We still prefer moderate credit risk over the duration in a world of low growth and financial repression, although the normalization of yields from very depressed levels might take longer, as the impact of the coronavirus on the supply chain is more likely to last well into the second quarter.
Anecdotal evidence points to a slower resumption of production in China and more disruption elsewhere than we had originally anticipated. At the same time, we note that the market is treating the virus as a demand shock rather than a supply disruption. Admittedly, the various travel bans and quarantine measures will curtail tourism and related shopping activities in large parts of the world. However, it is the supply of technology products and cars, among others, that is hit in the first place, not the ability of consumers to buy these goods.
We stick to our scenario of pent-up demand that will foster growth sometime later this year
Accordingly, we do not share the broad-based consensus that the shock is deflationary and will suppress prices from the short- to the long-term. The 5-year forward 5-year inflation swap rates, one of the best indicators for market-based long-term inflation expectations, fell to 1.88% in the USA and 1.18% in the eurozone, from 2.1% and 1.35% in mid-January, respectively. We have to acknowledge that these deflationary fears might take longer to dissipate. As a result, our economic research team is adjusting the forecast for the 10-year Treasury note slightly.
The key messages remain: we do not expect an escalation of the crisis to a point where the Fed is forced to slash rates as much as the market discounts at this juncture, and yields will more likely trend higher than lower from here on. Thus, we still prefer moderate credit risks, such as Baa/BBB and Ba/BB bonds.
