We held a conference call yesterday to discuss the market and economic impact of COVID-19. In case you missed it, each of our speakers shared their key takeaways.
Saurabh Lele, CFA, Senior Commodities Analyst
The spread of COVID-19 outside of China has caused a lot of anguish in markets. More testing is starting to happen across the US and elsewhere, and that will lead to more diagnosed cases and epicenters in the weeks to come. Here are signposts I’m watching to assess how the virus might progress from here:
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Quarantines. We need to see more quarantines. They are the only thing known to stop the virus from spreading. Unfortunately, so far, many countries have been very slow to enact containment efforts largely because of the economic risks.
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Number of cases at each virus epicenter. In China, the number of cases peaked after about three to four weeks of extraordinary quarantine efforts. If a similar pattern emerges in other epicenters, it will give us some idea of what to expect as the virus spreads.
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Evidence of seasonality. If COVID-19 turns out to be a seasonal virus, much like the flu, it could go away by summer. There is currently no evidence of this, but it’s something to watch.
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New epicenters. I’d like to see at least two to four weeks pass without any new epicenters to be confident that the worst of the virus may be behind us.
Tom Fahey, Co-Director of Macro Strategies
I’m breaking down the potential economic impact of COVID-19 into four categories: the good, the bad, the ugly, and the policy response.
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The good. China showed that the virus can be contained. Of course, the strict quarantines will likely mean one quarter of little to no growth for China. But the Chinese economy is coming back online, and we hope this pattern repeats in other affected countries.
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The bad. The virus has spread outside China. In January, our team identified this as our downside scenario—and here we are, with new epicenters around the world. Asset prices have hit the downside price targets we predicted in January, suggesting that markets have now priced in the risk of global spread. Currently, we expect second-quarter growth to slow to almost zero in the US and Europe before rebounding in the second half of the year.
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The ugly. There is a significant risk that we enter a global recession if the virus is not contained. In my view, the risk of a downturn is the highest it’s been since before the global financial crisis.
Michael Gladchun, Director of US Rates Trading
In an abrupt pivot before its March meeting, the Fed cut the fed funds rate by 50 basis points. This caught the market somewhat by surprise given the lack of earlier guidance. It was also surprising to see the Fed act unilaterally with an off-cycle cut given the coordinated G7 statement that preceded the action.
- The Fed has more policy space to act than any other central bank and it appears to be exercising prudent risk management by acting proactively in a time of heightened uncertainty—we expect this to continue.
- The market appears to be pricing in a bear-market scenario. As of 9:00am EST this morning, it has priced in over 90 basis points of additional easing through year-end and the 10-year Treasury is yielding 73 basis points. We are more sanguine and are projecting a bit less easing and an eventual recovery with the 10-year posting higher levels by year-end. The market could be basing expectations on history. The Fed has taken seven emergency inter-meeting rate actions since 1994. In all instances, the Fed made a similar rate adjustment at its subsequent meeting. All but one of these moves were of the same or greater magnitude as the emergency action.
- In terms of trading dynamics, we see investors buying duration for protection. Anticipation of further quick Fed action that leaves rates close to the zero lower bound could see the shorter end of the curve move lower. More thematic trades have been focused on yield curve positioning and expectations for a steeper curve.
- With regard to the repo market, there has been a mismatch in supply and demand. There could be some issues with payments globally as a result of the halting pace of business activity. However, the big takeaway is that the Fed appears to stand ready to take action if necessary, similar to its successful response to the repo market dislocation in the fall of 2019.
Michael Crowell, Co-Director of Macro Strategies
The coronavirus has roiled markets and heightened uncertainty. But in many ways, this is not an alien environment for us. Investors always face unknowns. Loomis Sayles has frameworks and resources in place to help us make informed, unemotional decisions in the face of uncertainty. Here’s what they’re telling us:
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The credit cycle. This framework examines the fundamentals of the credit market. We’re currently in a late-cycle environment, and the potential of entering a downturn is elevated. This means corporations typically have high aggregate debt levels and many companies are vulnerable. In this type of environment, our credit cycle framework suggests taking a more measured approach to credit exposure.
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The credit risk premium. Our credit risk premium models attempt to understand corporate bond valuations and how far prices may have departed from fundamentals. A higher premium (which incorporates factors like price moves, expected downgrades and defaults, and Federal Reserve cuts) suggests higher compensation per unit of risk. The risk premium was unattractive before the coronavirus outbreak. The impact of the virus has pushed the premium higher, but we aren’t yet seeing a clear signal to add credit risk.
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Sector Teams. Our sector teams are made up of portfolio managers, analysts and traders. These experts bring a diversity of perspectives and insights to help inform our sector views. Currently, our credit sector teams agree that while valuations may look more attractive, the opportunity is not straightforward. For example, though investment grade spreads are wider, dollar prices have actually gone up in many instances. This is atypical and something we’re watching.
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Commodity, interest and derivative trading involve substantial risk of loss.
This blog post is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. This information is subject to change at any time without notice.
© Loomis, Sayles & Co.
© Loomis, Sayles & Co.
Read more commentaries by Loomis, Sayles & Co.
Saurabh Lele, CFA, Senior Commodities Analyst
Tom Fahey, Co-Director of Macro Strategies
Michael Gladchun, Director of US Rates Trading
Michael Crowell, Co-Director of Macro Strategies