Resilient US and EM equities (relative to EU stocks) and credit markets were under fire this week, giving up most of their relative advance. As the virus expands in non-European DM countries, lockdowns are intensifying. Global recession and systemic liquidity fears engulfed most assets. The dollar soared, volatility reached record levels, money market rates burst out while assets sensitive to banks and corporate credit plunged. Safe-haven bonds, gold and defensive sectors provided limited shelter. Sentiment temporarily stabilized by the end of the week supported by coordinated monetary and fiscal pledges of a gigantic stimulus package (totaling $3tn so far and growing). How and how fast these packages will pass through to the real economy will be scrutinized.
As DM economies enter glaciation to contain the pandemic, the economic toll will rise exponentially. The overall -35% plunge in activity in Chinese provinces under full lockdowns (-20% in provinces under partial restrictions) provides guidance for DM economies.
Our base case is a recession with the bulk of the hit in Q2. We see a U-shape recovery unfolding in Q3 and Q4 supported by stimulus but constrained by some restrictions remaining in place for longer. Companies and governments could also seek to unload their ballooning debt, constraining both employment and capex. The longer the pandemic lasts, the likelier this liquidity crisis could morph into a solvency crisis.
We expect this pandemic to leave scars long after the virus is dealt with. Some are already getting apparent, including an accelerating deglobalization trend and increased vulnerability to the next shocks as public institutions are now left short of ammunitions. Political and geopolitical shifts are also plausible when the time for a crisis-management assessment comes, as well as in smaller countries under twin pressures from recession and the oil price war; some key political leaders could also be fatally caught up by Covid-19. Also, the crisis could alter US elections prospects (with implications for the economic agenda and the trade war). A greater role from states through nationalizations, regulations and taxation is probable, at the expense of central banks’ independence. Some aspects of capitalism as we know it might also be altered, whether it’s for the best or for the worst is not clear yet. The crisis also emphasized how market trading behaviors changed since the last financial crisis, witnessed by the extreme velocity of market moves. The rising share of algorithms and indexed products, and anomalies from resuming QEs are unlikely to make the allocators’ job any easier: this environment is calling for expert active managers – in particular, HF were resilient so far and are usually relatively favored in recessionary backdrops.
From a tactical standpoint, valuations and tactical indicators are increasingly calling for a trough, with an unusually rich number of opportunities to exploit in the months to come. In the short-term, we still think the risk/reward remains asymmetric. Until the US virus expansion is matured enough, measures of liquidity stress abate, and until the absence of the virus re-acceleration in Asia is confirmed, a material allocation reweighting looks premature to us.
Credit markets went through extreme dislocations, with some segments priced for another great depression, paving the way for juicy opportunities in the future. Yet, the asset-class remains most vulnerable to a liquidity crisis morphing into a solvency crisis and to the oil price war. We are UW US and EU HY. We are OW EU and UK IG, supported by asset purchases. We are UW on EU peripherals.
The recent bull-steepening of the US Treasury yield curve both highlights increased policy support but doubts as to the shape of the recovery. We see US 10Y govies yields rebounding towards 1.5% within a year, consistent with a U-shape scenario. We expect a bear-steepening in Gilts and Bunds despite ECB’s purchase.
US equities’ valuations are getting attractive, as growth estimates price about 1% real growth in 2020, and as the consensus for EPS growth was revised down to 0%. We are Neutral on US equities, given their still asymmetric risk/reward. We would OW Quality and remain OW Staples vs. Discretionary. We are OW Financials (steeper yield curve) and are Neutral Growth vs. Value.
In Europe, we favor cheaper and more defensive UK to EMU equities. UK longer term prospects are attractive given the oversold GBP. Dislocated EU Consumer Discretionary stocks exposed to China offer opportunities.
EM economies are facing multiple pressures, leveraged to a declining global economic cycle and to capital outflows. Oil producers would be under severe pressure and some countries face virus expansion. They will also need to adapt to an accelerating deglobalization trend. DM stimulus bode well for EM markets, but we first look for a stabilization in liquidity and dollar funding measures, in EM flows, in oil prices and, like elsewhere, better clarity on the virus containment. EM equities‘ relative outperformance keeps us Neutral in the ST. We are strategically long EM HC Debt, but tactically neutral.
A resolution of the oil price war between Russia and Saudi Arabia might not find a rapid solution, given their diverging targeted equilibrium prices (probably around $50/b for Russia, ie below US breakevens, $70/b for Saudi Arabia to finance its economic mutation). Meanwhile, the collapse in demand will dramatically inflate oil inventories. A minimalist OPEC+ deal by Q3 and a U-shaped world H2 recovery could push Brent towards $35/b by the end of Q2 and $50/b by yearend. We are strategically OW, but tactically neutral on Brent. Gold lost its ‘innocence’ after the margin call and surging real yield induced selloff. Yet, global tail-risks, resurfacing deflation fears, massive monetary and fiscal accommodation are powerful fundamental drivers. We turn OW on gold for hedging purposes.