Capital markets suffered a double whammy this weekend. First, the global spread of coronavirus picked up steam with confirmed cases outside of China still growing exponentially. Most acute has been the deterioration in Italy, which is now effectively on lockdown. Meanwhile, Saudi Arabia and Russia unleashed a poorly timed Game of Thrones price war in crude oil markets, ramping up production and cutting prices. Other major oil producers, including the US, will surely be collateral damage. The drop in oil is crushing energy stocks and putting their credits under severe pressure.
The fallout has been impressive and swift. Global equities have been gutted. Sovereign bond yields have plummeted, with the US 10-year Treasury hitting 0.54% while its German counterpart hit –0.86%. With swaths of the global economy effectively mothballed, corporate debt of all stripes has been hit hard. US and European high yield spreads have widened by 300 bps and 250 bps respectively since their recent lows, while credit default spreads have blown out as well. As the US Fed has most room to cut, the broad US dollar has tanked by 5% in three weeks. The flight from risky assets to safe assets has been nasty. (All data as of March 9.)
Volatility Will Be Here for a While
While the carnage in capital markets has been quick, the effects on the real economy will reveal themselves more slowly. High frequency data coming out of China has been exceptionally weak. To a lesser extent, this trend will start bleeding into other outbreak hotspots. GDP across Q1 and Q2 will likely take a meaningful hit. As markets begin to assess the duration and severity of the slowdown, earnings estimates globally will see downgrades. Big price moves across stocks, bonds, currencies, and commodities will eventually reveal over-leveraged players, while systematic de-risking of volatility-managed portfolios will exacerbate selling. Although the outbreak may be reasonably contained by April or May (our best guess, but definitely a guess), investors should expect elevated volatility to persist. The combined outbreak and oil price shock represent the biggest challenge to the global economy since the Great Financial Crisis.
Now for some more bad news: Aggressive rate cutting by central banks will have only a muted effect – largely signaling – with little pass-through to the real economy. Given the virus’s dual hit to both supply and demand, the cost of funds is of limited importance. Fiscal and monetary authorities would do better to develop a coordinated package of steps that addresses access to funds, i.e., liquidity. Businesses around the globe that were otherwise healthy are going to experience short-term cash flow gaps. The best way to reduce market volatility and put a floor under risk assets is to institute a compelling and credible set of countercyclical measures. While we think those announcements may be coming soon, their credibility and efficacy may remain in doubt for a bit longer.
As a result, a US or global recession, only a remote possibility a mere 40 days ago, is now a legitimate threat. At this point, however, that call makes little difference. The bond market is effectively pricing in recession whether it happens or not. Now for some good news: The shorter-term nature of the outbreak (i.e., a temporary shock) is some cause for optimism. If a technical recession ensues (two consecutive quarters of negative GDP growth), we don’t expect it to be deep or long-lasting. While the selloff in risk assets may feel 2008ish, this viral outbreak isn’t a structural weakness in the way that runaway housing prices or compromised banks were during the GFC. This crisis will take a different path than what we saw 12 years ago.
From Nasty to Namaste
Now for some emotional counseling. Forget the past. You can’t change it. How we got here is of little importance. The chaos and market disruption have created a new pricing regime across assets. It’s a new market landscape filled with new opportunities and new risks.
We’ll start with sovereign bonds as Fed cuts (past and future) have resulted in US bonds rallying the most. Yielding under 0.6%, the 10-year US Treasury is pricing in an unsustainable amount of negativity. By comparison, the US 10-year yield bottomed near 2.0% in the depths of the GFC. Going deeper, the yield can be further decomposed into a break-even inflation expectation of +1.0% with a real yield of –0.4%... for a decade. As real yields are a reasonable (but imperfect) proxy for real growth, US sovereign bonds are arguably pricing in a severe, long-term contraction of global economic growth. Moreover, they are pricing an inflation scenario that would run at half the Fed’s 2% targeted inflation rate. While we expect the economy to struggle through 2020, especially in the first half, this outlook is simply too bearish.
