies through loans. This will be done through off-balance sheet Special Purpose Vehicles (SPV), initially funded with $10 billion from the US Treasury and levered up by the Fed to whatever amount is necessary The Fed primary market SPV will buy newly-issued bonds with credit ratings as low as BBB- and maturities of four years or less. Eligible issuers are US businesses with material operations in the United States, although the Fed noted that the list of companies in the program may be expanded in the future. Eligible issuers do not include companies that are expected to receive direct financial assistance from the US government (i.e. no buying of bonds from companies getting bailout funds). The most significant details of the Fed’s new primary market corporate bond buying program are the numerical limits of what can be purchased. Any eligible company can “borrow” from the Fed, though bond purchases or direct loans, an amount greater than the maximum outstanding debt (bonds plus loans) on any day over the past twelve months. Those percentages are determined by credit quality: 140% of all debt for AAA-rated issuers, 130% for AA-rated issuers, 120% for A-rated issuers and 110% for BBB-rated issuers. Since those percentages are all greater than 100, this effectively means that the Fed will allow eligible companies to roll over their entire stock of debt through this program, plus some net new borrowing. The Fed is even calling this “bridge financing for up to four years” in their official term sheets for the new program.1 Issuers can even defer interest payments on the funds borrowed from the Fed for up to six months, with the interest payments added to the final repayment amount (again, any company choosing this option can do no share buybacks or dividend payments). In addition to this direct lending to investment grade rated issuers, the Fed is introducing another SPV that will buy corporate bonds of eligible investment grade issuers in the secondary market. This will be for bonds with maturity of up to five years and credit ratings as low as BBB-, with a buying limit of 10% of the entire stock of eligible debt of any single company. This secondary market SPV will also buy investment grade bond ETFs, up to 20% the outstanding shares of any single ETF. All of these programs are set to run to September 30 of this year, with an option to extend as needed. The Fed’s new initiatives represent a new step for the central bank, providing direct lending to any company that needs it. The Fed had to do this through off-balance-sheet SPVs, since direct buying of corporates is not permitted under the Federal Reserve Act. Thus, it is not like the Fed’s QE programs that used to buy Treasuries and MBS – in fact, it is the US Treasury that is taking on the initial credit risk through its $10 billion funding of each SPV. In this sense, the Fed's new program is also different than the corporate bond QE programs of the ECB, Bank of England and Bank of Japan, where the credit risk is directly taken onto the central bank balance sheet. The purpose of these new corporate bond programs is two-fold: 1. To ensure that companies do not suffer a credit crunch, either by being unable to roll over maturing corporate debt in primary markets or by only doing so at prohibitively high yields and spreads 2. To ensure the proper functioning of US corporate bond markets, by providing liquidity to both cash bonds and related ETFs. By doing this, the Fed can help mitigate the severe tightening of financial conditions that has already occurred because of the credit selloff in recent weeks. Also, by helping to reduce the extreme price/spread volatility in higher-quality credit, the Fed may be hoping this can spill over into lower volatility of other asset classes which are at the historical extremes of the past quarter century (Chart 3). Both can help mitigate the second round effects of the virtual shutdown of the US economy that has taken place to contain the spread of COVID-19. Chart 3Few Places To Hide From Historically High Volatility The Fed’s unprecedented intervention in the US corporate bond market is a positive step that has improved the risk/reward profile for US investment grade credit, coming after a period of significant spread widening that has restored some value to the asset class. We will further discuss the implications of the Fed’s actions in a corporate bond Special Report that we will publish jointly next week with our colleagues at BCA US Bond Strategy. For now, however, the Fed’s unprecedented intervention in the US corporate bond market is a positive step that has improved the risk/reward profile for US investment grade credit, coming after a period of significant spread widening that has restored some value to the asset class (Chart 4). Chart 4A New Huge IG Liquidity Backstop From The Fed Could the Fed’s actions spill over into non-US credit, as well? Chart 5This Is A Global Widening Of Credit Spreads Chart 6Signs Of USD Funding Stress, But Nothing Like 2008 The COVID-19 crisis has resulted in credit spread widening across the world, especially so for the big borrowers of USD-denominated debt in the emerging markets and US shale oil industry (Chart 5). For those issuers, a weaker USD would be more positive development, as would higher oil prices. The Fed’s other monetary policy actions – cutting the funds rate to 0%, moving to unlimited QE for Treasuries and MBS, should be helping to weaken the US dollar. The problem, however, is that all other major central banks are now doing similar policy easings as well, with even the likes of the Reserve Bank of Australia and Reserve Bank of New Zealand now starting bond-buying QE programs. This exacerbates the strong USD problem, seen in the stresses in USD funding markets (Chart 6). Simply put, the Fed cannot generate easier financial conditions, both in the US and elsewhere, through a weaker USD. Thus, the Fed has to seek other ways to ease US financial conditions – like helping cap borrowing costs for investment grade US borrowers by direct intervention in those markets. Bottom Line: The Fed’s move into buying investment grade corporate debt, and providing term lending to corporates more broadly, has effectively eliminated the left tail of the return distribution for investment grade US credit. The ECB Is Moving Towards Being The Lender Of Last Resort – For Euro Area Sovereigns The Fed is not the only central bank that ramped up its asset purchases. The ECB also increased its existing Asset Purchase Program by a massive €750bn last week, across both sovereign and corporate debt. This new program was dubbed the “Pandemic Emergency Purchase Program” (PEPP) and is to take place over the rest of 2020 in order to help fight the negative impacts on the European economy and financial markets from the COVID-19 outbreak. The most important part of the announcement of the PEPP, however, was in the loosening of previous restrictions of the ECB’s €2.6 trillion Asset Purchase Program (APP). Greek bonds were included in the PEPP by allowing a waiver to the rules of the APP that forbid the inclusion of Greece in the funding program. Also, the ECB hinted in its statement announcing the new program that the self-imposed limits on the APP could be revised, if necessary, for the more “temporary” PEPP to help fight the COVID-19 crisis. That was a clear signal to the markets that the ECB could deviate from the “capital key” country weightings, and the 33% single sovereign issuer limit, that have governed the