Even as vast sums are pumped into the global economy, inflation is probably the least of our worries, at least for now. Despite likely supply chain disruptions and some bottlenecks in the months to come, we view COVID-19 as largely a deflationary force in the near term. Plunging oil prices alone are enough to drive inflation down across economies; our new forecasts reflect this. Whether this crisis is deflationary over the medium to long term is unclear, as we wait to see whether reshoring to higher labor cost locations wins out over tech-driven innovation in the competition to bolster crisis-exposed supply chains. Whether inflation flares up down the line will also be the litmus test on whether MMT 2- type policy responses are viable.
Emerging market economies, which tend toward greater dependency on commodities including oil, metals, and agricultural products, may suffer an especially deep decline in GDP. Steep capital outflows are driving currency depreciation, leading debt servicing obligations to become more onerous and increasing the risk of default. EM countries with the strongest capacity for policy implementation — for delivery of effective health care services and for effective and sizable stimulus— are likely to fare far better, through this episode and beyond.
Our current asset allocation: Long growth assets with tactical hedges; opportunities in credit
Bearing in mind our broad expectations for the global economy and the unprecedented monetary and fiscal support taking shape across many economies, our current portfolio allocation continues to be long select equities and other risk assets, expressing a view in global large-cap equities and credit. We are slightly short fixed income overall; within that fixed income allocation, we are neutral to slightly short duration with a preference for credit over rates as companies move to preserve cash. Even as we’ve built up equity exposures over the past several months, we’ve continued to construct tactical hedges in gold, Treasuries, and cash.
We have retained a small position in European and EM assets, not because we hold a strong near-term viewpoint on Europe and EM prospects, but rather in recognition of the fact that cyclical bounces can occur in this market environment. Our proprietary Market Regime Indicator 3 has persisted in crisis range for some time. When this is the case, we tend to position our portfolios for a short-term reversal.
In equity markets, we favor North American equities for three main reasons. First, although it will be some time before analysts’ assessments of COVID-19’s impact are fully reflected in earnings assessments, North American companies have so far downgraded earnings less often than their counterparts elsewhere. Second, North American equities tend to be overweight quality. In the aftermath of the GFC, balance sheet strength was a leading indicator of equity performance. We believe the same will principle will hold as this crisis unfolds. Finally, we expect the lower-for-longer interest rate environment to broadly benefit defensive
sectors, where the US also has an advantage over other regions.
In fixed income, we see opportunities in both high yield (HY) and investment grade (IG) credit, as spreads between Treasuries and both HY and IG corporate issues have widened during the crisis. Prudent investors can find attractive opportunities in this environment that may allow them to benefit from the subsequent narrowing of spreads as conditions return to normal. It is, of course, important for investors to be well informed of potential outcomes when seeking to invest in times of crisis.
Liquidity issues are at the forefront in emerging markets, as investors have treated EM equities and EM debt alike as risk assets during the crisis, resulting in steep capital outflows. Valuations have improved across EM asset classes since we issued our last outlook, and EM economies have capacity to continue fiscal and monetary interventions, which should help to support fundamentals in the near term. But EM assets will require support from developed markets; resumption of growth in developed
markets, a rebound in oil prices, and reduction in US dollar strength are
critical for a rebound in EM. We prefer local-currency to hard-currency EM
debt, and encourage investors to look closely at their EM equity allocations.