Investors have had plenty to deal with since the beginning of 2020. What started out strong has become a bit of a roller coaster ride, to say the least. Concerns over COVID-19 impacts (both human and economic), varied government responses, and central bank actions all have led to a level of uncertainty that has weighed on markets. And then the Saudi Arabian/Russian spat on oil production opened the floodgates for stocks, oil and government bond rates to take a leg down. The good news is that markets have been operating efficiently and we have seen liquidity, although there has been some concerns there more recently and it is highly unlikely that these uncertainties will be resolved in the short term. This means that investors need to look longer term, to the latter half of the year and beyond and position accordingly.
Central bank actions The Federal Reserve (Fed) took swift action to curb the economic impact of COVID-19, cutting rates by 50 bps on March 3, along with other central banks, such as Bank of Canada and RBA. The IMF also announced a $50 billion emergency financing package. The uncertain spread and path of the virus translates into continued market volatility. However, easing monetary policy should help firms absorb a profitability hit, slow the possible deterioration in credit quality and the transmission to the labor market. Markets are pricing in additional rate cuts around the world. To date, there has been limited coordination across central banks, which has limited the effectiveness. Ultimately, we would expect there to be a widening of monetary policy tools beyond just rates, and the need to leverage the broader balance sheets to manage slow growth scenarios remains.
China's demand pipeline remains strong China has been at the center of the virus and provides potential insights on how the impacts might play out in other parts of the world. China’s manufacturing activity missed already reduced expectations and was dramatically lower in February amid travel and mobility restrictions. As the peak of the crisis seems to have passed in China, we would expect a recovery in new orders and employment in March and going forward.
In contrast to the downturn experienced in 2008, when there was a collapse in demand, recent data of China's PMI shows a spike in the backlog of work, suggesting that activity could rebound once normal activities resume and providing there are no future disruptions to demand. This will be an interesting path to watch as it may provide some insight to recoveries in other economies.
Source: IHS Markit, as of 3/13/2020
Economic impacts 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.
What's next? 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.
Market Risk Indicator (MRI) A proprietary macro indicator developed by the SSGA Investment Solutions Group. The MRI is designed to identify a level of forward-looking, implied volatility. Factors utilized to generate the signal include implied equity and currency volatility as well as spreads on fixed income.
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