With markets volatile and nations addressing the spread of COVID-19, investors have been bombarded with fast-evolving information. In the following highlights from a March 5 webcast, Dan Ivascyn, group CIO, Tiffany Wilding, North American economist, and Mohit Mittal, portfolio manager, discuss the economic impact and market implications of the coronavirus, and how we’re positioning portfolios for what’s ahead.
Q: Dan, how is PIMCO viewing the economic and market ramifications of COVID-19?
Ivascyn: Before anything else, this is a humanitarian crisis that is creating tremendous fear and anxiety. We are sympathetic to what all our clients and everyone else affected are going through, on both a personal and a professional level.
This is a unique crisis. It's not a traditional financial-market-driven crisis or a crisis tied to an explicit economic shock. In some sense the destination is more certain: Most of our internal and external healthcare industry experts believe this virus will ultimately be contained, and when that occurs, we will likely see a meaningful economic recovery.
However, the key point, and I can't emphasize this enough, is the path to that destination is incredibly uncertain. Fears and concerns across the industry will relate to GDP troughs and financial market responses. But people generally are much more concerned about their family's health, how they're going to manage their lives during periods of significant disruption, and that could lead to unpredictable market results. I don't mean to sound alarmist, but we have to have a healthy degree of respect for unpredictable market activity.
We believe we have yet to see the worst of it. We may see stabilization in China, but when we assess the situations across North America, Europe, and segments of emerging markets (EM), our best sense is that the number of cases will peak around May or June, or potentially in summer. There could be significant disruption in work environments outside and within this industry, and bouts of illiquidity or overshooting in fundamentals in order to clear markets.
However, one advantage I believe PIMCO has is our top-down-oriented investment model that allows us to shift to a centralized command-and-control structure during periods of significant volatility. This affects how we allocate across markets, how we manage risk, both in terms of sector concentrations and client liquidity, across significant portions of our strategies. We came into this environment with strong initial conditions, but we are not simply sitting back and saying, “Hey, we're fine now.” We are anticipating additional volatility or stress. In addition, although some areas are beginning to look a bit more attractive from a return perspective, we have been hesitant to add risk. To be sure, there will be a period where adding risk more aggressively will make sense and likely provide a great opportunity for our clients to help drive further returns.
Q: PIMCO entered the year with a theme of “Dealing With Disruption” – the title of our Secular Outlook last May – and noted the potential for disruptions in a low-growth environment. How has that view been reflected in portfolio positioning, and how is it evolving?
Ivascyn: We are focused on avoiding permanent capital impairment. We believe the combination of defensive investing, especially in the higher-yielding segments of the market, along with proactive liquidity management, gives us the resiliency we are looking for across client strategies and will position us to add risk when we believe the risk-reward proposition looks more attractive than it does today.
A lot of the assets that we have focused on over the last several months offer attractive yields but have defensive characteristics, such as agency mortgage-backed securities, and if we see a further leg down, we expect they should continue to exhibit strong relative resiliency. We also have focused on other defensive areas where fundamentals remain quite strong, such as investments tied to the consumer and housing, or segments of the corporate credit universe that have been positively affected by a cautious and conservative regulatory regime.
Q: Tiffany, could you discuss policy responses to address ramifications from the coronavirus, and what further responses PIMCO expects?
Wilding: It's important to keep in mind what monetary policy can and can't do. The Fed cannot stop the spread of the virus. They're not particularly well-suited to deal with supply chain shocks or to convince consumers to consume services they don't want. What monetary policy can do is try to create an environment of easier financial conditions. That may not buffer the economic shock, but it doesn't exacerbate it, and a substantial amount of academic literature suggests that financial market stress can deepen a downturn, particularly banking stress.
I think the Fed’s 50-basis-point (bp) emergency rate cut on March 3rd was likely the first in what will be synchronized action taken by the G-7. The Fed’s shock-and-awe move was clearly intended to arrest the equity market correction and help stabilize broader financial conditions. By our measure of financial conditions the Fed’s move offset around half of the tightening that we had seen after the initial coronavirus outbreak. However, equity values declined after the cut and that reduced the cut’s effectiveness. The Fed probably will need to cut a few more times, and that will likely be amplified as other central banks around the world cut.
Other central banks have followed the Fed’s lead. The Reserve Bank of Australia cut rates by 25 bps on March 3rd, the Bank of Canada on March 4th cut rates by 50 bps, and we think the Bank of England will probably cut at their next meeting. Rates are already negative in Europe, so the European Central Bank may look to asset purchases and targeted long-term refinancing operations that incentivize banks to lend to companies that might be having virus-related cash flow disruptions.
Emerging markets may have more room to ease because EM inflation responses to currency moves have generally declined of late. It's also important to keep in mind that real rates in EM are much higher than those in developed markets, so that gives them a little bit more capacity.
