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The coronavirus impact on fixed income markets

Macro impact

The spread of the coronavirus globally
has continued unabated in recent weeks. The combination of “business as usual”
in Europe and the US and limited testing has exacerbated the issue and
increased uncertainty regarding the extent of the outbreak and the ultimate
path the outbreak will take. As policymakers take more aggressive measures to
control the spread of the virus, we will likely see a large impact on global
growth. As the extent of the outbreak has expanded, investors have had to price
in a larger impact on growth over a longer period.

Invesco Fixed Income expects Q1 growth
in the US and Europe to be weaker than expected and Q2 growth to be
significantly negative, as these economies are hit by fear and the impact of
measures implemented to contain the virus. The path forward also remains very
uncertain, which is a headwind for markets.

China provides a model for us to think
about what lies ahead. China implemented strong measures to control the virus,
which has hit the economy badly in Q1. China has now controlled the outbreak
and is in the process of returning to work. Once the level of daily infection
peaked, the process of returning to work started. Infections in the US and
Europe are still rising, and it is likely the epidemic will take a while to
peak in these regions. It is the impact on growth and uncertainty around the
virus propagation that is causing current market action.

It is very important to acknowledge
that we believe this is a fundamentals-driven correction, which makes it very
different than a financial crisis. The resolution of this situation will likely
take time as we watch the epidemic play out in the US and Europe. Financial
conditions-driven crises, such as the one in Q4 2018 and the Global Financial
Crisis can be resolved quickly by central banks. In the case of
fundamentals-driven crises, central banks can only ameliorate, not solve, them.
We expect this market to follow a U pattern rather than a V.

We expect risk assets to continue to be
volatile, and markets will likely take a while to bottom. US interest rates
have been the shock absorber, but there is little room for bonds to rally
further, in our view, as we do not expect the US Federal Reserve (Fed) to
embrace negative interest rates. The Fed will likely cut rates close to zero,
but we expect the yield curve to remain positively sloped. Lower US interest
rates will likely erode the interest rate advantage of the dollar versus other
developed market currencies, which will likely weigh on the dollar going
forward versus other developed market currencies.

Energy sector impact

In a one-two punch, the impact of the
coronavirus was magnified by OPEC action that dramatically impacted the price
of oil. The failure of OPEC and key non-OPEC oil producers, notably Russia, to
coordinate production cuts and subsequent production increases by Saudi Arabia
precipitated a plunge in oil prices at the same time that fears over the spread
of the coronavirus mounted. We expect oil demand to face significant
year-over-year declines in the first quarter of 2020 amid excess supply, which
should continue to weigh on oil prices.

Oil prices at $30/barrel (bbl) is
punishing for most domestic producers, however, the duration of the oil price
weakness is a major concern for creditors. While many producers currently
benefit from robust liquidity profiles, an extended period of oil at $30/bbl
could quickly result in rapid liquidity consumption, increasing credit risk for
the entire sector.

Perhaps not unexpectedly, the market reaction to this
oil-related news has been strongly negative. US investment grade exploration
and production (E&P) credit spreads – the difference between the yields of
US Treasury vs. non-US Treasury securities of similar maturity —  have widened by 311 basis points, meaningfully
underperforming the Bloomberg Barclays US Credit Index (36 basis points wider)
and the Bloomberg Barclays US Midstream Index (116 basis points wider).1
This compares to average weekly changes in the Bloomberg Barclays US E&P Credit
Index and the Bloomberg Barclays US Credit Index of 7 and 3 basis points,
respectively, over the past 10 years.2 Amid heightened market and
sector volatility, bid-ask spreads (the difference between the highest price a
buyer is willing to pay for a security vs. the lowest price a seller is willing
to accept) have also widened dramatically. For example, highly rated Exxon’s
2.44% 2029 bond was quoted with a bid-ask spread of 15 basis points on March
12, compared to 5 basis points on March 4, a 200% increase.3 Without
coordinated supply support from OPEC and Russia, and with oil demand under
pressure, we expect energy credit to continue trading with an elevated level of
volatility and uncertainty in the near term.

Energy outlook

Uncertainty about the duration of oil
price weakness remains a key concern for investors in the US investment grade
energy sector. While we are actively monitoring the impact on corporate
fundamentals, we are tracking energy company liquidity profiles as well. We
expect rating agencies to announce downgrades in the near term across energy
sub-sectors as they reduce oil price assumptions. While the long-term corporate
fundamentals for the energy industry remain uncertain at such weak commodity
prices, we believe certain robust liquidity profiles raise the attractiveness
of some short-term bonds that have been indiscriminately punished by this
broader sector selloff, despite a high likelihood of repayment, even in a weak
oil price environment. Although forecasting commodity prices consistently and
accurately is challenging, we believe assessing near-term liquidity can be done
with higher conviction. While we are extremely cautious in this volatile market
environment, Invesco Fixed Income continues to seek unique investment
opportunities that exhibit attractive risk-adjusted return potential while
maintaining a focus on capital preservation during this historically
unprecedented time for the US energy sector.

