Volatility has risen due to increasing uncertainty over the coronavirus outbreak, albeit some encouraging macro signals supported sentiment in early February (ISM, China stimulus)
Risk appetite faded sharply in the past week. Investor sentiment was hurt due to increasing uncertainty about the economic impact of the coronavirus. The MSCI ACWI ($) was down by 3%, with Emerging Market equities under-performing heavily (-5%) and the Vix Index increasing to 19% (see graph page 3). On a sectoral level, US Energy (-6%) led the decline, falling in tandem with oil prices, as Brent has declined by 20% YtD. Moreover, Consumer Discretionary (retail, travel & leisure) has been hit hard, particularly in the euro area, with Utilities over-performing (see graphs page 3). In a similar vein, corporate bond spreads widened in the high-yield spectrum (USD: +35 bps to 403 bps | Euro: +19 bps to 335 bps) as risk-off mode prevailed.
Safe haven demand caused Government bond yields to decline significantly in longer-term tenors and curves flattened, with the UST 10Yr/3m spread reverting to zero (from 22 bps), thus reviving recession concerns. A slightly more-dovish-than-expected Federal Reserve weighed as well, with the US 10-year bond yield declining by 18 bps to 1.51%. Similarly, the German 10-year bund yield declined by 10 bps to -0.43%.
On a positive note, periphery bond spreads narrowed due to idiosyncratic issues both in Italy (the regional elections outcome in Emilia Romagna was deemed favorable for the current Government coalition) and Greece (as the debt management agency tapped markets with a 15-Year issue – the first issue to be priced over mid EUR swaps post crisis). As a result, BTPs spreads over Bunds narrowed by 20 bps to 137 bps and GGBs by 4bps to 161 bps. Low interest rates should keep the search for yield elevated. All told, investor sentiment recovered early in the current week, albeit is likely to remain under pressure in the short term, at least while the virus fallout continues to spread.
The Federal Reserve kept interest rates unchanged, as expected, at 1.5%-1.75%. Fed officials have reiterated their intention to keep interest rates at their current levels for the time being as policy is in a “good place”. Investor attention remains on the Fed’s liquidity provision to the financial system through T-bill purchases ($200bn since September), which is expected to continue until May 2020 in order to alleviate funding pressures in the repo markets. The IOER and RRP rates were raised by 5 bps and the statement included a dovish surprise regarding inflation and a less positive assessment vis-à-vis consumer spending. Finally, Mr. Powell noted that the Fed will remain vigilant for economic and financial risks stemming from China.
Note that US real GDP growth was 2.1% qoq saar in Q4:2019 (2.3% yoy), broadly the same pace as in Q3. However, recent downward revisions for retail sales in October and November have already led to more modest expectations for private consumption in Q4. As a result, private consumption rose by 1.8% qoq saar (2.6% yoy) from 3.2% qoq saar (2.6% yoy) in Q3. Business investment decelerated for a third consecutive quarter. Some green shoots emerged in the housing market, where residential investment rose for a second consecutive quarter reflecting, inter alia, sharply lower mortgage interest rates in H2:2019 (by 50 bps). Overall, private domestic demand decelerated to 1.4% yoy – the lowest rate since mid-2015. Looking forward, Q1 real GDP outcome is likely negatively affected by the grounding of Boeing’s 737Max aircraft, which is expected to shed around 0.5 pps from GDP growth (estimates: 1.5% qoq saar).