Viral volatility: uncertainty soars
Welcome to the second issue of Sharpe Thinking. Amid the intense volatility and global disruption caused by the Covid-19 pandemic, we provide the latest insights from our investment and economics teams.
The VIX, a measure of equity-market volatility, has not been at its present levels since the financial crisis, and is currently at its second-highest point in 20 years (see figure 1). The rise in global Covid-19 cases to well beyond 150,000 and the 30% collapse in oil price is driving the turbulence that has ended the longest equity bull market in history.
Figure 1. Volatility surges to its highest level since 2008
Source: Bloomberg, as at March 2020.
The global economy: a call for coordinated action
Our economists’ base case is that the coronavirus pandemic will have a sharp impact on the global economy. The situation will likely deteriorate over the next two-to-three weeks, before potentially recovering in the second half of the year.
This is supported by evidence that the disease could have peaked in China: the Bloomberg China Economic Recovery Index shows that 70% of economic activity was restored by 9 March, up from just 27% at the beginning of February. This suggests that we might see a similar pattern in other countries at earlier stages of combating the virus in the next couple of months.
In addition, we believe that significant policy support – both fiscal and monetary – is on its way. There have been sequential interest-rate cuts in the US, Australia, China and the UK, while the European Central Bank has delivered easing measures. Moreover, it seems that a coordinated global response has started to emerge after the Federal Reserve delivered an additional 100bp rate cut on Sunday night and announced it would work with Canada, the UK, Japan and Europe to lower the cost of borrowing dollars internationally.
Policymakers should aim to protect both supply and demand by providing ample liquidity to banks and corporations, in order to minimise the risk of default and job losses. The self-employed will also need support.
The collapse in oil prices is likely to have a mixed effect across economies. It will have a negative impact on oil-exporting emerging markets outside Asia, while it will also affect oil-and-gas related capital expenditure in the US. However, it will benefit net oil importers in Europe and Asia. Inflation should decline over the next few months, which could absorb shocks for beleaguered companies and consumers.
Equities: quality opportunities
Our equities teams are fully aware of the rapid velocity of market moves. Last week, trading circuit breakers were breached twice in the US, India, Indonesia and Thailand and short-selling bans enforced in Spain, Italy and South Korea. With long-term bond yields close to 1%, leading to lower equity valuations, our teams are keeping watch for opportunities while also concentrating on managing downside risk.
Following stringent isolation measures in Asian countries, the rate of new coronavirus cases has decelerated sharply, meaning that markets in the region have fallen less severely this month. Our Asia ex-Japan team thinks that two types of companies are likely to benefit from the current conditions: those with valuations that are unjustifiably low given their projected cash flows, and quality-growth companies that will benefit from ever-lower interest rates.
Our Global Emerging Markets team is underweight commodity-sensitive markets including South Africa and Saudi Arabia, and is neutral on Brazil. Its exposure to Russia is through technology stocks, rather than energy companies, and its overweight to India has performed well given the relatively closed-off economy’s resilience to the oil-price slide. The team remains focused on long-term structural themes: 5G networks, digitisation, the Internet of Things, rising financial penetration, healthcare, the growing middle class and infrastructure development, which we expect should help mitigate the economic uncertainty caused by the global spread of the virus and weak commodity markets.
Last year, our Global Equities team shifted to a more defensive stance amid the market peaks, looking for quality characteristics like balance-sheet strength and consistent cash-flow generation. These are precisely the type of characteristics that investors have favoured recently, while the areas most affected by the pandemic have been those reliant on global supply chains and discretionary consumer spending.
Credit: staying flexible
As with equity markets, credit instruments in Europe seem to have suffered more than in the US. Meanwhile, emerging-market debt has fared relatively well, helped by enhanced convexity in the high-yield sector – that is, a relatively greater proportion of bonds trading below their call prices – and a collapse in global rates. Among sectors, the energy industry should bear the brunt of the oil-price collapse for now and we should see a meaningful number of defaults.
The team remains firm in its long-term conviction in allocating to higher quality credit, despite the likelihood that the superior liquidity of these instruments means they could sell off before those lower in the capital structure (illiquid assets are still struggling to find a clearing price). Within our Unconstrained Credit strategy, we are also using a defensive options strategy to maintain convexity and protect our long positions. In terms of positioning, the team is waiting for signs of stabilisation before investing. To read more from our Fixed Income team, see our recent note where we argue that the recovery in credit markets is likely to be more ‘u-shaped’ than ‘v-shaped’.
Direct lending: looking through the uncertainty
Our Direct Lending team notes that some transactions have either been withdrawn from the market or delayed. Until the impact of the coronavirus can be quantified, all parties – including management, bidders, sellers and lenders – will likely be uncomfortable applying a value to a company, and therefore a suitable debt structure. There will likely be disruption to available liquidity as lenders withdraw from the market.
As we gain more clarity and deals resume, we anticipate upside for lenders, including higher yields, more conservative debt structures and improved legal terms. This should be driven by a more cautious view from both private-equity sponsors and lenders. Given the team’s legally binding partnership agreements with top-tier banks, we believe we are well placed to access any quality deals – either now, or when the market reverts to full capacity.
Our response to the Covid-19 pandemic
The coronavirus outbreak is a rapidly developing situation and we recognise the need to be agile in responding to it. We have a full contingency plan in place to ensure business as usual if a large number of the workplace are required to work from home and all members of staff have remote access capabilities. Our business continuity plan will ensure that we continue to stay connected.
If you have any concerns or queries, please contact your sales representative.