Consumer sector impact

The US consumer has the served as the
backbone of the US domestic economic expansion for more than a decade. Robust
employment trends, low interest rates, and lower taxes have driven confidence
levels to record levels, resulting in robust consumer expenditures.
Demographics are also supportive as millennials are now proceeding down the
same path as previous generations, buying homes and starting families. The
long-term trend is now at risk, however, as the uncertainty surrounding the coronavirus
impacts multiple facets of consumer spending. The ability of the US consumer to
spend is not in question, but only their desire, as the country faces a period
of uncertainty. Invesco Fixed Income shares the following views on key consumer
spending sectors:

Travel (airlines, hotels, gaming,
cruise lines and online travel agencies) —
Americans love to travel and have the resources to do it. We
expect travel plans to be changed or postponed rather than outright cancelled
to avoid group travel and with a preference for destinations that have less
exposure to large crowds. We expect theme parks, musicals (New York City), and
sporting events to suffer in favor of beaches, national parks, and family
reunions. Consumer balance sheets are robust enough to get through a moderate
business stagnation, in our view, but negative rating agency actions are likely
on the horizon.

Retail – Spending trends have remained intact,
although we are seeing spending shifting to “stockpiling” essentials such as
water and disinfectant, etc. We expect dollar stores, discounters, auto part
retailers, warehouses, grocers and other suppliers of essentials to see modest
gains to modest declines in sales, depending on the specific company. We expect
apparel stores to see less traffic, but we anticipate a material shift to
online shopping as consumers stuck at home continue to shop online. 

Restaurants and Leisure – We expect the impact to be less than
travel but more than retail. Table service dining will likely be hit much harder
than restaurants with delivery or drive-through options. Starbucks stores, for
example, were around 60% closed during the height of the outbreak in China, but
most have reopened, with less than 10% remaining closed.

Market reaction has been very diverse within the consumer sector versus the Bloomberg Barclays US Aggregate Bond Index which is now 80 basis points wider compared to the previous month.4  Restaurants and retailers have performed roughly in line with the market, but leisure has materially underperformed, with some 10-year bonds 550 to 250 basis points wider over the past month.4

Bank liquidity is solid

In the wake of the 2008 financial crisis
the Basel Committee on Banking Supervision produced a new set of regulatory
standards for the banking industry worldwide that significantly strengthened
bank liquidity and capital. Banks are now subject to more stringent liquidity
requirements, such as the Liquidity Coverage Ratio (LCR), which addresses the
minimum liquidity banks must have on hand to meet a potential run on the banks
and potential difficulties refinancing short-term obligations in extreme
economic or financial conditions, such as those experienced during the Global
Financial Crisis of 2008. The LCR requires banks to hold high quality liquid
assets (HQLA) that are sufficient to cover the outflows of deposits during
stressed economic conditions over a 30-day period. Banks also face stricter
capital requirements including the Basel III Tier 1 Leverage Ratio, which is
the ratio of Tier 1 Capital (equity capital and disclosed reserves) to its
consolidated assets. The ratio includes off-balance sheet exposures, such as
credit lines, in its calculation of consolidated assets, so banks are already
holding Tier 1 capital against these commitments and are not capital
constrained.

Impact on market liquidity

Despite the strengths of the financial
system, the sharp price moves and increased volatility are impacting fixed
income market liquidity. Bid-ask spreads (the difference between the price at
which you can buy a security vs. the price at which you can sell it) have
widened, and liquidity in cash credit bonds can be hard to find. On the other
hand, trading volumes are solid, and markets are functioning. On Thursday, the
Fed announced facilities designed to ensure that a liquidity event does not
develop from this fundamental shock. We expect central banks to continue
supporting the liquidity of the market, although their actions cannot directly
impact the cause of the current correction and will likely have limited impact
on the path of this correction.

With
contributions from
Bixby
Stewart, Senior Analyst – Energy; Ray Janssen, Senior Analyst – Consumer; and
Matt Bubriski, Senior Analyst – Bank Liquidity, Invesco Fixed Income.

End notes

1 Source: Bloomberg Barclays, data as of 03/11/2020 a. USIG independent energy Option-Adjusted Spread (OAS) of 580 at 03/11/2020 is 311bps and 115% wider than the 03/06/2020 level of 269

b. USIG credit index OAS of 172 at 03/11/2020 is 36bps wider than the 03/06/2020 level of 136

c. USIG midstream index OAS of 358 at 03/11/2020 is 116bps wider than the 03/06/2020 level of 242

2
Source: Bloomberg Barclays, data as of 03/11/2020-

Calculated as the average of the 10-year
absolute value of weekly (5-day) OAS changes for the USIG credit index and the
USIG E&P credit index (a sub-sector within the USIG credit index)

3
Source: Barclays dealer quotes

4
Source: Bloomberg Barclays, data from Feb. 12, 2020 to March 12, 2020.

Important
information

Credit:
Shawn Ang/ Unsplash

Index
Definitions

The Bloomberg
Barclays US Aggregate Bond Index
is an unmanaged index considered
representative of the US investment grade, fixed rate bond market.

The Bloomberg
Barclays US
Credit
Index
measures the
investment grade, US dollar-denominated, fixed-rate, taxable corporate and
government related bond markets. It is composed of the US Corporate Index and a
non-corporate component that includes foreign agencies, sovereigns,
supranationals and local authorities. Source: https://www.bloomberg.com/quote/LUCRTRUU:IND

The Bloomberg Barclays US
Credit E&P Index
is a sub-index of the Bloomberg Barclays US Credit Index.

The Bloomberg Barclays US Midstream Index is a
sub-index of the Bloomberg Barclays US Credit Index.

The opinions referenced above are
those of the authors as of March 12, 2020. These comments should
not be construed as recommendations, but as an illustration of broader themes.
Forward-looking statements are not guarantees of future results. They involve
risks, uncertainties and assumptions; there can be no assurance that actual
results will not differ materially from expectations.

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