BlueBay AM: We may pass the point of maximum panic within the next two weeks…

March 13, 2020

… and this will clearly be the moment to head in the opposite direction.

By Mark Dowding, CIO at BlueBay Asset Management

As virus contagion sweeps the globe, flight to quality in financial markets has become full blown over the past week. As liquidity has evaporated, price action in all assets, including government bonds, has become increasingly erratic, with large intra-day swings following the triggering of various stop losses.

Over the past couple of weeks, we have seen equities fall into bear market territory, corporate credit spreads have doubled and emerging markets have come under extreme pressure – compounded this week by the spat between Russia and Saudi Arabia, which has seen oil prices plummet to the 2016 lows.

Supportive central banks

Policy easing by the Bank of England and the ECB has been supported by further fiscal measures. Although, for the ECB and President Lagarde, a communication slip caused panic in European spreads, and did much to overshadow the finer details of the policy measures.

Central banks have an important role to ensure financial stability, though there is a sense that policy can soothe rather than fix the issues which are currently being faced. Arguably, as soon as we can move beyond containment to mitigation and adjust to Covid-19 as a fact of life the better.

Containment still required

However, this is first and foremost a human rather than an economic tragedy in the making. There is a growing sense that containment measures are destined to fail, yet containment is still required in order to slow the impact of the virus and to help limit the impact on overstretched healthcare systems.

Delaying the peak until the next winter season should also help give time for vaccines to be developed and for greater planning and preparation to be put into place. In this context, moves to suspend economic activities are understandable and one can also comprehend how financial assets will be vulnerable in the face of this.

It’ll get worse before it gets better

Over the next couple of weeks, it seems very probable that news flow around the virus will get worse. Infection rates are likely to accelerate in Europe and the US, and across the developing world. Further travel restrictions, event cancellations, social distancing and working from home may become commonplace for a time and it seems unlikely that life in many countries will have returned to ‘normal’ before the end of Q2.

In Asia, where rates of infection have fallen, it is likely that new hot spots will occur, unless borders remain closed and, in this context, there is a sense that safe havens are in short supply. All of this said, however, it should be stressed that the coronavirus – unpleasant as it is – does not represent an Armageddon scenario.

Are fears overblown?

Death rates are low and most who contract it will experience very mild symptoms. This is even more true of those of working age who are economically active, given that the impact is disproportionately greater with respect to those who are old and already frail, and not part of the working population.

In this context, we believe that history will regard the Covid-19 pandemic akin to a nasty flu-like illness – but it won’t at all come close to other historical pandemics like the Spanish flu, which was indiscriminate in its decimation of both the old and the young.

Hysteria yet to peak

Based on this thinking, we would be inclined to think that hysteria related to Covid-19 may be some way from peaking in the context of society at large. This point of maximal panic may yet be a month or two away.

However, financial markets will always try to be forward looking and, in this context, we think that we may have seen the bottom of the current sell-off at some point in the next couple of weeks. In saying this, we would reflect that some of the recent price action has been reminiscent of the dark days seen in 2008.

That said, the last global financial crisis was an event that was relatively slow to unfold and left long-lasting scars which took years to recover from. The difference today is that the timeline – both on the way down and on the way back up – is seemingly greatly compressed.

Policy response may take time to kick in

As we look ahead, it seems that the more severe things become in the short term, the more extreme will be the fiscal and monetary policy response. Noting that such policies act with time lags, it is very conceivable that the full boost from such measures will only really kick in just as activity rebounds, with pent up demand leading to a turbo-charged recovery in the second half of the year in the wake of an economic contraction in the context of the first half.

Cautious risk-taking

In line with this, we have wanted to be cautious with respect to taking risk for the time being, yet remain convinced that in the next couple of weeks there may be a time to start increasing exposure as long as one is prepared to invest on a 12–18-month time horizon. In some respects, it seems odd to reflect that there can be more confidence of where we should be in 12 months from now rather than 12 days from now.

However, in the short term, the speed of the market descent means that there has not been a very large window for risk transfer to take place. Many assets are still in the wrong hands and assets will also need to be forcibly sold in order to meet redemptions, which may occur.

On top of this, we confront an unprecedented situation where banks and managers, BlueBay included, are enacting protocols with respect to splitting teams and working from remote locations.

This will mean that liquidity will continue to be challenged and in this environment, some sales will surely occur at distressed levels and these are the moments when it is good to be in the position to buy rather than sell.

Patience is key

As we look ahead, it is important to retain a sense of calm and perspective. Valuations which looked rather expensive a few weeks ago now appear cheap in the absence of an extended recession and widespread defaults.

Risk aversion is never a permanent or lasting state and indicators like Vix won’t stay at current levels of over 60 for very long. As markets stabilise, there will be plenty of opportunities. We think that patience remains the order of the day for now.

Cherish the liquidity

In the volatility we are seeing, we feel confident that there will be situations where some investors will come to appreciate that they don’t have sufficient liquidity in their portfolios and thus are vulnerable to redemptions on daily funds even if they, like ourselves, are making use of mechanisms such as swing pricing in order to protect long-term fund holders from those investors who seek to redeem during the current investment environment.

When markets do turn, adding risk through liquid instruments would seem to make sense for us. Liquidity has a price and we believe that adopting a stance in which we cherish the liquidity in the funds which we manage should leave us well positioned to take advantage in the days to come.

Looking ahead

It is always darkest before the dawn. For now, there is still complacency that needs to be flushed out – notably in the US. Our thought would be that the situation in Italy today may easily be where Germany, France and Spain find themselves in a week or so from now and where the UK and the US will likely be in a fortnight’s time. As US attitudes adjust to this, hysteria will likely increase.

However, the moment of maximum panic is nearly here and when it does hit, it will clearly be the moment to head in the opposite direction. As for when this point is reached, surely when we are all getting a haircut on a stick, it will be a time for us all to get a grip!