Multi Asset Boutique
The first-time visit of Chinese President Xi Jinping to virus-hit Wuhan raises hopes that the outbreak is now mostly under control in Covid-19’s country of origin. Yet elsewhere, the respiratory disease has started to hamper everyday life and the economy. As the speed of the spread will decide forthcoming prevention measures and consumer behavior, markets are focusing on the number of new cases. At this point, we still expect a substantial increase well into the second quarter. Should we find enough evidence that a turning point may soon be reached, we would be willing to reverse our recent risk-off stance. Similarly, a bold and coordinated action by central banks, or by governments, could mitigate the negative economic effects and improve the sentiment on stock markets.
The rate of new infections in China has declined to the lowest level since January (see chart 1). This should give government officials enough confidence to continue the gradual opening of Chinese factories. Meanwhile, economic resumption rates are slowly rising towards normal production activity. In Europe, the situation is quickly worsening with hard-hit Italy being in a “semi-lockdown”, and Germany as well as France starting to ban mass gatherings such as sports events. This has a strong impact on consumption and adds a demand shock to the supply shock.
The US has so far reported a limited number of coronavirus cases, but we expect that more will emerge as testing will intensify over the coming days. The US is also more at risk due to only partial health care coverage of the population and lack of broad-based sick-leave compensations. Health care is likely to become an important issue in the Democratic Party’s contest between Joe Biden and Bernie Sanders who both hope to take on Donald Trump in November.
Judging by the 30% year-on-year contraction in Chinese export growth in January and February, the country’s economy will suffer in the first quarter. The low point was probably reached in February. Assuming a further stabilization in infection rates, China should return to normal production capacity levels by the end of March in most sectors and see a gradual economic recovery from the second quarter onwards. We don’t expect Chinese corporate sector default rates to rise significantly due to ample fiscal and monetary support. As long as defaults remain more or less under control, prospects of Chinese growth rates between 5.3% and 6.0% in the next two years are intact.
We now forecast a contraction of the euro zone economy in the first and second quarter, i.e. a technical recession. Our expectation of a stabilization towards summer remains unchanged. As in Europe, Japan’s economic outlook looks dim and a technical recession now very likely. Depending on the further development of the virus outbreak and the measures to prevent it in the US, the American economy may hardly register any growth at all in the first half.
The governments in the US, Europe and Japan, at first slow to adopt fiscal measures (unlike China), may now start supporting their economies more. It will be very important to keep any second round effects contained and to support the affected companies with liquidity in order to prevent potential insolvencies and ensure that employees will get paid. Otherwise, private consumption will slump and non-performing loans will hit the financial system. The governments of Japan, Italy, and the US now appear to be moving in the right direction. However, appetite for substantial and coordinated action seems low. A coordinated policy response from the G7 or even the G20 would improve sentiment and stabilize or even boost demand – even more so if coordinated with central bank’s policy response.
As we expect inflation to weaken for the time of the demand shock, see inflation expectations tanking and oil prices dropping, we forecast more central bank action following the US Federal Reserve’s emergency 50-basis-point emergency cut last week. We now expect the federal funds rate to come down by an additional 75 basis points in the coming months, combined with some government-led fiscal measures. Should the outlook deteriorate further, renewed quantitative easing measures are likely. The European Central Bank (ECB), despite limited room to go much lower, will nevertheless cut the key rate by 10 basis points, in our opinion. We believe the ECB will also provide additional support via increased asset purchases and better lending conditions for banks (so-called TLTROs) at its next meeting on March 12.
The Bank of Japan is facing a similar dilemma as the ECB, but we expect a combination of additional asset purchases, one more rate cut and government fiscal measures to help cushion the impact. These steps will also help to mitigate the Japanese yen’s rise, which would represent an additional headwind for the export-oriented economy.
This year, the oil market has already experienced two “black swan”1 moments that sent prices lower – a slump in demand due to recession fears, and the termination of agreement to limit production between the Organization of the Petroleum Exporting Countries (OPEC) and non-OPEC member Russia. In the short term, we expect the barrel of Brent crude oil to sell for as little as USD 30 (currently USD 37) as a simultaneous surge in supply and slump in demand is a nightmare scenario for oil markets. In the medium term, demand will perk up on cheap energy while high-cost producers such as US shale oil companies will suffer from low prices. A new agreement between OPEC and Russia is also conceivable, but we think oil prices will be “lower for longer”. In sum, financial markets are facing two “dark-grey swans”: the global fallout from the unexpectedly severe virus outbreak and the oil price shock.
Investors are currently between a rock and a hard place – it is either low yields or increasing default probabilities. We have gradually reduced risks in our model portfolios over the course of the past few weeks due to increasing uncertainty. After initially going neutral equities versus bonds, we are currently underweight equities versus bonds. Within equities, we prefer Switzerland versus emerging markets and Japan. Within fixed income, we are neutral for both government and corporate bonds. Generally, we will stick to our principle of applying a steady hand. We are investors, not traders.
A slowing rate of new infections and signs of only moderately increasing corporate default rates would give us confidence to start building risk positions again. The same would hold true if there were credible fiscal programs that would ideally boost growth, combined with supportive steps by central banks such as bond purchases and the creation of a safety net for troubled creditors – all of which would ideally be co-ordinated globally. Short-term programs to cushion the fallout from the demand shock would help sentiment too. Should the situation evolve favorably over the coming weeks, we would be ready to deploy capital in equity and corporate bond markets soon.
1. Sudden unexpected turn for the worse, a theory popularized in “The Black Swan: The Impact of the Highly Improbable” (Nassim Nicholas Taleb, 2007)