Financial markets slumped and yields fell dramatically this week as the spread of the coronavirus to Europe and the United States prompted fears that the economic impact of the outbreak could be much larger than originally thought.
The market has quickly repriced risk as the threat of contagion has grown
Over the past few weeks, we have seen concerns regarding the coronavirus outbreak transform from a perceived local China problem to more of a global shock as the virus has spread regionally in Asia, in addition to countries within Europe, the Middle East, and even Latin America.
U.S. markets—having been resilient to the initial sell-off in Asia—were awakened over the past few days to the potential impact on global growth of a broader disruption in economic activity—an outcome that looks increasingly likely.
Risk assets took another blow after the Centers for Disease Control and Prevention (CDC) press conference, where officials noted “it is not a matter of if, but a question of when”1 the virus is spread in the United States, while stating that a global pandemic is likely. The director of the CDC later assured, however, that steps that the United States has taken to contain the virus have worked, and that the country is well prepared to deal with an outbreak.
The fallout has sent U.S. Treasury yields down to record lows and the market is now pricing in two or three rate cuts from the U.S. Federal Reserve (Fed) over the next year.2 For its part, the Fed has yet to pivot from its neutral stance, with comments generally in keeping with a cautiously optimistic tone as it relates to the U.S. economy, while stating that current policy remains appropriate and that the Fed expects the coronavirus impact to be a temporary disruption.3
In the corporate high-yield universe, we have seen orderly selling thus far, which had caused spreads to widen by about 75 basis points (driven by weakness in the lowest credit qualities, in particular, CCC-rated debt). However, the total drawdown has been muted by the move lower in U.S. Treasury yields.1 From a currency perspective, the U.S. dollar has broadly benefited in February from a mix of safe haven demand and the United States' relative outperformance in economic growth expectations.
Our outlook: watch for dislocations, but maintain a defensive stance
We are cognizant of the fact that global growth expectations are likely to be revised lower in light of the prolonged duration of the outbreak, and recognize that the probability of a global recession has risen in recent weeks. Our base case scenario continues to be one of a temporary disruption to economic growth, barring a material escalation in the spread of the virus in the United States and Europe.
As the situation remains fluid, we believe it's prudent to remain cautious in the near term and continue to maintain a relatively defensive stance from an interest rate, credit, and currency perspective. We're currently looking for broad-based dislocations to identify targeted situations that we can take advantage of on a tactical basis, particularly in countries and sectors that are less reliant on global demand forces. That said, patience and selectivity will be key. At this juncture, we also believe that a slightly longer duration—at least in the coming weeks—makes sense if the situation deteriorates further (i.e., significant spreading of the infection across the United States).
1 “CDC official warns Americans it's not a question of if coronavirus will spread, but when,” CNN.com, February 26, 2020. 2 Bloomberg, as of February 27, 2020. 3 “Fed’s Clarida says ‘still too soon to even speculate about impact of coronavirus,” marketwatch.com, February 25, 2020.