global perspectives
Coronavirus spread turns into a global risk
Last week saw extreme selling in global equity markets as risk of a global recession rose driven by the spread of the coronavirus.
China's template of dealing with the outbreak shows that restricting economic activity is necessary to slow the spread of the virus. As the outbreak has taken hold in additional countries (especially Italy, South Korea and Iran), serious market fears that sequential economic system shutdowns may follow are driving risk premia in global markets, which had been pricing a far more benign outcome until 10 days ago.
In addition, high frequency data in China has also showed a slower pace of recovery than was assumed a week ago and business survey data released over the weekend was consistent with a very sharp contraction in activity in February. For instance, China’s February manufacturing PMI plunged to 35.7 and the fall was broad based irrespective of the size of the enterprises. Here, analysis run by the street indicates that even a 10% month over month contraction can result in a negative GDP growth print in the first quarter, whilst our monitoring shows that some parts of the economy, such as manufacturing and discretionary spending, experienced contraction of almost 50% month on month in February, with signs of a bounce back appearing as we enter March.
Globally, as other countries move from containment to a potentially full-blown mitigation phase, the ripple growth hit (if the China template of closing down cities is followed) has the potential to deal a blow similar to the one seen at the depth of the 2008/9 crisis. In addition, this contagious virus spread has the ability to put severe pressure on health care systems across the globe and more strongly in countries with weaker health care systems.
However, despite its very strong spread attributes, the virus does show reliance on cold weather as an accelerant and is also showing lower rates of fatality than initially seen, since it now lies in the range of between 1 and 2 percent compared to more than 2 percent a few weeks ago. That said, it’s very high spread intensity rate in today’s interconnected world is clearly amplifying concerns of a severe downside scenario appearing - especially the surrounding resilience of medical systems if a very high proportion of the population gets affected.
We think we are in the midst of genuine virus-induced economic fears taking hold and see the situation worsening in coming days and weeks.
Alongside downside moves in equity markets, we are also seeing sharp downwards moves in government bond yields, especially in the US, as markets are pricing in imminent central bank interventions. We think a coordinated cutting cycle – given the shock is now truly global - may start as outbreak numbers force economic shutdowns as quarantines are imposed in a similar fashion to China. Here, the Federal Reserve has the most room to ease, whilst moves from other key central banks are likely to be there for moral support. Indeed, a strong fiscal response in Europe and Japan would be more impactful to help growth and it would certainly help if policy makers also share details of contingency plans when it comes to suspending the complex debit/credit circles running through the economy should a wide-spread economic shutdown become necessary. Specifically, we see scope for a 50 basis point cut from the Fed over the next 10 weeks with potential for more if the outbreak impacts the US at the same scale as Italy.
As such, we think we are in the midst of genuine virus-induced economic fears taking hold and see the situation worsening in coming days and weeks. Unlike 2008/9, a sharper growth recovery is very possible, especially if either a medical breakthrough or the weather improves. That said, China will be important to watch here to see if reinfections return as the country opens the forced shutdown further and economic recovery takes hold.
All-in-all, when it comes to portfolio positioning, we have been in a defensive mode in equities and regionally prefer China equities (where infection rates are falling) as opposed to countries where infection rates are likely to go up and mitigation measures such as widespread quarantines are likely to be adopted if the situation continues to worsen. In duration, we are neutral given extreme pricing of policy support already priced in. We are cautious around industrial metals and energy, whilst see gold as a broad portfolio hedge.
Overall, our stance and views remain fluid and are watching the resumption in China, led by our Asia investment teams, to carefully calibrate the wider economic damage from what is now a global virus outbreak.
View from our Investment Teams
Our Asia equities team see emerging signs of differentiation amongst sectors and single names especially in China. They see some parts of the Chinese economy returning to normality faster, whilst areas such consumer discretionary spending remain relatively subdued, which is in line with the decision of the team to exit travel related plays on the expectations that first half earnings are likely to be severely impacted.
A number of companies have delayed reporting and are reserving judgement on the outlook. Those which have given guidance are clearly indicating a very tough first quarter. Local survey data of individuals in China, by local players, continue to highlight huge disruption to daily lives though there are also signs that people are starting to return to work, which was not the case a month ago. Barring a reinfection/re-spread risk, it appears that China is now starting to enter the resumption phase, whilst most developed markets are starting to move into containment, and potentially mitigation, as risks of economic shutdown similar to China’s loom large.
In Asia fixed income, duration risk has helped keep all in yields in check despite last week which saw a very sharp widening of credit spreads. Our team sees opportunities appearing as the broader panic based selling deepens and affects names which are fundamentally strong and still removed from the shock (e.g. high quality names in India, which have seen significant spread widening in recent days). In China, the government has already pumped CNY 3 trillion of liquidity alongside a number of fiscal and monetary measures, which reduces the risk of cash shortage-based bankruptcies. Moreover, as real risk free yields move deeper into negative territory, the search for quality backed hard currency credit is likely to strengthen further.
In global equities, luxury/travel sectors have been initially at the forefront of damage (which led to sector focused portfolio shifts in a number of our strategies) but as fears have become broad based the whole cyclical side of the market has seen severe pressure. We are watching signs of virus progression carefully to assess whether current pricing makes sense and continue to hold a more cautious stance compared to relevant benchmarks in our various strategies (which is visible in year-to-date outperformance generated by most of our portfolios).
In convertibles space, both the embedded long volatility exposure and defensive portfolio construction have helped as equities have come under severe pressure. Here, our team is using a stronger sectoral lens to assess opportunities and challenges arising from the current situation with focus on increasing positions in pharma and tech hardware (as valuations become attractive), whilst remaining cautious on travel related sub-sectors for now.
Turning to global fixed income, our team is starting to see stretched valuations and extreme pricing of potential Federal Reserve moves being priced in the curve. Indeed, a Fed cut in March/April is on the table for us but we would need Italy-like situation in the US to feel confident that the Fed will come to the rescue in a very big way as priced by the market. In credit space, we remain cautious given the strong rally we saw in 2019, given the rise in global recession likelihood and see continued need for protection as volatility is likely to remain elevated.
Lastly, in multi-asset space, our risk-based models are reducing equity and gross exposure. Our long volatility overlays are adding a hedge as short-term global recession probabilities rise and volatility becomes a more permanent feature of the investment landscape.
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