Our global economic forecast for 2020 is now 1.5%, as we eliminated the small 0.3% increase we had added in December. This forecast assumes that the peak of the virus hit China in Q1 and that there will be containment in Q2 in Europe and the U.S., so not a worst case scenario. The massive drop in oil prices should shave an additional 0.1% from expectations as the impact on energy companies ripples across the economy. This will be partially offset by the positive impact on consumers and some businesses. For now, we are not calling for a global recession, but we admit that how the Western countries look to lock down the spread of the virus could become very draconian and therefore a sizable risk to this view.
Investment grade spreads widen modestly
Where can you weather the storm? Government bonds have performed incredibly well, with rates in the US dropping to unprecedented levels. But that is unlikely to be the case going forward. We like investment-grade fixed income, given strong balance sheets, low interest rates and limited supply. While the hardest hit sectors have been Energy, Automotive and Commodities, overall spreads for investment grade are around the middle of the range from last year. The same has not been true for high yield, where spreads have been relatively stable until recently. The sharp drop in oil magnified the earnings and default concerns related to energy companies, driving the energy sector of high yield to a spread of 1,432 bps and the overall high yield market to 709 bps.1 In a low yield environment, this level of yield starts to look interesting, but we would rather remain neutral to this asset class, expecting there to be more risk in the near term.
Equity volatility is expected to continue
Equities have been in a very sentiment-driven environment, even before the Saudi/Russian dust-up, and it has only gotten worse since. As fears that the virus’s impact will cripple global growth, investors’ risk appetite has moved to extremes. Our Market Regime Indicator has moved to Crisis at the beginning of the month as implied volatility in equities and currency has spiked. With risky debt spreads widening as well, this implies that investors have become overly pessimistic. This extreme position is a contrarian indicator for us, and it is part of what has driven our decision to remain overweight in equities in our tactical portfolios.
Earnings expectations for developed-market equities have declined for Q1, reducing full-year estimates from 10% to 8%. And while estimates for the remainder of 2020 and 2021 remain the same, markets will need to wait and see continued policy responses, how quickly China returns to productivity, as well as how the virus spreads in Europe, North America and elsewhere. This becomes a key potential catalyst for stocks, given the ever-changing guidance from companies. We know that near-term results will be difficult, but for how long is still an open question for investors.
Emerging-market earnings expectations have not yet changed. However, we believe this is unrealistic and anticipate broad downgrades and a bumpy ride for the next two quarters. Long term, we prefer an active allocation to emerging-market equities to complement core index exposure.
Although we are positive on stocks as we look past these transitory disruptions, there is a need to manage portfolio risk, so we hold an overweight gold position in the portfolio. Gold has proven to be a good diversifier, and given the expectation of US dollar weakness and dropping bond yields, it has been a store of value with limited opportunity cost, and technical factors signaling it remains in a firm uptrend.
The economic and social impact of the virus remains fluid, and we expect that the geopolitical impact of the sharp drop in oil will be an issue for some time. This means that volatility will continue and we will look for opportunities:
- For those looking to add to equity allocations but were concerned about valuations, this creates an interesting entry point to adjust those positions.
- Keep a focus on overall objectives and avoid getting influenced by short-term swings in the markets. At some point, the market will begin to look beyond this short-term event and to future growth driven by the various stimulus introduced to help the economies.
- Key areas to watch for early signs of a return to normal will be corporate earnings expectations, a move from high levels of negative investor sentiment, a shift in the direction and level of interest rates, and a peaking in the overall infection rates.