BlueBay AM: Plague fears mount as we enter the Year of the Rat

24 januari 2020

By Mark Dowding, CIO at BlueBay Asset Management

Who would have thought there was an investment lesson to be learnt from Veganuary?!

Global yields rallied over the past week on building flight-to-quality fears related to the coronavirus outbreak. With China locking down travel to and from Wuhan, sentiment within the country has become increasingly anxious just as it breaks for it New Year holidays.

It would not be surprising for the Chinese economy to suffer a negative impact at a time when it has already been relatively weak. Given the importance of the Chinese economy, this has been having global ramifications.

In assessing the SARS outbreak in 2003, Treasury yields rallied by as much as 30bp at the peak of market fears – though this period also coincided with the start of the US invasion of Iraq. Consequently, virus fears may have only accounted for half of this move at the time.

It is also notable that as soon as the rate of new infections started to peak, then market fears were quick to abate. Therefore it is tempting to look at flight-to-quality trades as an opportunity to add risk and take an opposing view.

However, it may take a little longer for worries to peak and moreover, it is clear that China casts a much bigger shadow over global markets in 2020 than was the case 20 years ago and therefore it may be prudent not to rush to fade the market move.

Data positive

Away from these developments, we have been forming a more constructive view on the economic outlook.

Economic data releases in Korea and the UK over the past week have pointed to optimism. We expect that PMI indices may also highlight improving sentiment following a reduction in China / US trade concerns and with financial markets closing the year on a bullish note.

We are sceptical that the coronavirus outbreak will dent this, as long as it can be contained in due course. In this context, we are inclined to continue to reduce interest rate duration as we don’t see the US Federal Reserve (Fed) or the European Central Bank (ECB) lowering interest rates this year.

In credit markets, we would observe that valuations are already pretty full and for now we remain minded to sell into strength. CDS indices have been outperforming cash credit on basis.

ECB update: Remain on autopilot

In the eurozone, the ECB meeting was not a major focus for market participants. Monetary policy remains on autopilot and although the ECB has now started its strategic review, our sense from policymakers leads us to believe that this is unlikely to conclude before Q3 this year or lead a particularly material outcome.

Although policymakers in the eurozone would like to make further advances in areas like the banking union, for now there is an acceptance that this is going nowhere in a hurry.

In many respects, the absence of any crisis in Europe (away from the environment) means there is insufficient pressure or urgency to drive the compromises which need to be made in order to deliver tangible new results.

Italian politics back in focus

Within the eurozone, German voters and politicians continue to look nervously at Italy with a sense of distrust. The decision of Di Maio to stand down as leader of the Five Star Movement this week initially saw some volatility on worries that this could presage an early Italian election, which could open the door to Salvini and La Lega.

These worries were assuaged once it was understood that Di Maio was remaining as Foreign Minister within the coalition government and therefore the fate of the coalition may hang more on who Five Star chooses as its new leader in March.

Before then, this weekend’s regional elections may prove important for sentiment. Polls look very close in Emilia Romagna, as a wealthy region, which has been a traditional powerbase for the Democratic Party (PD).

Should the PD retain power in the region then Italian political risk may abate, whereas a decisive win for La Lega could trigger defections by MPs, causing the fate of the coalition to become increasingly fragile.

For now, we retain a flat position in Italy – but were spreads to widen materially on political concerns, we could potentially see this as a buying opportunity.

We currently put the probability of early elections at around 35% and ultimately, if it becomes possible to defer these until the end of the term in 2022, we are left wondering whether Mario Draghi will be persuaded to step in as the next Italian President – in a move which would likely be very reassuring to investors and which could, in our view, lead to a material re-rating of Italian assets, regardless of whether Salvini wins power at the time.

Could the UK bounce into a boom?

In the UK, we await the PMI release as this commentary is being written. The probability of a January Bank of England rate cut has fallen in the past week, on the back of a 2.5% monthly gain in house prices, positive labour market data and a robust rebound in CBI survey data.

In fact, the business optimism wasn’t far from a 20-year high in the UK and so more indicative of a ‘Boris boom’ than a ‘Boris bounce’.

That said, only a material jump in the PMI indicators will likely convince Carney that he should hold fire at his last meeting setting rates, with data having been soft into the end of 2019.

We continue to view Gilts as overpriced and given our expectations for yet more fiscal easing and a degree of pragmatism in EU trade negotiations, we would not be surprised if any rate cut would be reversed before the end of the year, if one were to take place.

Owning duration in the UK looks much less compelling to us than is the case in the eurozone. In comparing euro government bonds to their UK counterparts, there is a greater yield pick-up relative to underlying cash rates, ECB purchases create negative net supply of government bonds and there is much more reluctance to use fiscal policy to stimulate growth in the eurozone than in the UK, in our view.

Looking ahead

Chinese markets will be closed next week and so it will be interesting to watch price action in Asian hours in other markets to get a sense of whether virus fears are continuing to build or starting to peak.

In some respects, it has been interesting to observe that, so far, contagion worries have been quite contained. Given the positive performance in equity and credit markets over the past couple of months, it would be tempting to think that these markets are ripe for a correction, yet they seem to be proving resilient in the face of abundant liquidity at a time when investors seem to have plenty of cash they need to put to work.

FX volatility has fallen to record lows and the S&P sits close to its all-time high, which could be seen as symptomatic of complacency – but could equally signal a positive underlying trend.

This said, we see it as unlikely that equities can continue to rally with yields also going lower for very much longer.

From this perspective, we may think that short-term risks could be more skewed to a retracement in equities and spreads, while slightly longer-term risks are skewed to higher government yields. In both case we find ourselves selling rallies, which conforms with our overarching sense that 2020 will be a year in which markets may end up trading in ranges and so selling rallies and buying dips may be the key to delivering positive returns.

Hopefully the coronavirus will be contained and quickly forgotten in weeks to come and the Year of the Rat will be an auspicious one, rather than one remembered as seeing the onset of a global plague.

According to Chinese social media sources, it appears that the virus itself came from consumption of wild Chinese palm civets. Maybe Veganuary is not an idea to be sniffed at after all.