APP. This is very positive news for Italy, where COVID-19 has been particularly devastating and deadly, causing the entire country to be locked down to control its spread. The ECB could deviate from the “capital key” country weightings, and the 33% single sovereign issuer limit, that have governed the APP. This is very positive news for Italy, where COVID-19 has been particularly devastating and deadly, causing the entire country to be locked down to control its spread. Already, Italy and the rest of the EU have been given a temporary waiver of the EU’s fiscal policy targets (government deficit no larger than 3% of GDP, government debt no larger than 60% of GDP). Now that the ECB is also willing to consider suspending its own limits on asset purchases, Italy has been given the “space” to run larger deficits without the market punishment of higher bond yields – especially with the ECB only owning around 20% of the stock of Italian government debt, well below the 33% single country APP limit (Chart 7). Chart 7The ECB Can Buy More Italian Debt, If Necessary Already, the ECB announcement triggered a sharp decline in Italian bond yields (and Greek yields, for that matter) and tightening of the spread between Italian and German bond yields. So far, the threat of the ECB buying more Italy has been enough to get private investors to buy more Italian bonds, similar to Mario Draghi’s “whatever it takes” promise back in 2012. Draghi never had to buy a single bond to get the market to move in his favor then. In 2020, given the collapse in European growth seen so far in response to COVID-19 lockdowns, and the acute hit to the Italian economy from the virus, we suspect that Christine Lagarde will be far likely to actually buy more Italian debt – especially with even the hard-money Germans now engaged in deficit spending to stimulate the virus-stricken German economy. We interpret all this similarly to our read of the Fed’s buying of corporate debt – the ECB has changed the risk/reward profile of Italian government bonds by not only introducing the PEPP, but having it operated under different rules than the APP. Bottom Line: The ECB’s new bond buying program has significantly reduced the downside risk of Italian government debt over the next 6-12 months. Fixed Income Strategy Implications The Fed’s dramatic move into direct funding of US companies is a game changer for the US corporate bond market. By providing a full liquidity backstop to all companies, the Fed is ensuring that no US investment grade issuer will have to worry about rolling over their maturing debt in an illiquid and nervous corporate bond market. Simply put, the Fed has cut out the left side of the distribution of corporate bond returns for the foreseeable future. The same argument goes for the ECB’s increased purchases of government bonds, with promises to buy more Italian debt, if necessary. For these reasons, we are upgrading our recommended stance on US investment grade corporate debt, and Italian sovereign debt to overweight - both on a tactical (0-6 months) basis in our model bond portfolio and on a strategic (6-12 months) basis. Chart 8Upgrade US IG Corporates And Italian Sovereign Debt On CB Buying For these reasons, we are upgrading our recommended stance on US investment grade corporate debt, and Italian sovereign debt to overweight - both on a tactical (0-6 months) basis in our model bond portfolio and on a strategic (6-12 months) basis (Chart 8). We are focusing only on these two markets for now, as an initial step to increase our recommended exposure to fixed income risk assets. There may be a spillover into other credit markets and sovereign debt, like European investment grade and Spanish government bonds. For now, however, we are focusing on US investment grade and Italy, while keeping underweights in other credit markets as a hedge against a renewed flare-up of COVID-19 related market risk. Bottom Line: Upgrade US investment grade corporates to overweight from neutral, and upgrade Italian government bonds to overweight from underweight, on both a tactical (0-6 months) and strategic (6-12 months) basis. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The details of the Fed’s new corporate bond buying programs can be found here: https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200323b1.pdf https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200323b2.pdf Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
The ECB announced that it would implement EUR750 billion of government bonds purchases this year and that the program would remain open beyond December if need be. Moreover, the ECB seems to be ignoring its capital keys as self-imposed limits on its purchases…
We recommend investors closely follow the number of new COVID-19 cases in Italy. At 4,207, as of March 18th, this number remains lower than it was on March 13th. However, new cases have nonetheless trended up over that past three days. Italy is…
Highlights Policy Responses: The COVID-19 pandemic has become a full-blown global crisis and recession. Governments and central bankers worldwide are now responding with aggressive monetary easing and fiscal stimulus. Markets will not respond positively to such stimulus, however, until there is some visibility on the true depth, and duration, of the economic downturn. Fixed Income Strategy: With a global recession now a certainty, bond yields will remain under downward pressure and credit spreads should widen further. Given how far yields have already fallen, we recommend emphasizing country and credit allocation in global bond portfolios, while keeping overall duration exposure around benchmark levels. Model Portfolio Changes: Following up on our tactical changes last week, we continue to recommend overweighting government debt versus spread product. Specifically, overweighting US & Canadian government bonds versus Japan and core Europe, and underweighting US high-yield and all euro area and EM credit. Feature In stunning fashion, the sudden stop in the global economy due to the COVID-19 pandemic has triggered a rapid return to crisis-era monetary and fiscal policies. The battle has now shifted to trying to fill the massive hole in global private sector demand left by efforts to contain the spread of the virus. It is unlikely that lower interest rates and more quantitative easing can mitigate the negative growth effects from travel bans, closing of bars and restaurants, and full scale lockdowns of cities. Fiscal policy, combined with efforts to boost market liquidity and ease the coming collapse of cash flows for the majority of global businesses, are the only plausible options remaining. It is unlikely that lower interest rates and more quantitative easing can mitigate the negative growth effects from travel bans, closing of bars and restaurants, and full scale lockdowns of cities. While the speed of these dramatic policy moves is unprecedented, the reason for them is obvious. Plunging equities and surging corporate bond credit spreads are signaling a global recession, but one of uncertain depth and duration given the uncertainties surrounding the spread of COVID-19 (Chart of the Week). Chart of the WeekCan Crisis-Era Monetary Policies Be Effective During A Pandemic? Chart 2Risk Assets Will Not Bottom Until New COVID-19 Cases Ex-China Peak The ability for policymakers to calibrate stimulus measures is pure guesswork at this point. The same thing goes for investors who see zero visibility on global growth, with the full extent of the