Investment Strategy

Fallout from Covid-19 - a fixed income perspective

By Warren Potter
Senior Portfolio Manager New Zealand

As novel coronavirus or COVID-19 moves from just a Chinese outbreak to something approaching a global pandemic event, market volatility has increased substantially and market liquidity is becoming more constrained. The economic fallout from the virus has transitioned from something akin the SARS outbreak where there was a reasonably quick V-shaped rebound in economic activity to something more U-shaped where growth takes longer to stabilise and improve.  

There is also an increased risk that the event spirals into a more recessionary scenario, with significant slowing in growth and job losses and firm closures. The impacts are already being felt in terms of earnings downgrades across a raft of industries impacted by the virus, including airlines, airports, hotels, tourist businesses, oil and commodity producers, IT, automotive, shipping and freight businesses. The list of affected businesses is growing as supply chains remain impacted.

As a consequence of this uncertainty, equity volatility measures such as the Chicago Board Options Exchange Volatility Index are at levels not seen since the Global Financial Crisis (GFC). Similar volatility measures for fixed income are also significantly elevated, but not quite at levels seen during the GFC. Liquidity measures reveal widening spreads, and reduced volumes available to be executed close to best bid and offer across equities and fixed income show the increasing risk aversion in markets. 

Risk markets remain under pressure with large falls in equity prices and widening credit spreads.  

There have been significant falls in interest rates globally as market participants ramped up expectations around significant monetary policy easing.

However, policy makers are not sitting on their hands. Global central banks have responded with rate cuts either delivered or promised. The US Federal Reserve led these moves with a surprise 50 basis points (bps) easing of policy earlier this week and communicated that they will respond to future developments. 

Elsewhere central banks promised to support market liquidity or ease policy in response to the virus. However, some monetary authorities, with policy rates already negative (eg the European Central Bank or the Bank of Japan), have less scope and willingness to cut interest rates significantly. Therefore they may need to revert to their toolkit of unconventional monetary policy, including quantitative easing, yield curve control and asset purchases.

Closer to home, the Reserve Bank of Australia eased policy 25 bps last week and we are likely to see the Reserve Bank of New Zealand (RBNZ) follow suit and cut the Official Cash Rate (OCR), most likely at their policy meeting on 25 March 2020. The New Zealand fixed income market has already responded, like its offshore counterparts, and has priced sizeable moves lower in the OCR, with 43 bps of cuts priced for the March meeting and a total of 67 bps priced by November 2020 (as of the time of writing). The significant falls in interest rates globally, and in New Zealand, have boosted fixed income returns so far in 2020, proving again that fixed income remains a diversifier in an investment portfolio. 

There is also a fiscal response taking shape around the globe. Initially China responded saying they would respond to the virus with increased government spending and support for affected businesses. Elsewhere countries and supranational organisations are preparing fiscal packages to support the business and people impacted by the virus. These measures will help stabilise economics and eventually bring some stability to markets.

New Zealand fixed income markets, along with large falls in interest rates, saw yields curves flatten with longer end yields moving more than shorter maturity yields. More recently, with aggressive policy action from the RBNZ (and globally) being priced in the market, the yield curve has begun to steepen. However, with the outlook still uncertain the direction of yields and yield curve shape remains volatile.

In the AMP Capital NZ Fixed Interest Fund (Fixed Fund) we retain a long duration position, but have reduced the size of the long as a sizeable amount of monetary policy easing was priced in the market. Looking ahead, we will continue to look for opportunities to add duration on any bounce in yields and the outlook remains highly uncertain and the pressure remains for lower interest rates should sentiment further deteriorate. 

The Fixed Fund currently has a more neutral curve position and at some stage we will look to enter curve steepeners, but we would need to see signs of stability in global economic data and the receding of downside risks resulting from the virus. The credit position in the portfolio remains conservative and therefore less exposed to the risks of further widening in credit spreads. In fact, the portfolio is well placed to add credit risk at higher yields when markets stabilise. 

Looking ahead, it remains a very fluid situation and markets are likely to remain uneasy in the near term.

Liquidity in passive equity and other risk products is likely to be tested as investors looks to reduce risk positions and this could lead to more volatility in markets. As already mentioned, credit spreads are widening in this risk off environment, reflecting that investors need a higher yield to compensate for liquidity and credit risk. If there are more corporate earnings downgrades, or even corporate failure, then the significant proportion of BBB rated debt in global investment grade indexes could be problematic should we see forced selling in a market already struggling for liquidity. Such an outcome would further strain already stressed markets.

We remain nimble in terms of managing the Fixed Fund and its duration, curve and credit positions and are looking to take advantage of opportunities that emerge in this more volatile and less market liquid environment.

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Warren Potter, Senior Portfolio Manager
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Investors should read the relevant Product Disclosure Statement (PDS) before investing. The PDS contains important information on the Fund including specific risks. A copy of the PDS can be obtained from the AMP Capital Investors (New Zealand) Limited website www.ampcapital.com, by contacting the Client Service Centre on 0800 400 499, or by visiting the Disclose website www.business.govt.nz/disclose. The Manager and the Issuer of the Fund is AMP Investment Management (NZ) Limited, Meridian Building, Level 1, 55 Lady Elizabeth Lane, Queens Wharf, Wellington. While every care has been taken in the preparation of this communication, AMP Capital Investors (New Zealand) Limited makes no representations as to the accuracy or completeness of any statement in it. Past performance is not a reliable indicator of future performance. This communication has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this communication and seek professional advice, having regard to the investor’s objectives, financial situation and needs.

Important notes

This blog post has been prepared to provide general information and does not constitute 'financial advice' for the purposes of the Financial Advisors Act 2008 (Act). An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors.

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