March 11, 2020
Coronavirus: Positioning Portfolios for a Delayed Recovery
Coronavirus: Positioning Portfolios for a Delayed Recovery
March 11, 2020
Since our note of 27 February, the global spread of COVID-19 has continued to increase exponentially, causing substantial and sustained market volatility. Although China is seeing a reduction in cases and a return to normal manufacturing production levels, the virus has now spread to more than 60 countries, many of which have been slow to respond.
At the beginning of the outbreak, we saw global equities fall as the impact on China became visible. This led to opportunistic buying, which pulled markets back up, only to have them turn down again sharply as the contagion spread globally, hitting prospects for global growth in 2020. In this note, the Global Balanced Risk Control (GBaR) team provides an update on its latest market views and asset allocation positioning. These changes reflect our revised base case of a prolonged disruption to global growth in 2020, as well as how we are both defending the portfolios we manage and seeking opportunities.
Revisions to Global Growth
In early February, our initial expectation was that the virus would be contained within China and Asia. We believed that although countries economically exposed to these regions would take a hit, with negative impact to supply chains, containment and stimulus would revive growth to pre-virus levels.
Until the week commencing 24 February, we still expected the hit to GDP growth to be approximately 0.5% to at most 1%. This is similar to the OECD’s1 base case scenario of a contained outbreak, which estimates a reduction to 2020 global GDP growth of 0.5%. This positive view would have meant a V-shaped recovery, largely confined to Q1 2020. With fiscal stimulus and pent-up demand, there would have been the prospect of a sharp rebound in growth in Q2.
When the markets fell sharply from 24 to 26 February, we were expecting more decisive and credible action from western governments, as the virus started spreading further. We also expected investors to take the view that the virus’ impact on the global economy would be moderate and to buy into the decline. However, the virus has now spread beyond Asia to more than 60 countries. Crucially, no meaningful or credible actions are being taken in the US or most European nations, (aside from Italy, where the entire country is in lockdown) to slow what is clearly an exponential spread of the virus.
Our view is that the delay in taking appropriate action in the West only means that more drastic and economically more disruptive action will need to be taken shortly. Importantly, politicians seem to be counting on the virus running its natural course and are tolerating the rise in deaths among vulnerable elements of the population. We believe that the public will not tolerate this approach - especially as the hospital systems become overwhelmed – and that public opinion will force the drastic, economically-disruptive policies that will be needed to slow the spread of COVID-19.
We now envision global growth to be closer to that of the OECD’s “domino” scenario of broader contagion, where the virus’ negative impact could lower 2020 global GDP growth by an estimated 1.5% from pre-virus levels in 2020. Under this scenario, we see a more extended, U-shaped recovery. This scenario would lead to at least technical recessions in many regions and in any event to a more lasting adverse impact on growth.
Oil Price Shocks and High Yield
COVID-19 has been a catalyst for negative developments that could cascade many regions into at least a technical recession. The most obvious of these negative developments has been the strain that COVID-19-related declines in oil demand have put on the stability of the OPEC+ (OPEC + Russia) cartel. The COVID-19-linked falls in oil demand have led directly to cartel meetings aiming to further curb the supply of crude oil and thereby support its price. During the OPEC+ production meeting on 6 March these talks deadlocked, resulting in a complete breakdown in cooperation – at least for the moment – between cartel members, after Russia announced they will no longer cut production, believing that such cuts are reducing their market share. Saudi Arabia countered this with discounts to preferred customers and an increase in production. This has led to dramatic declines in oil prices.
The negative consequences of this are potential bankruptcies of indebted US shale oil producers, whose bonds make up roughly 17% of the US High Yield bond indices. US High Yield credit spreads have already widened sharply and are a likely knock-on effect to credit-sensitive instruments globally. There are likely to be losses in employment associated with this strain on shale producers and credit-sensitive companies more generally. A second negative implication is on the earnings of energy companies as a whole – these companies are some of the most capital-intensive, so a drop in their earnings is likely to lead to a noticeable pullback in business fixed investment. This in turn would weaken manufacturing, which had until recently looked like it was recovering from a prolonged slump. There is a silver lining in that lower energy prices in the medium term are a substantial economic stimulus, but this effect takes many months to be realised, while the negative effects above typically occur rapidly.
Widespread Impact on Economic Growth
The negative developments on economic growth from COVID-19 extend beyond this, including the well-documented shock to travel and leisure, as well as the likely shock to global consumption. Moreover, US household ownership of listed equities has recently risen to relatively high levels, and US non-financial corporations in general have increased leverage sharply. Both of these phenomena are likely due to the prolonged period over which central bank intervention has kept interest rates extremely low. Households received little, if any, interest on their bank savings or in ‘safe’ assets, so bought equities for their potential higher returns or higher yields. Similarly, non-financial corporations were able to finance stock purchases at very attractive interest rates and many did so, raising corporate leverage levels on a macro level. The COVID-19 related stock market corrections will impact US household wealth sharply, exacerbating the likely decline in US consumption, which is already suffering from virus-related reductions in travel and entertainment. The economic weakness due to the direct and indirect virus effects will probably stress the earnings of the leveraged US non-financial corporate sector generally (not just the High Yield segment) leading to job cuts and reductions in investment, which in turn will weaken economic growth.
