As the coronavirus-induced economic dislocation becomes more profound, Nick Maroutsos, Co-Head of Global Bonds, discusses positioning within the Absolute Return Income Strategy.

  Key takeaways

• There is a growing recognition that economies are facing a major reset as country after country tackles the virus.
• Relative to the 2008 Global Financial Crisis, the moves that we have seen in mid-March have been unprecedented in terms of the speed in which markets have moved weaker.
• The lack of visibility in the near term means that markets are likely to stay volatile as investors gauge whether measures put in place to tackle the virus and the ensuing economic fallout will succeed.
• Global sovereigns are moving in an unusual way with risk assets and being long duration has not necessarily offset credit spread widening. We have added to index credit derivatives as a hedge to further weakness in credit.

Background

After weeks of deflecting coronavirus (COVID-19) concerns, country after country is beginning to shut down in an attempt to combat the threat of the virus to their populations. Markets have reacted fiercely in March, causing equities to sell off and pushing the yield on ‘safe haven’ 10-year US Treasuries to record lows. Government and central banks are being forced to introduce critical/extreme measures as they attempt to offset what may be a major global economic downturn. We expect that governments and central banks will do even more to support the system in due course.

Given these extraordinary circumstances, financial markets are likely to remain volatile and risk sentiment weak, reflecting both the public health threat and the economic uncertainty. The only macroeconomic data that sufficiently covers the period since concerns began had been limited mostly to earnings revisions, temporary store and business closures across Asia, and the ripple effect of supply chain disruption. Data from China covering the Lunar New Year lockdown, however, made for uncomfortable reading with industrial output declining a record 13.5% and retail sales down by more than 20% in the first two months of 2020. This has been compounded by the collapse in oil prices to around US$30 per barrel after Russia failed to reach agreement with OPEC on production cuts and Saudi Arabia subsequently announced it would boost production and cut prices.

Markets are acknowledging that shutdowns of whole swathes of the economy across multiple countries will mean a serious hit to gross domestic product figures, not just within individual countries but at a global level. Within the space of a few days, the debate has moved away from whether there will be a recession to the extent of its severity.

Positioning

• We maintain a defensive stance by owning higher rated assets, increasing our liquidity allocation where possible and focusing our corporate bond exposure at the front end which we expect can offer more stability going forward – shorter-dated securities now provide quicker roll-down in the event of further credit spread widening. And with rates at the lower bound, the volatility at the front end of the curve should be lower.
• In mid-March, portfolio duration remains at c. 1.5 years, the higher end of our strategy range and is concentrated in the 2-5 year part of the rates curve. We anticipated that the US Federal Reserve (Fed) would have to ease policy and had already been favouring higher duration prior to the uptick in volatility driven by recent risk events. In addition, the Reserve Bank of Australia was the first to cut rates (and subsequently announced QE), followed by the Fed and then the Bank of England, as central banks strive to be proactive. More recently, government bonds have been moving in way that is positively correlated with risk assets, i.e. government bond yields have risen as credit spreads have widened, hence our long duration position has been less beneficial as a hedge.
• Prior to the sell-off in risk assets, we had already reduced credit spread duration, with credit spreads close to historical tights. We had offset approximately 20% of our credit spread exposure utilising credit default swap (CDS) protection. We were not however expecting the level of weakness we have witnessed in investment grade credit during March, with the Bloomberg Barclays US Aggregate Corporate Bond Index trading over 200bps wider month to date (Source Bloomberg, option-adjusted spread, to 19 March 2020). By 20 March 2020 we had further reduced credit spread duration to c. 1.2 years.
• Energy-related exposure consists of one-week commercial paper issued by pipeline companies. We believe this commercial paper provides an opportunity for extra yield without much more risk given its short-dated nature.
• We will continue to look to keep cash/liquidity at higher levels and investing any surplus in short term commercial paper for now.

Outlook

With interest rates near the zero bound, our base case is that there is little rates ammunition left for the Fed to use. Hence, we expect to see more quantitative easing and further stimulus in the form of fiscal policy. The measures announced mid-March by governments, with fiscal support equating to as much as 15% of GDP in the UK, begin to address the seriousness of the situation but whether even these measures are sufficient will depend on the longevity of the changed circumstances in which we all find ourselves.

While it is difficult to predict the duration of the coronavirus pandemic, an economic and market recovery is likely to occur against a backdrop of low rates, no inflation and ample stimulus. We are, however, in extraordinary times so parallels with recent downturns may no longer be valid. No-one can say for certain whether containment of the virus will be a success worldwide or how long the economic disruption will be in place. This reduced visibility means markets are likely to remain volatile, in our view, so we take some comfort from our defensive stance.