The coronavirus alarm points to broader credit shakeout
Red-hot demand for US government bonds is a good sign that fear is ruling over greed among investors.
The benchmark 10-year Treasury yield blasted through its four-year-old record of 1.32 per cent this week, setting a low of 1.15 per cent by Friday. That big slump in yields — the flipside of soaring prices — adds to evidence that coronavirus is causing broader disruption around the world. The days when this was a Chinese problem are over.
US president Donald Trump took to the airwaves to encourage people to buy the dip in equities. But for investors, the warnings of both European and US health authorities held greater sway.
Making an informed judgment about the full impact of the outbreak on the global economy in the coming months remains very difficult. At the very least, a poor first quarter beckons. The danger is that, rather than a relatively swift rebound in activity, weakness extends towards the summer.
“The debate . . . in markets is whether the impact of the coronavirus is much bigger than expected,” said Wouter Sturkenboom, chief investment strategist for Europe, the Middle East and Africa at Northern Trust Asset Management. For now, the asset manager remains overweight US equities and areas of high-yield debt. Mr Sturkenboom said it was “too early to tell whether something fundamental has changed”.
Co-ordinated action by central banks and governments is becoming more likely. Assuming that happens, and helps to spread calm, then in time it should stem demand for havens such as government bonds and gold. Long term, equities led by quality and growth companies are a more profitable class of assets than owning sovereign bonds that provide a lower fixed rate of return.
But investors and policy officials will need to wait until May, at the earliest, before they can fully assess the tone of any rebound and what that entails for corporate profit growth and margins. Only then will we see economic data covering April, after the first quarter has wrapped up, giving a chance to assess any longer-term damage.
The benefits of owning US government bonds in a diversified portfolio have been demonstrated, not just over the past week but over the past 12 months. So far this year, the Bloomberg Barclays index of US Treasury debt with maturities of 20 years or more has generated a total return of 11.9 per cent. It is up 29 per cent over the past year.
Well before coronavirus began to spread, government bonds and gold benefited from doubts over an ageing global economic cycle, stubbornly low inflation and lacklustre earnings growth at a time of rising leverage in many corporate balance sheets. All of that contrasted sharply with exceedingly high valuations in equity and credit.
The credit market will be important for investors to monitor in an effort to discern shifts in broader sentiment. Until recently, companies were comfortably borrowing plenty of money at historically narrow premiums over government debt. Bond-fund managers, meanwhile, were ploughing into credit, seemingly confident that defaults and stress would remain low and that central banks could keep the economic cycle running for at least a little while longer. In recent years credit investors have largely downplayed feeble growth in profits and shrinking margins, while ignoring record-high levels of financial leverage for US companies.
US high-yield risk premiums have climbed sharply in recent days and are not that far from the peak seen in late 2018, when credit previously flashed a red alert.
It is important, then, to watch the reaction when companies try to refinance their debt in the coming months. There is now a real risk of a severe tightening of credit in leading economies, spurring a rising default rate among companies.
Fred Cleary at Pegasus Capital noted: “Our primary concern remains the credit markets and debt rollovers that need to take place over the next three to six months, especially if cash positions at more highly geared companies become impaired due to unexpected or acute revenue shortfalls.”
That is why, amid all the chatter of central banks coming to the rescue soon, it may be smarter for authorities to try to ensure that lines of credit do not dry up for smaller- and medium-sized businesses, in the event of greater disruption ahead.
“Micro-measures to support businesses during periods of major disruptions, including tax and fee waivers and cash support, are probably more effective than broad rate cuts by central banks,” said Tai Hui of JPMorgan Asset Management, based in Hong Kong.
Free flows of credit matter. An all-clear signal for investors depends on officials and governments removing any blockages.