The spread of cases to South Korea, Japan and Italy has raised concerns that the impact to growth could be broader and last longer than initially anticipated. Indeed, while cases are slowing in China, they are rising elsewhere, which could lead to delayed and extended disruptions. For now, we remain of the view that the disruptions will prove mostly temporary, and that 2020 growth will not be derailed. However, we acknowledge that the growth impact could extend beyond the first quarter, and that the first quarter might be even weaker than previously thought. Moreover, the subsequent recovery may not be V-shaped as companies may take time to ramp up activity again, especially if different areas are affected at different times.
Travel and entertainment remain the most hit segments, and will not get back losses. Supply chain disruptions to technology and the automobile sector are ongoing as well, though that should pick up more swiftly once containment is achieved. We believe that manufacturing, which had started to recover, is likely to stall for now, but should rebound as factories ramp up again.
Against this, the global backdrop remains generally supportive. We expect the trade truce to last, as we do not believe President Trump will escalate the situation in the current context. And the longer the disruptions last, the closer we get to the US elections, with Trump unlikely to be too aggressive and risk jeopardizing growth. In addition, central banks remain ultra-accommodative, though many have limited options to react to the COVID-19 shock. On the fiscal side, we expect to see ongoing targeted action by Chinese policymakers, but Europeans are likely to be slower and less expansionary than needed.
Whether these factors remain supportive enough for markets is the main question. For now, we maintain our medium-term constructive view, though we have reduced our allocation as we expect higher volatility to persist for some time. Earnings warnings and earnings growth expectations for 2020 are likely to lead to some re-rating as well, though again the scale is difficult to measure for now. Until we see clearer signs that the virus is “under control,” markets may struggle to push much higher, but we believe they will ultimately resume their march higher.
Safe haven assets have been the obvious beneficiaries, though they have benefited more than equities have suffered. Sovereign yields have reached new lows in the US, and we believe that while yields should not fall much further, they are likely to remain low for longer. As such, we have added some duration, though we maintain an underweight to European sovereigns given how overvalued they are. We maintain our preference for credit, which has shown resilience and which offers some carry. We have also kept some core holdings as protection, and believe that gold should see short-term momentum continue. The US dollar (USD) has taken the safe haven mantle for currencies, as concerns over the Japanese economy and its proximity to China have weighed on the Japanese yen (JPY). We believe that USD strength can continue, though we may have already seen the bulk of the move.
Following a rise in COVID-19 cases outside of China, equity markets started repricing the breadth and depth of the impact from containment measures. For now, we believe that higher volatility will persist for some time, but that markets will resume their upward move once the virus is “under control.” As such, we maintain our allocation, though we have reduced our overweight and our cyclical tilt.
Defensive sectors are likely to remain well bid, and more exposed sectors such as travel, retail and even automobiles could remain challenged. Given supply chain disruptions and higher valuations, we keep an eye on technology, though we maintain our longer-term constructive view. We will also continue to follow any earnings warnings due to the outbreak, though for now we still expect earnings growth in the mid-to-high single digits in the US – and somewhat lower in Europe – for 2020.
We have reduced our allocation to European and Japanese assets, as we believe that global growth and trade will be impacted by the outbreak and affect these more export-oriented markets. We believe that US markets will remain in demand and be seen as more defensive, and we maintain our overweight. Emerging markets could remain under pressure given the epidemic.
Until we have a clearer view on the full impact of the virus outbreak on global growth – and beyond Q1 – we believe that yields will remain extremely low. Nonetheless, we believe that we are near extreme levels and do not expect them to drop much further from here. At the same time, we believe that it will take time before they move meaningfully higher again. As such, we have added duration to portfolios, though we remain underweight European sovereign debt, given valuations. We have a more neutral view on US Treasuries.
We maintain our preference for credit over sovereign debt, as sovereigns are even more overvalued, and yields should be close to their lows. Credit spreads have shown resilience, though US high yield spreads widened more, as expected given energy prices. As concerns over growth linger, support for IG should persist, though we believe that European HY can continue to perform well, in part thanks to ongoing European Central Bank corporate bond purchases.
We continue to see opportunities in hard currency emerging markets debt, particularly corporates, where spreads have held in and carry is attractive.
The US dollar remains the currency of choice, strengthening further on virus fears, growth uncertainty and demand for Treasuries. While most of the move is likely over, we believe that underlying support is likely to persist. Sterling has advanced versus euro, but is also more volatile given upcoming trade negotiations. The euro has tentatively stabilized at lower levels, but remains under pressure. Emerging market currencies continue to offer attractive carry, albeit with higher volatility and idiosyncratic risks.
Oil prices continue to suffer from the virus’s impact, despite production cut pledges from OPEC. Global growth questions are unlikely to be resolved swiftly, suggesting prices are likely to remain weak for some time. We later expect a recovery, though medium-term supply is expected to remain ample thanks to shale production, which should cap prices.
Gold continues to benefit from a flight to safety and lower yields, and momentum is likely to remain supportive.
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.
Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.
Commodity-related investments, including derivatives, may be affected by a number of factors including commodity prices, world events, import controls, and economic conditions and therefore may involve substantial risk of loss.
Currency exchange rates between the US dollar and foreign currencies may cause the value of the investments to decline.
Alternative investments involve unique risks that may be different from those associated with traditional investments, including illiquidity and the potential for amplified losses or gains. Investors should fully understand the risks associated with any investment prior to investing.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed may change based on market and other conditions.
All investing involves risk, including the risk of loss. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.