Andrew Harmstone, senior portfolio manager in Morgan Stanley Investment Management’s global multi-asset team and head of its Global Balanced Risk Control strategy, asks where the safe haven assets are amidst the coronavirus crisis.
In the last week of March, sentiment became more optimistic, with markets rising from their lows, albeit with continued volatility. The strong rally was sparked by the unprecedented monetary and fiscal measures taken globally to counter the impact of COVID-19. We retain the view that it may be too early to re-invest in risk assets as investor sentiment remains fragile and the markets could retest their lows.
Investment grade credit support; high yield remains less attractive
The Federal Reserve has played a large role in stabilising the markets through stimulus. March saw extreme moves in credit spreads as credit sold off. However, the Fed’s corporate bond purchases provided much needed support. This includes corporate credit facilities for both the primary and secondary markets totalling $20 billion, but with the option to increase this should there be a need.
The immense support and cheap valuations make investment grade credit an attractive opportunity, especially in the US. Smaller businesses with under 500 employees may also access support through the US government’s small business loans. However, the $2trn stimulus package must be deployed quickly to those households and companies who need it, before they default, and the economy suffers further damage and job losses. The 2 April US jobless claims report published 6.6 million job losses – the largest since records began in 1967, greater than the previous week’s 3.3 million and far greater than the previous high of 695,000 in October 1982, indicating that it is already too late for some.
In addition, the number of fallen angels is growing. As companies with high yield debt may not be eligible for the Fed’s support, bankruptcies become more likely. Half of the investment grade credit market is made up of BBB rated companies, which gives an idea of the potential scale of the problem.
Moreover, as they are downgraded, the size of these companies is causing further volatility in the high yield market, pushing spreads wider.
We expect many companies’ revenues to suffer significantly in the next 3-6 months, so further ratings downgrades and fallen angels are likely, particularly in sectors like Gaming, Lodging, Leisure, Airlines, Autos and Energy.
However, context is also important. Whilst we expect the dollar value of fallen angels to be higher than in previous crises, growth in the size of the market means they are likely to represent a smaller proportion of investment grade bonds overall. Nevertheless, in the near-term we believe other asset classes are more attractive on a risk-adjusted basis, so remain underweight high yield bonds.
It is not only the size of stimulus that is important. The Fed and US government appear to recognise this, and are making efforts to direct the stimulus to where it is needed most. That said, further fine-tuning may be required.
Where are the “safe haven” assets?
If we experience a further sell-off, investors requiring liquidity are likely to sell traditional safe haven assets. This was the case earlier in the year when all assets including gold and yen sold-off indiscriminately and before the Fed stepped in decisively. If this happens again, there may be few places to hide. Indeed, across equities and fixed income, only US treasuries held up during the sell-off and are benefitting from unlimited quantitative easing. For this reason treasuries and cash may be the only real safe haven assets.
Oil: Downside risk remains significant
Oil markets are experiencing a staggering oversupply due to the exceptional fall in demand caused by the spread of COVID-19, as well as a lack of production cuts from key players such as Saudi Arabia and Russia. Oil price curves are now in a steep contango, with futures prices higher than today’s. The barrage of supply has reached the extent that inland producers (many of which are in the US) are being forced to curb production, as pipelines and storage facilities are reaching maximum capacity.
The largest casualty of the downgrades to high yield in March was a big oil company. Default rates of energy companies are likely to increase, especially considering oil and gas represents 10% of US high yield. The crash in oil prices may also impact oil producers’ sovereign wealth funds, causing them to sell equities and bonds. We believe there could be further downside in the short term and there could be a more attractive point to enter the market.
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