Unigestion | Stock and bond investors seem to have very different assessments of the impact of the virus: despite a pickup in realised volatility, equity markets (especially in the developed world) have reached new highs over the last couple of weeks. The VIX index rose above 17 at the end of last week, but is well below the levels seen in August 2019 in the midst of the US-China trade war (24.6) or at the end of December 2018 when recession fears gripped markets (36). Implied earnings growth rates for equities remain solidly positive, even for the MSCI Emerging Markets index (about 5% over the next year). The view from the equity market seems clear: COVID-19 is a risk but should not derail the supportive context for corporate earnings and stock prices.
Over the period, bond yields have fallen, with the US 10-year yield down to 1.47% and the 30-year yield down to a historical low of 1.91%. The driver of the move has been real yields: the 10-year yield is down 40bps from before news broke about the virus, 25bps of which come from real yields that are now negative. The 5-year yield is down 34bps, with the corresponding 5-year real yield falling by 28bps to -0.3%. At the short end of the US interest rate curve, two cuts are now priced in for 2020. While the yield curve remains about 12bps from inverting (based on 10 vs 2-year yields), bond investors are giving a clear signal that the virus will have a meaningful, non-transient negative impact on growth.
Bonds exposed to reversal of fear premium
From our perspective, bonds seem more at risk than equities at this point. The focus on the virus has turned attention away from the relatively positive growth data we have been seeing over the last few weeks. Assessing the economic impact of the virus has also focused largely on the demand shock and less on potential inflation pressures from low inventories and reduced capacity (though the drop in oil prices is a large offsetting factor for inflation). And while portfolio rebalancing post the 2019 rally in equities has been supportive for bond inflows this year, yields have moved tightly with virus headlines. Thus, we see the bond rally as driven more by fear than a change in underlying fundamentals and it is therefore prone to a sharp reversal if these fears dissipate.