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Virus creates liquidity threat for lower quality bonds

Markets are dominated by coronavirus fears, triggering significant positive performance in high quality fixed income assets. As the threat of a global pandemic increases, economies are likely to collectively suffer with both lower demand and significant supply disruptions.

There isn’t a magical human policy which can easily make this go away. Interest rate cuts and liquidity will help, but they cannot solve the clear and present dangers we are currently facing. That’s worth thinking about as we look forward over the coming months, because we don’t think liquidity helps with supply issues this time.

Jamieson Coote Bonds (JCB) believes that the global environment was already slowing into the onset of this outbreak, but it is almost certain that economies will suffer intense slowdowns as a result. Virus-effected economic data for February is only now coming through.

Looking at China data to date, as the earliest country to experience COVID-19, it has been far worse than expected. This could trigger a cashflow crisis in corporates, and we hold grave fears for markets’ and central bankers’ ability to help in a ‘supply’ side shock.

Weak manufacturing data from China

The depth of the shock is sobering indeed. The official Chinese Government manufacturing data and the private sector manufacturing series for February posted outcomes far worse than the depths of the GFC. This type of economic outcome is likely in all virus-affected geographies over rolling time frames as the virus spreads.

The outlook for bonds in the short term

For bonds there are two clear pathways forward as we see it.

  1. The virus has already created significant supply and demand destruction, putting large pressure on corporate cashflows, killing incoming economic data. Hoping for the best, if the virus can be contained in the days and weeks ahead, markets will still require huge policy accommodation to deal with this shock. We are seeing the start now as the RBA cut rates 0.25%, the US Federal Reserve (the Fed) cut rates by a 0.50% emergency, the first since GFC, the Bank of Canada cut by 0.50%, and Hong Kong also followed suit. Rate cuts and liquidity programs will see bonds, as well as some other assets, continue to perform well.

  2. Our worst fears are realised, the virus drags on for a prolonged period and triggers a global credit event. In this instance return ‘of’ capital will be paramount, rather than return ‘on’ capital and government bonds would be one of the few standalone asset classes to provide that certainty plus providing significant liquidity. In this instance we would expect strong returns both on an outright and relative basis versus other asset classes.

Liquidity is the key in this uncertain terrain

We cannot stress enough the possibility that markets may totally seize. The speed and velocity of the current moves in an algorithmic dominated world are quite astounding versus what we previously experienced in the GFC. A total panic moment could potentially be ahead if the plumbing of the financial system cannot be lubricated – the credit markets must find a way to re-open and provide corporates the ability to roll existing debt obligations forward.

There is a very serious liquidity crunch unravelling, as parts of the funding markets and most of the corporate credit market are frozen. To date, central bank rate cuts have clearly not resolved these issues. It is highly likely the Fed and other central banks will need to inject an avalanche of additional stimulus and liquidity. In other words, more rate cuts, liquidity provision, extended swap lines, uncapped repurchase agreements and further quantitative easing.

 

Charlie Jamieson is Executive Director and CIO of Jamieson Coote Bonds (JCB). This article contains general information only and does not consider the circumstances of any investor.

JCB is an investment manager partner of Channel Capital, a sponsor of Firstlinks. For more articles and papers from Channel Capital and partners, click here.

 

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