Timing the bottom in yields (or the top in bonds) is impossible. Traders who think the world will implode can bet that yields will fall further as central banks suppress overnight rates and will take already-overvalued bonds off their hands – effectively buying high and selling higher. But to be clear, at these prices, that is a trade, not an investment. For long-term investors, the best case scenario is that the central banks lock down sovereign yields, resulting in positive but paltry returns for US Treasuries and slightly negative returns for core Europe and Japan. Worst case scenario is that the world doesn’t end, central banks relent (at the margin) and growth and/or inflation pick up, resulting in meaningful principal losses with little income to offset them.
A final cross-asset note on sovereign bonds: Traders/investors inclined to think yields are going lower may first want to sell their stocks before buying more bonds. If the world does end (not likely in our view), equity losses will far outstrip fixed income gains.
Stocks & Credit: Adult Swim Only
Our caution extends to both equity and the credit sectors of the bond market as well, but the risks differ. Credit spreads have widened quite dramatically, but not evenly. Given the pricing war between Russia and Saudi Arabia, energy credits have rightfully been taken to the woodshed. To a lesser degree, cyclical names are under increasing pressure as the possibility of recession grows. Undoubtedly, amid this risk-off credit chaos, traders will sell first and ask questions later. This will create opportunities to distinguish the overleveraged and structurally doomed credits from those that are only temporarily impaired. To be sure, this is adult swimming only. We double our warning for the high yield and bank loan sectors. Larger dislocation in below-investment grade names will present even better opportunities for good security selection, but the risks are commensurately higher as well.
Meanwhile, as of this writing, the S&P 500®1 Index sits 18.9% below its February peak while the MSCI World ex US Index2 is 17.3% below its January peak. In other words, well into correction territory and a whisper above bear market levels. Like the credit sectors, this has brought some much needed value back to global equities. As with credit, stocks are not demonstrably cheap. They are, however, much cheaper than they were, and their relative value versus high quality bonds has skyrocketed as sovereign yields collapsed. At 15.9x forward earnings, the S&P 500® now trades at a slight discount to its 30-year average. After adjusting for the Tech Bubble years, we estimate that the index sits almost exactly at its 30-year average and median P/E ratio. For non-US stocks as measured by the MSCI World ex US Index, we see the forward P/E of 12.9x to be about 8%–10% below its longer-term (15-year) average.
Another comparison of relative value is instructive as well. Normally, we caution investors against comparing dividend yields to investment grade bond yields as stocks are 4x–5x times more volatile. It’s a good risk comparison if you think getting attacked by a jaguar is the same as being attacked by a tabby cat. However, risk differentials notwithstanding, the gap in income potential between stocks and bonds is at historic highs. In the US, the S&P 500® dividend yield of 2.3% is nearly 100 bps higher than the Bloomberg Barclays US Aggregate Bond’s3 yield-to-worst of 1.3% and 175 bps higher than the US 10-year Treasury (yielding 0.5%).
In starker terms, the S&P 500® now yields more than 4x the US 10-year Treasury bond. With dividend yields higher and sovereign bond yields in negative territory, this measure of relative value is even more compelling across Europe and Japan. Ultimately, the relatively attractive yields on global equities allow investors to “get paid” while they are waiting for the virus to run its course and the economy to stabilize.
A final word of caution: The coming global slowdown will require some companies to pull back on their dividends, so like credit, security selection will be key.
Stocks: Getting Paid to Wait?
Source: Bloomberg, Natixis Investment Strategies Group, Jan. 31, 2006 – Mar. 9, 2020 (monthly). YTW: Yield-to-Worst.
2 The MSCI All Country World Index ex-US is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global developed (excluding the USA) and emerging markets. The index is shown with minimum dividend reinvested after deduction of withholding tax.
3 The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based index that covers the U.S.-dollar-denominated, investment-grade, fixed-rate, taxable bond market of SEC-registered securities. The index includes bonds from the Treasury, government-related, corporate, mortgage-backed securities, asset-backed securities, and collateralized mortgage-backed securities sectors.
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