virus yet to be felt in large economies like the United States and Germany – even as new cases in China, where the epidemic began, approach zero. The response from central bankers has been swift and bold – rapid rate cuts, increased liquidity programs for bank funding and increased asset purchases. The fact that global financial markets have remained volatile, even after what is a clear coordinated effort from policymakers, highlights how the unique threats to growth from the COVID-19 pandemic may be beyond fighting with traditional demand-side stimulus measures. We continue to recommend a cautious near-term investment stance, particular with regards to corporate bond exposure, until there is clear evidence that the growth rate of new COVID-19 cases outside China has peaked (Chart 2). Policymakers Throw The Kitchen Sink At The Problem The market moves and policy announcements have come fast and furious this past week, from virtually all major economies. We summarize some of the moves below: United States The Fed cut rates by -100bps in a Sunday night emergency move, taking the funds rate back to the effective lower bound of 0% - 0.25%. Importantly, Fed Chair Powell made it clear at his press conference that negative rates are not on the table, suggesting that we may have seen the last of the rate cuts for this cycle. A new round of quantitative easing (QE) was also announced, with purchases of $500 billion of Treasury securities and $200 billion of agency MBS that will occur in the “coming months”; Powell hinted that those amounts could be increased, if necessary (Chart 3). The MBS purchases are a clear effort to help bring down mortgage rates, which have not declined anywhere near as rapidly as US Treasury yields during the market rout (bottom panel). The Fed also cut the discount window rate – the rate at which banks can borrow from the Fed for periods of up to 90 days – by -150bps, bringing it down to 0.25%. The Fed said it is “encouraging banks to use their capital and liquidity buffers” – essentially telling banks to hold less cash for regulatory purposes. The Fed also reduced the rate on its US dollar swap lines with other central banks. The new rate is OIS +25bps. Coming on top of the massive increase in existing repo lines last week, the Fed is attempting to ensure that banks, both in the US and globally, that need USD funding have more liquidity available to support lending. Already, there are signs of worsening liquidity in the bank funding markets, like widening FRA-OIS spreads, but also evidence of illiquidity in financial markets like wide bid-ask spreads on longer-maturity US Treasuries and the growing basis between high-yield bonds and equivalent credit default swaps (Chart 4). Chart 3A Return To Fed QE Chart 4Market Liquidity Issues Forced The Fed's Hand Turning to fiscal policy, the full response of the Trump administration is still being formed, but a major $850bn spending package has been proposed that would provide tax relief for American households and businesses while also including a $50bn bailout of the US airline industry. This comes on top of previously announced plans to offer free testing for the virus, paid sick leave, business tax credits and a temporary suspension of student loan interest payments. Chart 5The ECB Has Limited Policy Options Euro Area The European Central Bank (ECB) unexpectedly made no changes to policy interest rates last week. It opted instead to increase asset purchases by €120bn until the end of 2020 (both for government bonds and investment grade corporates), while introducing more long-term refinancing operations (LTROs) to “provide a bridge” to the targeted LTRO (TLTRO-3) that is set to begin in June. The terms of TLTRO-3 were improved, as well; banks that accessed the liquidity to maintain existing lending could do so at a rate up to -25bps below the current ECB deposit rate of -0.5%, for up to 50% of the existing stock of bank loans. The ECB obviously had to do something, given the coordinated nature of the global monetary policy response to COVID-19. Yet the decisions taken show that the ECB is much more limited in its ability to ease policy further, with interest rates already negative, asset purchases approaching self-imposed country limits and, most worryingly, inflation expectations falling to fresh lows (Chart 5). The bigger responses to date have come on the fiscal front, with stimulus packages proposed by France (€45bn), Italy (€25bn), Spain (€3bn) and the European Commission (€37bn). The biggest news, however, came from Germany which has offered affected businesses tax breaks and cheap loans through the state development bank, KfW – the latter with an planned upper limit of €550bn (and with the German government assuming a greater share of risk on those new KfW loans). The German government has also vaguely promised to temporarily suspend its so-called “debt brake” to allow deficit financing of virus-related stimulus programs, if necessary. Other Countries The Bank of England cut interest rates by -50bps last week, while also lowering capital requirements for UK banks by allowing use of counter-cyclical buffers for lending. On the fiscal side, a £30bn package was introduced last week that included a tax cut for retailers, cash grants to small business, sick pay for those with COVID-19 and extended unemployment benefits. The Bank of Japan held an emergency meeting this past Sunday night, announcing no changes in policy rates but doubling the size of its ETF purchase program to $56 billion a year to $112 billion, while also increasing purchases of corporate bonds and commercial paper. The central bank also announced a new program of 0% interest loans to increase lending to businesses hurt by the virus. The Bank of Canada delivered an emergency -50bps cut in its policy rate last Friday, coming soon after the -50bp reduction from the previous week. The central bank also introduced operations to boost the liquidity of Canadian financial markets. The Canadian government also announced a fiscal package of up to C$20bn, including increased money for the state business funding agencies. The Reserve Bank of Australia did not cut its Cash Rate last week, which was already at a record-low 0.5%. It did, however, signal that it would begin a quantitative easing program for the first time, and introduce Fed-like repo operations, to provide more liquidity to the economy and local financial markets. The Australian government has also announced A$17bn of fiscal stimulus. Fiscal packages have also been introduced in New Zealand (where the Reserve Bank of New Zealand just cut its policy rate by -75bps), Sweden, Switzerland, Norway, and South Korea. To date, China has leaned more on monetary and liquidity measures – lowering interest rates and cutting reserve requirements – rather than a big fiscal stimulus package. Will all these policy measures be enough to offset the hit to global growth from COVID-19 and help stabilize financial markets? It is certainly a good start, particularly in countries with low government and deficit levels that have the fiscal space for even more stimulus, like Germany, Australia and Canada (Chart 6). Given these competing forces of global recession and monetary policy exhaustion on one side, but with increasingly more expansive fiscal policy on the other, we recommend a neutral (at benchmark) stance on overall global duration exposure on both a tactical and strategic basis. The ability to calibrate the necessary policy response is impossible to