Can you provide an
update on the implications of the coronavirus?
As of today, there are nine
confirmed deaths in the U.S. If we apply the approximate global fatality rate
of 1%, it would mean that a ballpark figure for the number of infected has to
be close to 1,000 cases, not the officially confirmed cases of approximately
100. This means the U.S. likely has a much higher rate of infections than has
been diagnosed. The worry is that the policy and public health measures to come
might well be more severe than what the general public population is expecting.
As test kits become more widely available to health professionals, the U.S.
will have to brace for a material rise in the numbers infected. The implication
is likely to be more containment measures, either explicit or implicit that
will impact U.S. economic growth.
What might be behind today's Federal Reserve
With this emergency cut of 50 basis
points (0.50%), the lower bound of federal funds rate is at 1%. This means that
the Fed only has 100 basis points (1.0%) of ammunition between now and the next
recession—that is if the Fed is serious about holding the line at 0%, and not
letting rates go into negative territory. If we look at Federal Funds Futures
after the cuts, it›s still pricing in three more cuts. So either the Fed is
looking at an imminent recession or it might have wasted valuable ammunition.
The timing of this action today, instead of just waiting a couple of weeks for
the scheduled Fed meeting is what spooked the markets. Deploying cuts now,
before fundamental data, before widespread public health actions, is being
interpreted negatively by markets.
What has been the impact on currencies?
Interestingly, as U.S. equities have
been selling off, the U.S. dollar has been weakening. This is likely due to the
U.S. interest rates falling much faster than the rest of the world, compressing
nominal rate differentials, which is a key driver of short term currency moves.
Over the next few quarters, the direction of the U.S. dollar will depend on the
differential in growth of the U.S. relative to the rest of the world. If China
is successful in stimulating its economy while the U.S. slows, then we might
see stronger Asian currencies relative to the U.S. dollar.
What has been the impact on credit markets?
Commodity & oil channel—The U.S. high yield is
getting hit as many energy companies were already teetering. With oil at around
$50 per barrel, several U.S. high yield oil and gas companies are expected to
default. As defaults rise and spreads increase in U.S. high yield, it reprices
credit spreads globally. The silver lining is that U.S. high yield spreads
started at multiyear lows while Emerging Market credit spreads, especially Asia
spreads, were already wide from the U.S. China trade dispute, so we expect the
repricing of credit risk to be more violent in the U.S. than in Asia.
Liquidity channel—Unlike China where the government has
already instructed banks to just blanket roll over short-term debt, no other
jurisdiction can ask for that level of forbearance of their banks. This means
that access to funding could be problematic for firms that need working
capital. This is a global problem and might in part explain the pre-emptive
rate cuts by the Fed.
What actions have you been taking on your
As bond investors, we are constantly looking out for
asymmetric opportunities to the upside. Since the beginning of the year, we've
adjusted the portfolios on the margin to take advantage of some opportunities
created by the coronavirus. For example, we are finding good opportunities in
convertible bonds that are priced below their bond floor. In other words,
receiving a credit spread that is higher than a plain vanilla bond of the same
issuer. In these cases, the potential for upside far outweighs the downside
risk, which is underpinned by the value of the bond floor.
From a risk management perspective, we are revisiting borrowers that are
most vulnerable operationally and financially. The combination of high
operating leverage and high financial leverage is the kryptonite of high yield borrowers. These
companies are most susceptible to sudden stop of capital from lack of market
access. Given the current outbreak, the most vulnerable industries are travel,
airlines, and commodity linked companies like oil service providers.
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