The US Federal Reserve cuts rates by 50 basis points
Bonds have repriced due to safe-haven flows on the back of heightened uncertainty on fears of a wider contagion of the Covid-19 virus. Most notably, the US 10-year and 30-year yield reached new lows at 1.02 and 1.60 respectively.
The US Federal Reserve (Fed) responded with an emergency cut of 50 basis points (bp) on 3 March and justified this as follows: “In light of these risks and in support of achieving its maximum employment and price stability goals.” The Euro dollar future market is pricing in two more cuts over 12 months.
The Fed clearly wanted to avoid a scenario whereby it is running behind market expectations as in 2019. Given that now only four 25bp cuts are left to the 0% mark, it is likely that the Fed will be prudent in using this ammunition. However, should inflation and inflation expectation remain below the Fed’s 2% target, a further cut within the next 12 months should not be ruled out.
In this environment we believe that interest rates stay lower for longer while the significant move opens up surprise potential with yields bouncing should a deep recession as implied by depressed yields not crystallise.
High-yield looking selectively attractive
The flow from riskier assets to safe haven has led to a substantial widening of spreads within the high yield market. In Europe, as well as in the US, spreads have widened by more than 100bp and with the average yield for US high yield now at around 6% we feel risk seems better priced and the period of expensive valuations resolved.
High yield bonds carry higher risk of default in an economic downturn which makes selection even more important. Investment grade bonds yield lower in absolute terms but on a relative perspective the segment combines stable return prospective with additional moderate yield pickup.
Equity markets bottoming out
Following the sharp correction at the end of February, equity markets appear to have found a bottom, supported by technical (oversold levels) and fundamental (several companies highlighting a relatively benign aftermath of the Covid-19 outbreak in China) factors as well as monetary (US Federal Reserve cutting interest rates) and fiscal (governments pledging dedicated stimulus programs) boosts.
Despite volatility, positive on equities
The recovery from here will likely be gradual. While investors may be reassured that authorities are standing by to support economic growth, they remain powerless with regards to the epidemic. As such, the focus will now turn back to more fundamental data points such as new global cases or factories and retail activity. This is likely to result in heightened volatility in the weeks ahead.
We expect that global economic activity will rebound and normalise in the second half of the year. In this context and following the recent de-rating, we are turning incrementally positive on equities.
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