assess without knowing the full impact of COVID-19 pandemic on the global economy – including the size of related job losses and corporate defaults/bankruptcies. Policymakers are likely to listen to the combined message of financial markets – equity prices, credit spreads and government bond yields. The low level of yields and flat yield curves, despite near-0% policy rates across the developed world (Chart 7), suggests that investors see monetary policy as “tapped out”, leaving fiscal stimulus as the only way to fight the economic war against COVID-19. Chart 6At Global ZIRP, The Policy Focus Shifts To Fiscal Chart 7Are Bond Yields Discounting A Global Liquidity Trap? Given these competing forces of global recession and monetary policy exhaustion on one side, but with increasingly more expansive fiscal policy on the other, we recommend a neutral (at benchmark) stance on overall global duration exposure on both a tactical and strategic basis. Bottom Line: The COVID-19 pandemic has become a full-blown global crisis and recession. Governments and central bankers worldwide are now responding with aggressive monetary easing and fiscal stimulus. Markets will not respond positively to such stimulus, however, until there is some visibility on the true depth, and duration, of the economic downturn. Corporate Bonds In The US & Europe – Stay Tactically Defensive Chart 8This Crisis Is Different Than 2008 The COVID-19 global market rout has generated levels of market volatility not seen since the 2008 Global Financial Crisis. The US VIX index of option-implied equity volatility spiked to a high of 84, while the equivalent German VDAX measure reached a shocking high of 93. Equity valuations in both the US and Europe remain much higher on a forward price/earnings ratio basis compared to the troughs seen in 2008, even after the COVID-19 bear market. Yet even though volatility has returned to crisis-era extremes, and corporate credit has sold off hard in both the US and Europe, credit spreads remain well below the 2008 highs (Chart 8). Nonetheless, the credit selloff seen over the past few weeks has still been intense. Both investment grade and high-yield spreads have blown out, and across all credit tiers in both the US (Chart 9) and euro area (Chart 10). Even the highest-rated segments of the corporate bond universe have seen spreads explode, with AAA-rated investment grade spreads having doubled in both the US and Europe. Chart 9Broad-Based Spread Widening For Both Investment Grade... Chart 10...And High-Yield With the COVID-19 pandemic tipping the global economy into recession, it is not clear that the spread widening seen to date has been enough to compensate for the typical surge in downgrades and defaults seen during recessions – even though spreads do look wide on a duration-adjusted basis. With the COVID-19 pandemic tipping the global economy into recession, it is not clear that the spread widening seen to date has been enough to compensate for the typical surge in downgrades and defaults seen during recessions – even though spreads do look wide on a duration-adjusted basis. One of our favorite metrics to value corporate bonds is to look at option-adjusted spreads, adjusted for interest rate duration risk. We call this the 12-month breakeven spread, as it measures the amount of spread widening over one year that would leave corporate bond returns equal to those of duration-matched US Treasuries. We then look at the percentile rankings of those breakeven spreads versus their history as one indicator of corporate bond value. Chart 11US Corporates Look Cheaper On A Duration-Adjusted Basis For the US, the 12-month breakeven spreads for the overall Bloomberg Barclays investment grade and high-yield indices are in the 82nd and 97th percentiles, respectively (Chart 11). This suggests that the latest credit selloff has made corporate debt quite cheap, although only looking through the prism of spread risk rather than potential default losses. Another of our preferred valuation metrics for high-yield debt is the duration-adjusted spread, or the high-yield index option-adjusted spread minus default losses. We then look at that default-adjusted spread versus its long-run average (+250bps) as a measure of high-yield value. To assess the current level of spreads, we use a one-year ahead forecast of the expected default rate using our own macro model. Over the past 12 months, the high-yield default rate was 4.5% and our macro model is currently calling for a rise to 6.2%. That estimate, however, does not yet include the certain hit to corporate profits from the COVID-19 recession. By way of comparison, the default rate peaked at 11.2% during the 2001/02 default cycle and at 14.6% during the 2008 financial crisis. In Chart 12, we show the historical default rate, our macro model for the default rate, and the history of the default-adjusted spread. We also show what the default-adjusted spread would look like in four different scenarios for the default rate over the next 12 months: 6%, 9%, 11% and 15%. The placement of these numbers in the bottom panel of Chart 12 indicates where the Default-Adjusted Spread will be if each scenario is realized. Chart 12US High-Yield Is Not Cheap On A Default-Adjusted Basis Right now, our expectation is that there will be a virus driven US recession, but it will be shorter in magnitude than past recessions; this suggests a peak default rate closer to 9%. Such a scenario would still be consistent with a positive default-adjusted spread and likely positive excess returns for US high-yield relative to US Treasuries on a 12-month horizon. However, if a default rate similar to that seen during past recessions (11% or 15%) is realized, that would lead to a negative default-adjusted spread. Adding up both pieces of our valuation framework suggests that, while US high-yield spreads offer value on a duration-adjusted basis, spreads do not compensate enough for potential default losses if the US recession lasts longer than we expect. Thus, we recommend a tactical underweight position in US high-yield until we see better visibility on the severity, and duration, of the US recession. Adding up both pieces of our valuation framework suggests that, while US high-yield spreads offer value on a duration-adjusted basis, spreads do not compensate enough for potential default losses if the US recession lasts longer than we expect. As for euro area corporates, spreads for both investment grade and high-yield do look relatively wide on a breakeven spread basis, although less so than US credit (Chart 13). However, with the World Health Organization declaring Europe as the new epicenter of the COVID-19 pandemic, the harsh containment measures seen in Italy, Germany, France and elsewhere – coming from a starting point of weak overall economic growth – suggest that euro area spreads need to be wider to fully reflect downgrade and default risks. Chart 13Euro Area Corporates Look A Bit Cheaper On A Duration-Adjusted Basis We recommend a tactical underweight allocation to both euro area corporate debt and Italian sovereign debt, as spreads have room to reprice wider to reflect a deeper recession (Chart 14). Chart 14Stay Underweight Euro Area Spread Product Bottom Line: Corporate bond spreads on both sides of the Atlantic discount a sharp economic slowdown, but the odds of a deeper recession – and more spread widening - are greater in Europe relative to the US. A Quick Note On Recent Changes To Our Model Bond Portfolio In last week’s