- The first signs of significant economic disruption have emerged in the US. In China, business activity is resuming gradually, but consumer habits are still far from normal.
- Our fundamental investment base case is that drastic measures and policy responses can avoid a systemic crisis. This supports our view of a ‘U-shaped recovery’. The main risk is that the COVID-19 shock morphs into a systemic crisis that leads to a more severe global recession scenario.
- Our market temperature metrics are flashing ‘dark green’, which typically is a good contrarian ‘buy’ signal. Technical analysis suggests a rebound is possible.
- Asset allocation: we overweight US, eurozone and emerging market equities, underweight eurozone bonds and are long US inflation and gold.
Coronavirus keeps markets in turmoil
As a result, risky assets have suffered severe losses since their peak in mid-February. Unlike in previous crises, traditional safe havens such as government bonds, the US dollar and the Japanese yen have offered little shelter to investors.
Part of the reason is that the COVID-19 virus is an exogenous shock. It is not rooted in economic or financial imbalances. As such, the way to mitigate it is not just by using the traditional economic policy tools. Rather, policymakers need to find health-related solutions to tackle the disease and policies to mitigate the huge economic and financial spill-overs.
Controlling the spread of COVID-19 is one of the key elements needed to break the market rout. News of a vaccine or a cure would be a game changer. Otherwise, we need to closely monitor the evolution of the virus and the measures taken to contain it.
Economic damage likely to be substantial
It is highly likely that the global economy will be in recession for most of 2020. This is borne out by initial US macroeconomic data. The numbers are beginning to reflect the effects and pointing towards significant economic disruption. As an example, the Empire manufacturing index for March fell to its lowest on record.
In China, the world's second-largest economy, economic activity collapsed in February. The data was dismal: e.g. retail sales dropped by 21% YoY and industrial production fell by 16% YoY. However, energy consumption, passenger traffic, online retailing, and business at hotels and restaurants have been picking up. This is partly the result of the virus control measures and policies supporting small and medium-szied companies, vulnerable people and consumption.
Our base case is for a gradually recovery towards the end of the year in what we see as a ‘U-shaped’ bounce.
In addressing the economic impact, fiscal policy is crucial. It can be deployed quickly to support demand and can help companies and people in a targeted way.
Leading central banks such as the ECB and the Fed have eased policy as much as they can, given their different constraints. The ECB committed to more quantitative easing (QE), announcing a EUR 750 billion bond buying programme, and the Fed slashed US interest rates by 100bp to close to zero. Most other central banks in the developed world have followed suit. Many have deployed measures to increase liquidity.
So far, risky assets appear to have largely ignored these efforts.
Exhibit 1: US interest rate easing in context - graph shows the real (inflation-adjusted) policy rate of the Federal Reserve falling to below the real neutral interest rate (R* estimate), signalling an accomodative policy stance
Stepping up fiscal measures
Market participants know that the right medicine is fiscal rather than monetary policy. Until recently, fiscal support in the developed world had generally been underwhelming in size. It was also uncoordinated, limiting its efficacy. For example, Italy’s package to support business and households was worth only 1.2% of GDP.
In Germany, targeted measures are the equivalent of around 1% of GDP. Government guarantees for USD 550 billion of loans to the corporate sector imply a potential government liability of 14% of GDP. France’s fiscal package lacks details. Its support for USD 338 billion of loans to the corporate sector implies potential government liabilities 12.3% of GDP.
EU finance ministers have committed to fiscal measures at the national level of about 1% of GDP on average for 2020. Germany has suggested that EU members could consider eurobonds: a jointly issued bond guaranteed by member states that could be bought by the ECB. This would be big step towards fiscal integration in the European Union and mark a big positive for eurozone risky assets and a negative for core bonds.
US measures totalling USD 1.2 trillion amount to 5.5% of GDP and include cash payments to households, provisions for small business loans, stabilisation funds, and tax deferrals.
China’s fiscal efforts are estimated at 2-3% of GDP. However, it is likely that this figure underestimates the true size given the state guarantees for loans.
In terms of market sentiment, regaining confidence is key to easing market stress. Both Google searches and news stories mentioning the virus are still on the rise, suggesting depressed sentiment and little confidence. Funding stresses and USD shortages have been creeping up, but are not unanchored for now.
Key views & asset allocation
We still see an economic ‘U-shaped’ recovery in the medium term as the virus wanes and policy support kicks in. But the downside risks of a systemic crisis and a more prolonged global slowdown/recession have clearly increased.
We are cautiously looking for opportunities across financial markets.
Our main views are:
- We are long US, EMU and EM equities. We are open to adding to our positions given our base case, but will be equally nimble in taking profits
- Carry trades: we are long emerging market USD debt and EMU real estate investment trusts (REITs)
- We are short core EUR bonds, long US breakeven inflation, short US Treasuries via options and we hold a USD interest rate curve steepener via options
- We still see gold as an attractive asset offering protection as central bank easing debases major currencies. After a recent price drop, we added to our position.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.