BlueBay AM: Black swan replaces green swan

BlueBay AM: Black swan replaces green swan

Financial markets China

By Mark Dowding, CIO at Bluebay Asset Management

  • Epidemiology replaces ESG as the driving force behind market price action, for now at least.
  • Price action in global financial markets has been dominated by headlines surrounding the spread of the coronavirus during the past week.
  • Notwithstanding draconian measures to close transport links and the mandatory wearing of masks in public places, there is no sense that the acceleration in new infections has yet peaked and there are growing fears that the number of cases outside of Hubei province are starting to escalate.

Viral impacts

With airlines suspending flights to China and businesses and factories extending shutdowns beyond the Chinese New Year holiday, it seems likely that Chinese GDP may be impacted by 1-2% depending on offsetting policy measures designed to stimulate demand.

In assessing how GDP in other countries is impacted by shutdowns from strikes or snow days, it is possible to see how activity may evolve – though it is clearly very difficult to predict how quickly and widely the virus may spread and what the resultant global implications will be.

At a sectoral level, travel and tourism are obvious casualties. Elsewhere, shortages or bottlenecks could push inflation up in the near term.

Looking further ahead, it appears that the low level of mortality rates to-date, with deaths concentrated among the old and the sick, should mean that even in the case of more of a global pandemic – from a statistical point of view, it may be that what we are looking at is a mortality rate which effectively doubles the number of those who would typically have died from seasonal flu.

Were the rate of new infections to slow, it is tempting to think that markets would start to look beyond the coronavirus – as was the case when SARS reached containment in April 2003.

However, for now it is difficult to fade risk-off sentiment in markets as we are dealing with a situation which is very difficult to analyse and is characterised by an unquantifiable, left-tailed risk distribution.

In one sense it has felt that ‘green swan’ events would dominate thinking in 2020, based on the threats to the environment and a potential tipping point with respect to climate change. But what we’re now facing is more of a ‘black swan’ in the form of global pandemic, which is for the time being, at the front and centre of our thinking.

Yields rise as corona spreads

Amidst these developments, global government bond yields have continued to rally in the past week with 10-year Treasury yields moving below the cash rate as the yield curve inverts.

Markets now discount close to two rate cuts from the US Federal Reserve (Fed) in the coming 12 months, even with the Fed giving a very neutral assessment at the FOMC meeting this week.

We are very sceptical that the Fed will cut in this fashion and with the US equity market being supported by constructive earnings, we believe that unless there is a widespread outbreak of the coronavirus in the US, we struggle to project a material slowing in domestic growth based on endogenous, domestic factors.

A weaker picture for China could be more negative for Europe and emerging economies in 2020. However, we expect that fiscal stimulus in China and Europe should help to offset this.

For the time being, data in the eurozone remains consistent with a modest upswing in growth at the start of this year and growth around 1% in the region. Policymakers have recently been communicating a reduction in downside risks and the coronavirus may change this narrative, though we are very sceptical that this will lead to any change in ECB policy given the widening perception that cutting rates further could well do more economic harm than good.

Rate rumblings

By contrast to the ECB, interest rate policy at the Bank of England (BoE) has appeared much more open to question of late.

Following recent comments from MPC members, it had appeared as if the BoE was ready to cut rates from 0.75% to 0.50% this week. However, recent data has suggested an upturn in activity since the UK election.

Subsequently, the BoE decided to keep rates unchanged.

Markets continue to discount lower rates in the UK in the months ahead, though with fiscal policy moving more stimulative more quickly in the UK than in the rest of Europe, we are doubtful that such action will prove to be necessary.

Consequently, with 10-year Gilt yields trading more than 20bp below prevailing cash rates, we believe that yields are too low and that risks are skewed much more to higher than lower rates in the months ahead given the current starting point.

The flight-to-quality related to the coronavirus has seen credit spreads widen, with high-yield and investment-grade spreads ending January wider than where they started the year. Many equity markets are also in negative return territory, though the US market has continued to outperform thanks to healthy earnings momentum.

In emerging markets (EM), a flight-to-quality has also seen a reversal in some FX rates and credit spreads. However, prospects for lower global rates has helped local EM rates to rally, offsetting local FX weakness to some degree.

In the Eurozone, robust demand for a 15-year Greece issue saw GGB spreads rally in the past week in the wake of a rating upgrade to BB from Fitch.

Meanwhile, Italy was the leading contributor at the start of the week, when victory for the Democratic Party in Emilia Romagna saw a downward revision in perceived political risks, with an early election appearing less likely with the coalition government seemingly more secure for the time being.

It all hinges on containment

Much would appear to rest on if and when the spread of the coronavirus can be contained.

For now, we believe that it would be wrong to buy into a view which sees this threat causing a global recession, though it is clear that China growth will be weaker and further policy accommodation from Beijing will be warranted.

Ultimately, even if the coronavirus isn’t contained in China and becomes a global pandemic, we are hopeful that low levels of mortality and warmer weather in the spring will limit its impact.

However, in such a scenario, it is possible that fear may build further before it recedes. In this context we would like to be able to look through current market price action and look for flight-to-quality trends as an opportunity to further shorten duration and add exposure in our favoured long positions in risk assets.

Yet we feel that we can be patient as we look to do this and it makes sense to follow newsflow day by day with data on the disease spread likely to drive daily price action over the next week or two.

We know that with hysteria will come opportunity. However, the nature of the current threat means that it is difficult to quantify and analyse with certainty given that epidemiology isn’t our skillset – with part of our combined ‘wisdom’ having been gleaned from playing the video game ‘Plague’ on our phones or iPads in years gone by.

In this case we can’t adopt an attitude of complacency and acknowledge that market direction may well be easier to call in a few weeks from now.