report, we made several adjustments to our model bond portfolio recommended allocations on a tactical (0-6 months) basis.1 Specifically, we downgraded our overall recommended exposure to global spread product to underweight, while increasing the overall allocation to government debt to overweight. The specific changes made to the model bond portfolio are presented in tables on pages 14 & 15. Within the country allocation of the government bond side of the portfolio, we upgraded US and Canada (markets more sensitive to changes in global bond yields, and with central banks that still had room to ease policy) to overweight, while downgrading core Europe to underweight and Japan to maximum underweight (both markets less sensitive to global yields and with no room to cut rates). On the credit side of the portfolio, we downgraded US high-yield to underweight (with a 0% allocation to Caa-rated debt), while also downgrading euro area investment grade and high-yield debt to underweight. We also lowered allocations to emerging market USD denominated debt, both sovereign and corporate, to underweight. We left the allocation to US investment grade debt at neutral, as the other reductions left our overall spread product allocation at the desired level (35% versus the 43% spread product weighting in our custom benchmark portfolio index). In terms of the specific weightings, the portfolio is now +11% overweight US fixed income versus the benchmark, coming most through US Treasury exposure. The portfolio is now -7% underweight euro area versus the benchmark, equally thorough government bond and corporate debt exposure. The portfolio is now also has a -7% weight in Japan versus the benchmark, entirely from government bonds. Note that these weightings represent a tactical allocation only, as we are recommending a defensive stance on spread product exposure given the near-term uncertainties over COVID-19 and global growth. On a strategic (6-12 months) horizon, however, we are neutral overall spread product exposure versus government bonds. Corporate bond spreads already discount a sharp economic slowdown and some increase in defaults. However, the rapid shift to aggressive monetary and fiscal easing by global policymakers to combat the virus will likely limit the duration and, potentially, the severity of the global slowdown currently discounted in wide credit spreads. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Train Is Empty", dated March 10, 2020, available at gfis.bcarsearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights China is moving from virus containment to normalization and economic stimulus. The full weight of the virus panic is only now hitting the US public and has not yet peaked. The US – and western democracies in general – have the raw capabilities to manage the virus outbreak. The profile of global political risk is shifting as a result of the economic shock stemming from the virus. This implies that while equity markets are close to their bottom, they face more volatility. Feature Chart 1No Peak In New Cases Outside China China’s President Xi Jinping visited Wuhan, the epicenter of the coronavirus breakout that has triggered a global bear market, on March 10. While he did not declare outright victory over the virus, his symbolic visit reinforced the fact that China has drastically reduced the number of new daily cases both within and without Hubei province. Meanwhile the virus is spreading rapidly across the rest of the world (Chart 1). It is not clear if the outbreak and emergency response in the United States will follow the Italian or South Korean trajectory. The initial US response is not encouraging, but the US has latent institutional strengths. Either way the US is facing a tsunami of new cases in the very near term. Hence the panic among the American population can still escalate from here (Chart 2). Panic among households translates to a drop in economic activity that will ensure financial markets remain volatile, even if US equities are close to their bottom. Chart 2US Public Panic Has Not Peaked Yet Can Democracies Manage The Crisis? Chart 3Developed Economies Have Better Health The question has become salient because of the poorly managed cordon sanitaire in Italy and the slow and halting initial reaction of the United States. Moreover, to distract from China’s domestic crisis, the Communist Party has turned up the volume of its propaganda organs, advertising the success of China’s draconian containment measures and warning that the virus cannot be contained if the rest of the world does not follow suit. However, it is not the case that the pandemic can only be managed through absolutist policies. To date, developed economies and democracies – including westernized countries like Japan – have the best record in the world of improving public health and reducing mortality from infectious diseases. This is apparent simply by looking at life expectancy for those aged 60. Europe and Japan have the longest lives beyond 60, including extension of life when dealing with late-life health problems, while other regions lag, including Asia. The United States is on the low end of the developed countries but still considerably better than emerging market economies at prolonging life, even for unhealthy elderly folks (Chart 3). Chart 4US Has Reduced Flu/Pneumonia Deaths Dramatically The United States, like other countries, has done battle with a range of infectious diseases over the course of its history – in which it was the leader in economic, scientific, and technological advancement. These include cholera and viral epidemics like smallpox, Yellow Fever, the Spanish Flu, and SARS. The death rate for influenza and pneumonia has generally declined since the 1950s, although a counter-trend increase is conceivable given what occurred in the 1980s-90s (Chart 4). The strategy that the US and developed economies have used, embodied in documents like the World Health Organization’s interim protocol for rapid operations to contain pandemics, is one of creating a containment zone with movement restrictions and a closely watched buffer zone in which a combination of anti-viral treatment and non-pharmaceutical treatment (e.g. social distancing) is employed. “Containment and isolation” strategies are generally successful even though they often fail to establish an impenetrable geographic cordon sanitaire, must rely on voluntary behavior, and will never receive total compliance. The survival instinct and social pressure are powerful enough to convince most individuals and households to keep their distance from others once they are informed of the risks. Targeted government measures by credible regimes with a monopoly on the use of force – in cases where strong restrictions are necessary – are effective. And in democracies they are kept in place only as long as necessary (the incubation period of the virus plus a few more weeks). Developed economies and democracies have the best record of improving public health and reducing mortality from infectious diseases. The overall effect is to “flatten the curve,” e.g. to slow the spread of the virus, and delay and reduce the peak intensity of the number of cases and burden on hospitals and doctors.1 Of course, nations need institutional capacity and leadership to deal with a pandemic and the indirect impacts on their economies, trade, and supply chains. When businesses grind to a halt, will households be able to get what they need? If not, civic order could break down. Supply