While we are in the throes of an unprecedented health crisis, leading to an unprecedented standstill in economic activity and rarely seen market reactions, a number of questions continue to weigh on investors: How long will it take to get the virus “under control”? How deep and how long will the recession be? Will massive monetary and fiscal stimulus measures be enough to avoid the worst case scenario? What will the recovery look like? What is priced in today?

Waiting Game
Most of these questions do not have answers yet, and will not have answers for some time. Indeed, while we have some indication from China, Japan and South Korea on containing the outbreak, different countries are at different stages of contagion, with different containment measures, suggesting it will not be a uniform answer. However, estimates vary between a few weeks and a few months. For now, we hope that containment measures can be broadly eased across most developed countries by the end of June.

This suggests a very deep fall in economic activity from March to May/June, with possible double-digit drops in growth for Q2. Nonetheless, if we can “flatten the curve” enough to ease stringent containment measures before the summer, we could see only a short recession rather than a protracted one. This will mostly depend on policymakers’ ability to avoid waves of bankruptcies, downgrades and especially defaults. Indeed, the current health crisis is leading to an economic crisis, but it can still turn into a full-blown financial crisis, which would then make a long recession inevitable.

We remain hopeful that policymakers will do whatever they can to avoid such a scenario. Indeed, they took a page from the 2008 playbook, and enhanced all of the measures, but ring-fencing defaults will likely prove challenging. And while we believe the drop will be short-lived, we do not expect to receive an “all clear” announcement, but rather an easing in containment measures and a slow and gradual ramp up in activity – no V-shaped rebound.

The Road Ahead for Markets
A very negative scenario is already priced in by markets, but we remain cautious for now as we believe that a peak in cases is likely needed for a sustainable recovery, given the above lingering questions. As such, we are underweight equities, with a preference for more defensive regions such as Emerging Asia and Switzerland. Valuations have come down sharply, but given the ongoing contagion across developed markets, downside risks remain.

We have also reduced our allocation to credit, closing our HY positions entirely given default concerns. We have brought our sovereign allocation closer to neutral in both the US and Europe in an effort to add some duration to portfolios. In Europe, we believe that peripheral spreads will tighten thanks to European Central Bank support. In the US, the Fed will buy most of the Treasury’s new issues in an effort to keep yields contained and liquidity abundant. We maintain some exposure to gold even though the bulk of the move may already be done.

Given our expectation for a sharp, but short, drop in activity, we maintain a more constructive medium-term outlook for risk assets. And these are more attractive entry points for the longer term. However, until cases start to peak across most developed market regions, we remain cautious.

Following an unprecedented collapse in global equities – mainly in terms of the speed of the drop – we believe that equity markets will remain fragile until we see a peak in cases across most developed markets. As such, we remain cautious despite large stimulus announcements and maintain a slight underweight allocation.

We believe that countries that show more defensive characteristics or that were “first in, first out” of the virus outbreak should show signs of resilience. As such, we have a small preference for Switzerland and Emerging Asia, and slight underweights to Europe and the US, for now. We believe that sectors most impacted by the outbreak and ensuing containment measures will remain at risk, including travel, entertainment, and of course energy.

Valuations have come down sharply since the outbreak, suggesting much more attractive entry points for the longer term, but it may still be too early to add a lot of risk to portfolios. Nonetheless, with hope that containment measures can be eased before the summer, we maintain a constructive medium-term outlook.

Fixed Income
Yields have stabilized after a few wild days and a sharp drop due to global growth concerns. Liquidity and funding markets also showed signs of stress, leading the Federal Reserve to announce virtually unlimited measures to fight the crisis. As a result, yields have stabilized at low levels, and should remain contained for the time being. A similar move occurred in Europe, with peripheral sovereign spreads widening sharply until large-scale European Central Bank intervention calmed markets with over EUR1 trillion in asset purchases planned for this year.

As such, we have added more duration back to portfolios, with a more neutral allocation to government bonds in Europe and the US. We have reduced our allocation to credit by cutting our HY exposure for the time being. Indeed, default risk has risen significantly, especially in the US given the drop in oil prices, and central banks are more focused on protecting the IG segment. We believe that spreads can remain wide for some time, though we may have already seen the bulk of the move.

Yields are currently pricing in a very negative growth scenario, but even once the outlook improves, we believe that yields will remain lower for longer.

The US dollar remains the currency of choice, spiking during the worst of the market selloff. While it has retreated from recent highs, we believe it will remain underpinned given ongoing uncertainty and growth fears. The euro and sterling continue to face headwinds, though the interest rate differential with the dollar has shrunk again following the Fed’s rate cuts to zero. Emerging market currencies can offer selective opportunities, but with higher volatility and idiosyncratic risks.

Following the oil price war between Saudi Arabia and Russia and the ensuing drop in both WTI and Brent, oil prices have stabilized. They are likely to stay low for some time given both a demand and supply shock. We later expect a recovery, though medium-term supply is expected to remain ample, which should cap prices.

Gold should continue to see underlying demand as a safe haven, though the bulk of the move may already have occurred.

We continue to see a place for alternatives in portfolios, as we look for de-correlating and diversifying strategies to complement traditional asset classes, particularly with liquid alternatives. We believe that real assets can also help provide income in a low yielding world.
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