By Jim Keegan, Chairman, Seix Investment Advisors and Perry Troisi, Senior Portfolio Manager, Seix Investment Advisors
Coronavirus is a “black swan” event that occurred during a global synchronized slowdown driven by the manufacturing side of the global economy. Global GDP in 2019 grew an anemic 2.9% (global recession is defined as below 2.5%). The consensus is that this coronavirus will be transitory followed by a V-shaped recovery, but the risk is that a supply shock could become a demand shock if it spreads and is not contained.
From an investment perspective, this black swan hit at a time where risk was priced for perfection in both equities and credit as valuations are very stretched. The U.S. Treasury market represents the best relative value in the developed bond markets and should continue to benefit from a flight-to quality bid, global relative value allocation, and any anticipated policy response by the Federal Reserve (Fed). The Fed has said that it expected to be on hold for 2020 unless there is a “material change in the economic outlook”. A material change in our view would also include a tightening in financial conditions (lower stock prices and/ lack of credit availability for corporations).
The short-term economic implications are a supply chain hit from Asia and the second derivative hit to commodity prices (industrial metals and oil). The supply chain issues with China are well known, but South Korea is a major global supply producer of intermediate goods to the global economy. Should the coronavirus spread and not be contained, the risk of a global recession would become elevated. The key is to watch infection rates outside of China as most countries cannot lock down whole cities/regions like China has done as a command and control country.
The key to the U.S. economy has been and remains the consumer and the strength of the labor market. The labor market has peaked in 2019, in our view, and we must remember that the unemployment rate and consumer confidence are lagging indicators. Should the consumer change behavior and pull back due to the coronavirus, the risk of a recession in the United States will increase. It should be noted that the 3 month-to 10 year U.S. Treasury inverted for a persistent period in 2019, which in the past has signaled a recession in the next 9-18 months. Will this time be different due to aggressive Fed action in 2019? Time will tell.
Longer term, the U.S. economy should benefit from the de-globalization trend in general, the need to diversify supply chains (following the U.S.-China trade conflict) and now the coronavirus demonstrating the downside from overreliance on any one country.
From an investment strategy perspective, the United States should benefit with U.S. Treasuries leading the way (flight to quality and global relative value) along with precious metals led by gold (negative real rates and almost $15 trillion in negative nominal yielding debt). Remember: 2019 was a very unusual year where risk assets (stocks, credit) and haven assets (UST’s and gold) both had a banner year. Something had to give, and given the bond markets’ history of more accurately capturing these inflection points, it is not surprising to see risk reprice in light of this black swan event. The Fed will likely capitulate and cut rates, which will not contain the virus or boost the economy. The key question is whether market participants re-engage and chase risk further, or do they sell into any Fed-led strength and take profits after this 11-year rally.
Corporate debt as a percentage of GDP is at a record high and the overall quality of the corporate bond market is very low with 60% of non-financial corporates rated BBB. Moreover, about one-third of the BBB sleeve have leverage statistics that are consistent with non-investment grade ratings and a slightly higher percentage are either on watch for downgrade or have a negative outlook. The danger here is that in the next recession these credits are at risk to become fallen angels and that fallen angel supply will hit the high yield market at a time where they will likely be experiencing elevated redemptions with passive credit ETFs most vulnerable.
The key in this environment where liquidity is very challenged due to the change in the market structure is to have dry powder to be the provider of liquidity to illiquid markets where dislocations will increase. Our strategy has been to overweight UST’s with risk priced for perfection and returns per unit of risk close to record lows so that we are in a position to buy dislocated/mispriced credits as redemptions typically lead to people selling what they can sell (better credits) rather than what they want to sell (weaker credits).