security is a fundamental national interest and governments that cannot provide it risk a loss of legitimacy and control. Major nations devote extensive resources to building and maintaining internal lines of communication so that neither natural nor man-made disasters can stop them from ensuring security and essential goods and services. Europe and North America will ultimately deal with the crisis successfully. A look at some basic indicators and indexes of national capabilities shows which nations are best and worst positioned to meet the logistical and supply challenges of the virus’s economic shock: The US ranks close to Japan in logistical capabilities, while Italy ranks between these two and Iran, which is woefully lacking (Chart 5). Chart 5Italy Suffers From Logistic Weaknesses Italy resembles China in having significant supply chain vulnerabilities (Chart 6), including quality of infrastructure (Chart 7). Obviously China has made leaps and bounds, but interior regions are still underserviced. Clearly China has benefited from greater government authority and capacity relative to Italy. Chart 6US Supply Chains Are Resilient Chart 7US Infrastructure Is High-Quality Even when it comes to basic food security, Italy and China are more vulnerable than others (Chart 8). Yet China has kept food shortages to a minimum throughout the crisis. The US is large enough that different regions will have greater vulnerabilities when it comes to the health crisis. The National Health Security Preparedness Index shows California, Florida, Georgia, Texas, and Michigan are below the national average in the ability to execute countermeasures to health crises (Chart 9). Chart 8Food Security Risks Under Control In China Chart 9US: Regional Differences In Health Preparedness These institutional factors suggest that Europe and North America will ultimately deal with the crisis successfully, although in the near term the consequences are unpredictable. Italy’s experience has made it apparent to all nations that if the reproduction rate is not suppressed through containment and isolation, then the health system will be overwhelmed and the death rate will go up. But clearly this has nothing to do with Italy’s being a democracy, as neither Japan nor South Korea have had the same experience. Investment Conclusions The United States is moving more aggressively to mitigate the problem, beginning with President Trump’s ban on travel with continental Europe and declaration of a national emergency. With a bear market having occurred, and a recession likely, President Trump is losing the primary pillar of his reelection campaign. He will continue to make reflationary efforts to salvage the economy. He has announced $50 billion in emergency spending and a waiver on student debt loan payments worth as much as $85 billion. But he has also become a “crisis president.” This means that he may take dramatic, surprise actions that are market-negative in the short term in order to delay the spread of the virus. Emergency powers are extensive and he will utilize them not only to combat the pandemic but also to double down on the narrative that got him elected: closing off America’s borders and reducing its exposure to the risks of globalization. This can include the movement of people, from places other than China and continental Europe (already halted), and even capital flows. This is another reason to expect greater volatility in the near term despite the huge discounts on offer. We are not bottom-feeding yet. The profile of global political risk is shifting as a result of the virus and its economic shock. If Trump is seen as having mishandled the health and wellbeing of the nation, then he loses the election regardless of whether stimulus measures help the economy rebound by November. Whereas if he takes drastic, economically painful measures now to control the virus, and ultimately the virus subsides, there is still a slim chance he can win election. His approval rating, at an average of 45%, has lost its upward momentum but has not yet collapsed. Regardless of the election, the financial bloodbath should not obfuscate for investors the fact that the US is the world’s most advanced economy and longest continuously running constitutional republic. It has survived a total Civil War, two World Wars, a Great Depression, and countless outbreaks of disease. It has the ability to take emergency action and mitigate pandemics. This means that a great buying opportunity is just around the corner. The profile of global political risk is shifting as a result of the virus and its economic shock. The above should make it clear that the US and Italy face the most immediate ramifications – both are much more likely to see changes in ruling party over the next year than they were. Policy, however, will remain counter-cyclical (reflationary) regardless. Rogue regimes like Iran, Venezuela, and North Korea face renewed risks of regime failure and/or military confrontation with the US and its allies beginning in the immediate term, especially if President Trump becomes a clear “lame duck” in the coming months. Down the line, the Japanese, German, and French elections will be affected by the economic fallout of the virus scare. China and Russia face medium-term risks due to new difficulties in improving their populations’ quality of life. Their leaders and ruling parties have an authoritarian grip, but political risk will increase as a result of slower growth. China retains the ability to stimulate aggressively – which it is doing – but that will slow the reform and rebalancing process. Russia, meanwhile, faces another wave of internal devaluation if it does not call off its emerging market-share war with Saudi Arabia. Presidents Vladimir Putin and Xi Jinping are likely to re-consolidate power by 2022, but they face much greater risks of domestic instability than they did before this year’s turmoil. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Martin S. Cetron, “Quarantine, Isolation and Community Mitigation: Battling 21st Century Pandemics with a 14th Century Toolbox,” September 20, 2006, available at nationalacademies.org.
Highlights Uncertainty & Yields: Global bond yields, driven to all-time lows as investors seek safety amid rioting markets, now discount a multi-year period of very weak global growth and inflation. Bond Portfolio Strategy: Maintain overall neutral portfolio duration exposure with so much bad news already priced into yields. Downgrade overall global spread product exposure to underweight versus governments on a tactical (0-3 months) basis given intense uncertainties on COVID-19 and oil markets. Model Bond Portfolio Changes – Governments: Upgrade countries that are more responsive to changes in the level of overall global bond yields and with room to cut interest rates (the US & Canada) to overweight, while downgrading sovereign debt with a lower “global yield beta” and less policy flexibility (Germany, France, Japan) to underweight. Model Bond Portfolio Changes – Credit: Downgrade US high-yield, euro area corporates and emerging market USD sovereigns & corporates to underweight. Feature Chart of the WeekOn The Verge Of Global ZIRP The title of this report is a quote from a worried BCA client this morning, discussing his daily commute into Manhattan from the New York suburbs. We can think of no better analogy for the mood of investors in the current market panic. After having enjoyed a decade of riding the gravy train of recession-free growth and robust