Fiscal policy is likely to be critical, especially in more adverse scenarios. We believe the fiscal policy response will be more targeted to the healthcare sector, and there could be targeted responses to cushion cash flow disruption at affected companies. In the U.S., for example, Congress passed a bill to provide about $8 billion to combat the virus. That is a limited amount, but we expect governments across the EU to provide similar measures.
Q: In a recent blog, “COVID-19: Repercussions Could Worsen Before They Improve,” you discussed the economic risks in China, including the likelihood of a substantial first-quarter contraction. Are we seeing any improvement in China, and what about risks outside of China?
Wilding: High frequency data on traffic congestion and port shipments suggests that activity is still severely depressed. In the last week or two we’ve started to see some normalization in the largest port cities, but elsewhere activity remains depressed. China accounts for about 25% of global manufacturing activity, so disruptions will be felt throughout the global supply chain. Exports to China also will take a direct hit, and prices for oil and industrial metals have already fallen.
As cases outside of China increase, this is no longer limited to a global manufacturing and trade shock. Quarantines, and cancelled travel outside of China, will likely disrupt global services consumption.
U.S. trade and tourism constitute around 3% of U.S. GDP, but in the case of a more severe outbreak, other services, including gambling, hospitality, recreation (admissions to live events, or museums), and personal care services are also likely to be disrupted. Together, these sectors make up around 9% of GDP. It’s also useful to think about a worst-case scenario with severe outbreaks in large cities (MSAs) – New York, San Francisco, Los Angeles – which make up around 16% of GDP.
There are a wide range of possible outcomes. U.S. growth could be 0.4 percentage points lower in the case of milder shock to travel, or 2.5 points lower if activity in several large MSAs is depressed. This would be on top of the meaningful hit to U.S. growth from trade and manufacturing disruptions, and these estimates don’t consider additional effects from heightened stress in markets or at banks.
Q: Mohit, how has the market absorbed this recent bout of volatility? And given that much of the world has seen a very strong rally in fixed income, what do you make of the absolute level of rates?
Mittal: Liquidity conditions have changed moderately as would be expected in periods of high volatility, but so far liquidity has held up much better relative to the fourth quarter of 2018. We have seen bid-offer spreads widen only moderately. With respect to valuations, credit spreads have widened but have generally held up better than in Q4 2018, except in directly impacted sectors like energy and transportation. Given the ongoing uncertainty, there is a risk of additional weakness in credit spreads and deterioration in liquidity before we see stabilization.
Markets are fluid, but as we are having this discussion the yield on U.S. 10-year Treasuries is below 1%. I think the outlook is tied to how the coronavirus spreads. If we see dramatic increases in cases and an associated slowdown in business activity or deterioration in financial conditions, the Fed will likely be prompt to act and cut further. On the other hand, if cases start to plateau and activity starts to normalize, the Fed may not need to deliver the additional cuts, and then a 10-year yield below 1% in the context of the Fed’s 2% inflation objective would make less sense.
Q: Could you share insights into key overweights and underweights? What industries or sectors does PIMCO see as more vulnerable than others?
Mittal: While broadly credit has not widened significantly, there are sectors within credit markets that have underperformed. The energy sector has been one of the largest underperformers given the weakness in oil. PIMCO estimates for first-quarter-2020 peak and full-year crude oil demand destruction are 2 to 2.5 million of barrels per day and 700,000 to 1 million barrels per day, respectively. However, it’s too early to know the longevity of the demand impact. OPEC weighed additional production cuts, but at the time of this conversation the talks appeared to reach a stalemate. Given the uncertainty in demand and supply, many U.S. energy producers with higher leverage have underperformed. Similarly, sectors tied to travel like airlines, autos, leisure, and gaming have widened.
Given our cautious outlook based on tight beginning valuations, we have been underweight broad corporate credit generally and many cyclical sectors. In lieu of such corporate credit exposure, which becomes even more vulnerable if conditions worsen, we have held exposure in higher-quality spread structures like mortgages where there may be volatility but default risk is negligible, in our view.
Within corporate credit, our focus has been on more resilient and defensive sectors, focusing on companies with strong balance sheets and healthy cash flow generation. We like financials, select telecom operators, REITs, housing and building material sectors, and have underweights in retail and energy companies.
Q: Dan, all things considered, what are your high-level thoughts on fixed income allocations?
Ivascyn: We continue to believe that higher-quality bonds have a role in investors’ asset allocation. They should, even at these very low yield levels, provide relative performance versus higher-risk segments of the market. However, even in the U.S. and other higher-quality bond markets, we are approaching some form of a lower bound, which doesn't necessarily have to be zero. Although we think policymakers in the U.S. will be much more cautious and try to use alternatives rather than take the policy rate negative, that doesn't prevent the market from taking rates even lower than zero.
But the point is that under most reasonable longer-term scenarios, the ability of fixed income markets to provide the price appreciation that we've seen has come down. And we believe in order to maximize returns in this space, having a more flexible mindset – a mindset of having some capital on the sidelines to respond to volatility overshooting – is likely to add incremental returns on a go-forward basis.