From Iran Tensions To Coronavirus: Event Risks Dominate In January

January was something of a bifurcated market. Equities generally tried to remain sanguine amid unsettling geopolitical developments, and US bond market tilted decisively to a more negative view.

 

First Iran…

After a solid fourth quarter where equities in many countries all but levitated, investors tried to keep the party going into 2020. But they soon hit a ceiling. First was the assassination of Iran’s major general, Qasem Soleimani, on 3 January, which briefly caused fears of another major confrontation in the Middle East. Markets hiccupped for a couple days but settled down after the Revolutionary Guard mistakenly and tragically shot down a Ukrainian passenger jet. Overall, the incident focused global attention on how sanctions have crippled Iran’s economy and led to an increasingly restive population. For now, Iran is out of the headlines. But the next Iranian conflagration could just as likely be domestic as with one of its neighbours – with highly unpredictable implications almost guaranteed.

 

…Then the Coronavirus

The S&P 500 grinded higher over the next two weeks, eventually posting a year-to-date gain of 3% on 22 January on generally good earnings. Then talk of the coronavirus in China surfaced. The daily trading range widened and trended down, and the index closed near where it had opened for the month. Talk about leaving a fresh slate for February!

Meanwhile, bond markets traded in a narrow range until the coronavirus hit. The 10-year Treasury yield remained close to 1.8% and corporate investment grade and high yield spreads were little-changed. Neither the tension with Iran or positive reaction to earnings had any discernible impact. But as equities started trending down, the 10-year yield dropped decisively to near 1.5%. More ominously, the yield curve between 3 months and 10-year inverted, and the real rate as measured by the 10-year TIPS note dropped below zero.

 

Recession Risks?

The traditional interpretation of the recent bond market performance is that recession risks are rising. Commodities and the high yield bond market corroborate this bearish view. The threat of soft global demand caused oil prices to fall more than 12% in the last week of January, bringing the WTI benchmark to near $50. That in turn put pressure on indebted shale oil producers’ high yield bonds, causing the HY market spread to gap out 60 basis points. Copper, a proxy of industrial metals, plummeted 14% in late January. Safe haven Gold, meanwhile, continued to rise 3.5% over the month to reach $1,581.

 

A New Beginning?

US equities bounced back on the first day of trading in February, with the S&P 500 rising 0.75% on signs that the coronavirus virus infection might be slowing. China’s equity market fell 7% after being closed for a week, but that was in line with expectations and so was viewed positively.

The 10Y Treasury and bond markets were little changed.

 

Fed Faces Another Tough Choice

This is a perilous time for the Fed. Barring a noticeable improvement in economic data, if the Fed doesn’t cut rates (or at least signal willingness to do so) equities will be vulnerable to a sharp selloff. But if it cuts rates before the coronavirus epidemic has run its course, it will effectively be trying to combat a virus with monetary policy. The short run response may be positive. But if the monetary elixir fails to stop the virus (a given) and otherwise can’t deliver hoped-for economic benefits, equities will sell off, bonds will rally further, credit spreads will gap out, and worse of all, the Fed risks losing credibility as a steward of the economy.

 

Dollar Remained Strong

Much of the risky backdrop highlighted above has manifested in strong USD performance since the turn of the year (DXY +1.58%). This renewed challenge to the dollar short trade occurred amid a classic bout of haven currency buying as markets grappled with the prospect of an L-shaped recovery in the global economic cycle. Looking ahead, a number of factors favour USD resilience: (i) uncertainties over the severity of the virus outbreak; (ii) an insulated US economy that is holding up relatively well; and (iii) net investor positioning moving from short to neutral in recent weeks. However, it won’t all be plain sailing for the greenback. Election risk premia could begin to creep in with the inception of the Democratic nominee selection process, and there has been growing concern over the force majeure clause in the US-China trade deal.

 

UK Formally Departs From the EU

Across the pond, UK equities and bonds performed largely in line with their developed counterparts in January (S&P being an exception). This comes despite soft data indicating an improvement in the UK economy, abating Brexit concerns, and an expected fiscal boost.

Much of the action occurred in the second half of the month, most notably in the rates market. The return of jittery risk sentiment was accompanied by a strong rally in the long end of the Gilt curve, before subsequently exhibiting a bear flattening bias as the Bank of England left the Bank Rate unchanged and money markets pushed back easing expectations. Arguably, the case for the BoE staying on hold in 2020 has indeed strengthened – not only due to the above factors but also the prospect of higher equilibrium interest rates as a result of these factors (as highlighted in the Monetary Policy Report).

For February, UK assets should remain supported in the absence of any clear Brexit events. Nothing changed with the UK’s formal departure from the EU on 31 January although recent comments from key officials remind us of the real possibility of a disruptive departure once the transition period ends on 31 December A follow-through of improving soft data into the hard data, and further details of the impending fiscal stimulus ahead of the 11 March budget, will also help.

 

EM Asia Feels the Brunt of the Coronavirus Fears

EM Asia in January was a tale of two halves and an ambivalent end. In the first half of the month, the conditions for an extended rally in risk assets remained intact – given signs of continued improvement in EM activity, a US-China phase one trade deal, and accommodative monetary policy globally. Indeed, this was reflected in asset prices, with MSCI Asia posting a +3.71% gain and USD/CNY testing 6.85. However, the market was subsequently blindsided by a negative demand shock in the form of the virus outbreak in China, leading to a selloff in currencies most responsive to Chinese demand (THB and KRW), cyclically sensitive EM equities, and commodities such as oil and copper.

The question now is how do investors reconcile this previously favourable backdrop of improving economic activity with the virus outbreak? While it is still too early to gauge the full impact on the real economy, it pays to be selective in the EM Asia universe – typically via higher-yielding, relatively cheap currencies. That said, investors will be closely watching two key sub-narratives. First, any signs of fresh policy stimulus from the Chinese authorities. Second, whether factories reopen on 9 February, thereby avoiding any additional shocks to the global supply chain and a prolonged slowdown.

 

 

 

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)