returns on risk assets, all underwritten by accommodative monetary policies, worries about a deflationary bust following the boom have intensified. The global spread of COVID-19, the ebbs and flows of the US presidential election and, now, a stunning collapse in oil prices – markets have simply been unable to process the investment implications of these unpredictable events all at once. At times of such stress, the obvious thing to do is to stand aside and hedge portfolios while awaiting better visibility on the uncertainties. At times of such stress, the obvious thing to do is to stand aside and hedge portfolios while awaiting better visibility on the uncertainties. It is clear that global government bonds have been a preferred hedge, with yields collapsing to record lows worldwide. While most of the market attention has been on the breathtaking fall in US yields that has pushed the entire Treasury curve below 1% as the market has moved to discount a swift move to a 0% fed funds rate. New lows were also hit yesterday in countries that had been lagging the Treasury rally: the 10-year German bund reached -0.85% yesterday, while the 10-year UK Gilt fell to an intraday all-time low of 0.08% with some shorter-maturity Gilt yields actually dipping into negative territory (Chart of the Week). The common driver of yesterday’s yield declines was the 25% plunge in global oil prices after the weekend collapse of the OPEC 2.0 alliance between Russia and Saudi Arabia. The inflation expectations component of global bond yields fell accordingly, continuing the correlation with energy prices seen over the past decade. Yet the real component of global bond yields has also been falling, with markets increasingly pricing in an extended period of weak growth and negative real interest rates – especially in the US. Collapsing US Treasury Yields Discount A Recession, Not A Financial Crisis Chart 2Re-opening Old Wounds While this latest plunge in US equity markets has been both rapid and powerful, the damage only takes us back to levels on the S&P 500 last seen as recently as January 2019 (Chart 2). The turmoil, however, has reopened old wounds in markets that had suffered their own crises over the past decade, with European bank stocks hitting new all-time lows and credit spreads on US high-yield Energy bonds and Italian sovereign debt (versus Germany) sharply blowing out. The backdrop remains treacherous and global equity markets will likely remain under pressure until the number of new COVID-19 cases peaks outside of China (especially in the US). If there is one silver lining amidst the market carnage, it is that there appears to be few signs of 2008-style systemic financial stress. If there is one silver lining amidst the market carnage, it is that there appears to be few signs of 2008-style systemic financial stress. Bank funding indicators like Libor-OIS spreads and bank debt spreads have widened a bit over the past week but remain at very subdued levels (Chart 3). This is in sharp contrast to classic risk aversion indicators like the price of gold and the value of the Japanese yen versus the Australian dollar, which are closing in on the highs seen during the 2008 global financial crisis and 2012 European debt crisis. Chart 3A Growth Downturn, Not A Systemic Crisis We interpret this as investors being far more worried about a deep global recession than another major financial crisis. That is also confirmed in the pricing of US Treasury yields, especially when looking at the real yield. Chart 4Does The UST Market Think R* Is Negative? Chart 5Another Convexity-Fueled Bond Rally The entire TIPS yield curve is now negative for the first time, even with the real fed funds rate below the Fed’s estimate of the “r*” neutral real rate (Chart 4). The combination of low and falling inflation expectations, and plunging real yields, indicates that the Treasury market now believes that the neutral real funds rate is not 0.8%, as suggested by the Fed’s estimate of r*, but is somewhere well below 0%. With the fed funds rate now down to 0.75% after last week’s intermeeting 50bps cut, the Treasury market is not only pricing the Fed quickly returning to the zero lower bound on the funds rate, but staying trapped at zero for a very long time. The Treasury market is not only pricing the Fed quickly returning to the zero lower bound on the funds rate, but staying trapped at zero for a very long time. Yet that may be too literal an interpretation of the incredible collapse of US Treasury yields. The power of negative convexity is also at work, driving intense demand for long-duration bonds that puts additional downward pressure on yields. Large owners of US mortgage backed securities (MBS) like the big commercial banks have seen the duration of their MBS holdings collapse as yields have fallen. The result is that banks are forced to buy huge amounts of Treasuries (or receive US dollar interest rate swaps) to hedge their duration exposure of negative convexity MBS, hyper-charging the fall in Treasury yields – perhaps over $1 trillion worth of buying, by some estimates.1 This is a similar dynamic to what occurred last summer in Europe, when sharply falling bond yields triggered convexity-related demand for duration from large asset-liability managers like pension funds, further fueling the decline in bond yields (Chart 5). Yet even allowing that some of the Treasury yield decline has been driven by a mechanical demand for duration, a 10-year US Treasury yield of 0.56% clearly discounts expectations of a US recession, as well – which appears justified by the recent performance of some critical US economic data. In Charts 6 & 7, we show a “cycle-on-cycle” analysis of some key US financial and indicators and how they behave before and after the start of the past five US recessions. The charts are set up so the vertical line represents the start of the recession, and we line up the data for the current business cycle as if the latest data point represents the start of a recession. Done this way, we can see if the current data is evolving in a similar fashion to past US economic downturns. Chart 6The US Business Cycle Looks Toppy Chart 7COVID-19 Will Likely Trigger A Confidence-Driven US Recession The charts show that the current flat 10-year/3-month US Treasury curve and steady decline in corporate profit growth are both accurately following the path entering past US recessions. Other indicators like the NFIB Small Business confidence survey, the Conference Board’s leading economic indicator and consumer confidence series typically peak between 12-18 months prior to the start of a recession, but appear to be only be peaking now. The same argument goes for initial jobless claims, which are usually rising for several months heading into a recession but remain surprisingly steady of late – a condition that seems unlikely to continue as more companies suffer virus-related hits to their sales and profits and begin to shed labor. Net-net, these reliable cyclical US data suggest that the Treasury market is right to be pricing in elevated recession risk – especially with US cases of COVID-19 starting to increase more rapidly and US financial conditions having tightened sharply in the latest market rout. Bottom Line: Global bond yields, driven to all-time lows as investors seek safety amid rioting markets, now discount a multi-year period of very weak global growth and inflation – most notably in the US. Allocation Changes To Our Model Bond Portfolio The stunning fall