Global Weekly: Corona virus and the oil price

News item -

After US President Donald Trump banned travel from Europe to the US (except for the UK), investors became spooked and markets tanked. The outbreak and spreading of the Covid-19 virus sent markets south.

On top of this, Saudi Arabia started an oil price war. At the time of writing on Thursday morning, the Euro Stoxx 50 Index is trading around 2,700 – a reduction of 30% from its top. The S&P 500 Index is down by 20% from its top.

It is not clear to what extent policymakers and health authorities will act. Italy has taken radical measures, closing down the north. Other countries have taken measures as well, but not to this extent. We believe most readers are well informed on this subject so let’s see what the financial market repercussions might be, starting with the oil price war. We expect that effects of the failed OPEC+ meeting, which led to a sharp oil discount decision by the Saudis, will be solved soon. Saudi Arabia’s current account balance cannot afford a price war. Oil inventories are now building and that can push prices even further downward, which is not in any oil-producing country’s interest. We expect OPEC+ parties will return to the table and solve their issues. The price of oil can likely recover to around USD 50-55 for Brent crude by the end of the year. This is our base-case scenario.

There are few things certain in terms of the Covid-19 virus, including its spread and the effects on health, economies and markets. We see, however, that after China took unprecedented measures, the number of new infections is declining and industry activity is starting up rapidly. It took roughly six months from the first case until now. We expect China to be fully operational by the end of the month. If this is a proxy for all other countries, then by the fourth quarter, a large part of the virus and its aftermath will be behind us. The economic effects will no doubt be severe. Equity markets are suffering in the short term; the longer-term effects are difficult to estimate.

Bonds: Challenges ahead

On Monday, US Treasuries reached a low of 0.313%, later moving up to 0.678%. German Bunds reached a low of -0.90% on Monday and moved slightly up to -0.80%. Japanese and German government bond yields fell below 1% in 2012 and 2014 respectively and currently remain in negative territory. Government bond yields have stayed near or below zero across Europe and Japan over the past six to eight years, because the economic rebound that followed their first entry into zero rates did not lead to any meaningful rise in inflation, which remains below central bank inflation targets. US Treasury yields of zero are now closer to reality, as the Federal Reserve is expected to engage in more rate cutting soon -- if not this week.

An environment with no inflation, low productivity growth, little fiscal expansion and higher savings can keep rates low and even in negative territory. Only countries with clear and strong fiscal expansion should be able to avoid deep negative interest rates on their sovereign bonds.

How did US Treasuries yields come so close to zero? It took a combination of shocks and it is still unclear if these shocks will bring about an official recession instead of just a major slowdown. The shocks started with last year’s US-China trade war, which brought global capital spending to a virtual standstill in the fourth quarter. This problem was compounded by the coronavirus, which is set to shrink Chinese economic growth in the first quarter and likely the rest of the world in the second quarter. Another shock was the Opec price war, where oil prices have been cut in half since early January.

The key portfolio management question now is whether the selloff in risk markets will continue, or whether a sufficient share of the bad news is now priced-in, meaning it is sensible to expect risk markets to trough soon. Any answer to that question must acknowledge great uncertainty, however.

Risk markets will most likely be challenged by additional decisions by policymakers in large developed countries that restrict the movement of people and goods. One big question concerns the extent to which investors have already built the expectation of such restrictions into risk market prices. Another question is whether markets have come to take too bearish a view on the likely duration of those restrictions or whether (instead) investors remain too sanguine in their view of the economic consequences of the virus and therefore need to price-in more gloom and doom. We do not have a high degree of confidence about the answers to these questions. Countries, for example, are still undertaking restrictions. Risk markets will continue to struggle in the coming weeks to balance the news related to the virus and the policies undertaken to fight the virus and support economies. There are additional economy-hampering policy restrictions on the movement of people (in the context of rapidly rising infection frequencies in the US and Europe) to consider versus two types of risk-market-friendly factors: (1) policy efforts to stimulate the demand for goods and services and (2) the high likelihood that the restrictions on movement will be a lot lighter later this year than they will be over the next couple of weeks.

Within fixed income markets, credit spreads are, on average, higher, despite the search for yields, as investors prefer positive yielding bonds. We believe that a long-term investor should have mostly credit in their bond portfolio. High-yield bond spreads have widened to levels last seen in the commodities crisis in early 2016, and, previously, at the tail-end of the Greek debt crisis in 2012. Yields have crept up to near the 5% threshold last seen at the end of 2018. Besides lagging compared to B-rated bonds, BB-rated bonds have sold off strongly versus BBB-rated credits. We think that expectations of an increase in asset purchases by the European Central Bank have helped to support BBB credits. The flows picture is truly concerning, because the lowest quality segment has almost no liquidity. Some investors who need cash, will prefer to sell their higher quality bonds, due to better liquidity. This could signal more risk, but it is a choice to sell the better credit and keep the most illiquid lower-rated credits. We will watch these developments closely. If liquidity is improving, the market should give more support as well.