Global Weekly: Markets defy virus threat

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If you read the newspapers these days, you may find it hard to believe that equity markets, especially those in the US, have just reached new all-time highs. At the same time, the number of confirmed cases of the coronavirus reached 28,000, with confirmed deaths at 565. Nonetheless, market participants are optimistic about the development of effective medicines to tackle it.

Gilead Sciences announced the trial of Remdesivir, an unapproved anti-viral drug developed for the infectious diseases Ebola and SARS.

On top of that, the fourth-quarter earnings season in the US has been generally upbeat. Close to 50% of S&P 500 Index companies have reported and earnings are better than expected. The star of the week was undoubtedly Tesla, as the electric auto manufacturer’s good earnings data took many short sellers by surprise. As a result the stock skyrocketed by more than 50% during the week.

The output of the Iowa caucus, which is the first state gathering to select a Democratic candidate in the US presidential election, triggered buying interest in US health care companies. This came as Bernie Sanders as well as Elisabeth Warren lost ground against rival Pete Buttigieg, UnitedHealth, for example, rose by more than 5%.

Overall, equity markets appear healthy and resilient, which supports our neutral stance, together with a clear cyclical bias.

Bonds: A preference for credit risk

There are two sources of risk driving returns in fixed income. There is interest-rate risk and there is credit risk. We believe credit risk will be our major source of returns in fixed income markets going forward.

For euro-based investors, changes in interest rates are often associated with price movements in German government bonds (the so-called risk-free rate). The interest rates of most German government bonds are negative. It is possible to invest in US Treasuries instead, where rates are much higher. But these bonds are priced in US dollars. If you hedge this currency risk, the yield that is left is similar to that of the German bonds. So unless you decide to leave the currency risk unhedged, you end up with a negative yield.

All other bond price movements are related to credit risk movements. Credit risk is a collection of different sorts of risks. One of these is the risk that a company goes bankrupt (a risk that materialised on a grand scale back in 2008). But there is also the risk that a country defaults on its debt, as happened to Greece during the euro crisis. Another important risk is so-called liquidity risk: the inability for buyers and sellers to agree a price instantly. Bond markets have become less liquid over the past 10 years. This risk is often overlooked.

The big question now is which one of these forces should be the driving force of your fixed-income portfolio. Falling interest rates have clearly favoured interest-rate risk for decades. However, bonds that have no, or only a little bit, of credit risk now have negative yields. This means interest rates need to go down even further for these bonds to make any return. This would happen only in an adverse macroeconomic environment. This means that these bonds are very unattractive, but would still help to weather an (unexpected) storm. However, given that we have a modestly positive macroeconomic outlook, that is, we expect growth to be slow but to improve in the course of the year, means that we believe it is unlikely that rates will fall much further.

We could also switch some of our rate exposure to cash, taking out the risk of interest-rate swings. Cash, however, also has a negative interest rate now. So it’s not an attractive option either. The relatively favourable conditions for taking credit risk means that by far the largest chunk of the bond portfolio should be exposed to it. Corporate bonds, Italian government bonds and also emerging-markets debt are therefore preferred and should help to make a return this year.