in global bond yields has already gone a long way. Yet it is very difficult to forecast a bottom in yields, even with central banks easing monetary policy to try and boost confidence, before there is evidence that the global COVID-19 outbreak is being contained (i.e. a decreasing total number of confirmed cases). By the same token, corporate bonds (and equities) will continue to be under selling pressure until the worst of the viral outbreak has passed. We raised our recommended overall global duration stance to neutral last week – a move that was more tactical in nature as a near-term hedge to our strategic overweight corporate bond allocations in our Model Bond Portfolio amid growing market volatility. Yet with the new stresses coming from the collapse in oil prices and increasing spread of COVID-19 in the US and Europe, we are moving to a much more cautious near-term stance on global credit. Yet with the new stresses coming from the collapse in oil prices and increasing spread of COVID-19 in the US and Europe, we are moving to a much more cautious near-term stance on global credit. This week, we are making the following additional changes to our model bond portfolio to reflect the growing odds of a global recession: Downgrade global corporates to underweight versus global governments Maintain a neutral overall portfolio duration, but favor countries within the government bond allocation that are more highly correlated to changes in to the overall level of global bond yields. Chart 8Favor Higher-Beta Bond Markets With Room To Cut Rates Given how far yields have declined already, we think raising allocations to “high yield beta” countries that can still cut interest rates, at the expense of reduced weightings toward low beta countries that have limited scope to ease policy, offers a better risk/reward profile than simply raising duration exposure across the board. Such a nuanced argument is less applicable to global corporates, where elevated market volatility, poor investor risk appetite and deteriorating global growth momentum all argue for continued near-term underperformance of corporates versus government bonds. Specifically, we are making the following changes to our recommended allocations, presented with a brief rationale for each move: Upgrade US Treasuries and Canadian government bonds to overweight: Both Treasuries and Canadian bonds are higher beta markets, as we define by a regression of monthly yield changes to changes in the yield of the overall Bloomberg Barclays Global Treasury index (Chart 8). The Fed cut 50bps last week as an emergency measure and has 75bps to go before reaching the zero bound, which the market now expects by mid-year. Additional bond bullish moves after reaching the zero bound, like aggressive forward guidance, restarting quantitative easing and even anchoring Treasury yields in a BoJ-like form of yield curve control, are all possible if the US enters a recession. Meanwhile, the Bank of Canada (BoC) followed the Fed’s cut with a 50bp easing the next day and signaled that additional rate cuts are likely to prevent a plunge in Canadian consumer confidence. The collapsing oil price likely seals the deal for additional rate cuts by the BoC in the next few months. Downgrade Japanese government bonds to maximum underweight: Japanese government bonds (JGBs) are the most defensive low-beta market in model bond portfolio universe, thanks to the Bank of Japan’s Yield Curve Control policy that anchors the 10yr JGB yield around 0%. This makes JGBs the best candidate for a maximum underweight stance when global bond yields are not expected to rise in the near term, as we expect. Downgrade Germany and France to Underweight: The ECB meets this week and will be under pressure to ease policy given recent moves by other major central banks. A -10bps rate cut is expected, which may happen to counteract the recent increase in the euro versus the US dollar, but there is also possibility that ECB will increase and/or extend the size and scope of its current Asset Purchase Program. Given the ECB’s lack of overall monetary policy flexibility, and low level of inflation expectations, we see limited scope for the lower-beta German and French government bonds to outperform their global peers. Remain overweight UK and Australia: While both Australian government bonds and UK Gilts have a “median” yield beta in our model bond portfolio universe, both deserve moderate overweights as there is still the potential for rate cuts in both countries. The Reserve Bank of Australia (RBA) cut the Cash Rate by -25bps last week and they are still open to cut further to boost a sluggish economy hurt by wildfires and weak export demand from China. The RBA will stay more dovish for longer until we will see clear signs of a rebound of the Chinese economy from the COVID-19 outbreak. The Bank of England (BoE) will likely cut its policy rate later this month, or even before the next scheduled policy meeting, as COVID-19 is starting to spread through the UK. Downgrade US High-Yield To Underweight: US junk bonds had already taken a hit during the global market selloff in recent weeks, but the collapse in oil prices pummeled the market given the high weighting of US shale producers in the index (Chart 9). With additional weakness in oil prices likely as Russia and Saudi Arabia are now in a full-fledged price war, US high-yield will come under additional spread widening pressure focused on the weaker Caa-rated segment that contains most of the energy names. We recommend a zero weight in the Caa-rated US junk bonds, within an overall underweight allocation to the entire asset class. Downgrade euro area investment grade and high-yield corporates to underweight: COVID-19 is now spreading faster in Germany and France, after leaving Italy in a full-blown national crisis. The export-oriented economies of the euro area were already vulnerable to a global growth slowdown, but now domestic growth weakness raises the odds of a full-blown recession – not a good environment to own corporate bonds, especially with the euro now appreciating. Downgrade emerging market (EM) USD-denominated sovereigns and corporates to underweight: EM debt remains a levered play on global growth, so the increased odds of a global recession are a problem for the asset class – even with sharply lower interest rates and early signs of a softening in the US dollar (Chart 10). Chart 9Downgrade US Junk Bonds To Underweight Chart 10Still Not Much Broad-Based Weakness In The USD We will present the new specific model bond portfolio weightings, along with a discussion of the risk management implications of these changes, in next week’s report. Bottom Line: Maintain overall neutral portfolio duration exposure with so much bad news already priced into yields. Downgrade overall global spread product exposure to underweight versus governments on a tactical (0-3 months) basis given intense uncertainties on COVID-19 and oil markets. Upgrade high-beta countries with room to cut interest rates (the US & Canada) to overweight, while downgrading lower-beta countries with less policy flexibility (Germany, France, Japan) to underweight. Downgrade US high-yield, euro area corporates and emerging market USD sovereigns & corporates to underweight. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1https://www.wsj.com/articles/fear-isnt-the-only-driver-of-the-treasury-rally-banks-need-to-hedge-their-mortgages-1158347080 Recommendations Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns