Central Bank “Puts”

Investors are ending the week in a tentative state as the number of reported coronavirus cases has surged in the wake of a change in diagnostic protocol. Global risk control markets continue to reflect growth concerns, while risk asset markets appear more sanguine in the face of expected central bank “puts.”

Here are five things to consider as we head into the long weekend:


The Known Unknowns:

Many updated forecasts are based on assumptions regarding the impact of the coronavirus on economic growth within and outside China. It has become pundits’ conventional wisdom that markets typically calm after the peak in new cases. That particular takeaway is based on a sample of one, SARS. It is important for investors to realize that the band of uncertainty is wide. We are unsure of when a true peak will happen, the speed at which the Chinese economy will reboot, and the ultimate economic damage outside of China. The damage is acute within China, with auto sales set to fall a record amount (25-30%) in the first two months of 2020. What we do know is that cases continue to be heavily concentrated (99%) in China and that Chinese authorities are attempting to offset the economic damage with easier fiscal, monetary and credit policies.


Another Potential Headwind:

Many strategists had called for a weakening in the US dollar in 2020 as global growth rates converged and “structural monetary accommodation,” which is a key element of our base case, becomes consensus. We believe that central banks will remain ultra-accommodative around the world and that low rates will increasingly be seen as a structural element of the global landscape, versus a cyclical element. However, with the onset of coronavirus investors are increasingly seeking safety and security, and that means US dollar assets. The trade-weighted US dollar has strengthened nearly 3% year-to-date. It has become consensus that the US economy may remain relatively immune to the negative impacts of the coronavirus. For investors, the strong dollar may be a headwind to US earnings. Last year, a strong dollar was referenced more than trade and tariff concerns on quarterly earnings calls, so a significantly stronger greenback will dampen earnings for the S&P 500 given the nearly 40% revenue exposure to non-US sources. This exposure is even more acute in the technology sector, where 56% of revenue is derived outside the US.


What’s Priced In, Bond Edition:

Global fixed income markets are reflecting both a cautious risk-off sentiment and a potential downward rating of growth expectations related to the impact of the coronavirus. In the US, the nominal 10-year treasury yield has fallen 26 basis points since peaking in early January, while the real rate has fallen 18 basis points. So most of the decline in the real yield has been a function of decline in growth expectations, not inflation expectations – which fell only marginally. The shape of the yield curve in the US remains interesting, with the curve inverted inside of 5 years. This suggests that the market continues to pressure the Federal Reserve to take action and lower Fed funds. Currently, the futures market has two rate cuts priced in: one in September 2020 and another in January 2021. That aligns with our outlook as well; however, we remind investors that more important than the timing or magnitude of any rate cuts is the premise that the Fed will not be hiking rates any time soon. The bar is simply too high, and this stable and potentially even easier monetary backdrop will continue to support risk asset markets.


What’s Priced In, Equity Edition:

Although risk asset markets are ending the week on a cautious note, many markets are at/near peaks (US, Germany). We believe that global equity markets are continuing to reflect central bank “puts”— that is, that central banks around the world will continue to provide stimulus and liquidity to markets and support risk asset prices. Many investors have been particularly perplexed at the performance of the German stock market (the DAX), which has been able to post solid performance (year-to-date, 12-month trailing) despite weak economic reports and concerns about future growth as the coronavirus fears deepen. In addition to the ECB “put,” it is likely that investors are looking at bad news being good news in regard to fiscal stimulus. We have heard new ECB president Christine Lagarde comment several times that fiscal stimulus is needed. A steep slowdown related to coronavirus may be the crisis that prompts action, which has thus far been lackluster.


Cats Chasing Dogs?

Sometimes, the market offers pricing that seems quite out of step with logic – like cats chasing dogs. Today’s example comes courtesy of Greece, where 10-year Greek sovereign bonds breached the 1% yield level yesterday for the first time in history. Perhaps investors have forgotten the relatively recent partial default on Greek government bonds that led to a bailout. Are investors overlooking the debt-to-GDP of 180%? Why would Greek bonds yield less than the US treasury? The short answer is that negative rates across Europe have pushed investors into taking more risk to get any return – hence the flow into Greek debt. At the same time, the Greek economy is on more solid footing, and there is the potential that Greek debt will be eligible for ECB purchases soon – currently, it is rated as “junk” and is ineligible for inclusion into the asset purchase program. Bottom line: The yield environment is not reflecting true risk and is not differentiating based on risk; rather, it is a function of central bank policy. We do not expect this to change, particularly given the near-term growth challenges of the EU related to exposure to China.


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