Federal Reserve Rate Cuts
After cutting rates three times in 2019, our base case prior to the escalation of COVID-19 was that the Federal Reserve would pause. Last week, the Fed’s 50bps out-of-cycle cut spooked markets, which may have interpreted this as a signal that the situation is worse than previously thought. The last time we saw such a cut was in 2008. However, we believe that the willingness by the Fed to do whatever it takes is positive for markets in the long run.
Prior to the emergence of COVID-19, equity valuations were elevated, so there was potential for markets to revise valuations for 2020. EPS estimates and prices have both been revised lower, with earnings expectations suggesting a moderate impact from COVID-19. If this is the case, current valuations are already attractive. However, if countries are increasingly unable to contain the spread of the virus and the impact proves to be severe, equity valuations are still expensive and may need to be revised down further.
As mentioned in our note issued on 27 February, whilst the 2020 US Presidential election is not the primary driver of the recent volatility, its influence should not be underestimated. Indeed, as the year progresses it should become an increasingly important focus for markets. In late February, Bernie Sanders’ success in the Primaries was a likely contributor to the market sell-off as the threat of a business-unfriendly Democratic Nominee became a real prospect. However, Joe Biden’s surprise wins in unexpected territory in early March have made him the frontrunner for the candidacy.
Managing Portfolios’ Broad Asset Allocations
Managing the risk profile in our portfolios is the single most important consideration. As reported earlier, we gradually reduced risk over the course of February. However, the sell-off continues with the spread of COVID-19 outside China and the crash in oil prices has added to market jitters. Therefore, we have taken action to decrease the overall risk level of our portfolios further, by trimming equities based on our view that a correction in equities will likely range between 15%-20%.
Tactical Asset Allocation Changes
We have been focusing on overall risk levels and also on areas which may have been hit too hard during the sell-off. Within equities, we have shifted from more cyclical to defensive sectors such as Consumer Staples. Without a V-shaped recovery, the performance of cyclicals is likely to lag the index. Conversely, defensive equities are likely to benefit from a protracted slowdown and a U-shaped recovery.
With respect to Fixed Income, we have also reduced risk, underweighting High Yield and removing our overweight to Emerging Market Local Debt, as spreads have lagged the move in equities in this sell-off. The more prolonged the disruption to growth, the higher the risk of credit downgrades and defaults. Instead, we have been moving into “safe haven” assets, such as US Treasuries and cash.
Below we have provided an overview of the key tactical asset allocation changes we have made recently:
China: Initiating an Overweight
Whilst China was first to be hit by COVID-19, it is also closer to getting back on track. Chinese authorities were swift to react to the crisis and this appears to have been effective. The number of reported new cases of COVID-19 has begun to decline in China and we believe that whilst economic activity has fallen in the short term, the disruption should be temporary, given the decisive monetary and fiscal response. Whilst the situation is escalating in the West, China is already back to 55% - 75%2 of its original manufacturing production levels. It is estimated that by the end of March the majority of activity should be back to normal levels3.
Japan: Moving from Overweight to Underweight
Japan is not only contending with the impact of the virus, but has the additional layer of the increased consumption tax, hitting consumer confidence, as its impact has been worse than anticipated. Although there is fiscal stimulus, there is likely to be a lag before its effects are fully apparent.
Consumer Staples: Initiating an Overweight
Although consumer confidence has been undermined, Consumer Staples should still do well due to people self-quarantining, working from home and preparing for the worst by stockpiling.
High Yield: Moving from Neutral to Underweight
High yield spreads are widening significantly and liquidity is low. High yield is likely to suffer, given the sharp decline in oil prices, especially as oil companies represent a significant proportion of US High Yield. Although the oil price shock could lead to oil companies slashing investment, as was the case in 2014, this could in time lead to cheaper energy, which could help consumers and businesses. That said, there is likely to be a substantial lag before any of this effect is seen.
Emerging Market Local Currency Debt: Moving from Overweight to Neutral
There are two opposing forces at play (FX and Rates), given the downward revision to the growth outlook. This should give central banks an opportunity to cut rates, especially in those countries in which real rates are already quite high (e.g. LatAm, Russia). However, this complicates the outlook for FX, as currencies struggle to rally in a slowing global growth environment. The key is where the duration rally could offset the small FX depreciation. We have seen this happen before, so this could happen again.
US Treasuries: Overweight
US 10-year Treasuries are one of the few asset classes which are up over the past few days. The flight to safety has, at the time of writing, also seen US Investment Grade and Yen up, whilst Gold has remained flat.
We have provided the latest tactical asset allocation signals as follows, as of 9 March 2020: