COVID-19 Impact: AXA IM’s macroeconomic and investment strategy update: The cost of the lockdown
The COVID-19 crisis continues to cause significant volatility. This is an exceptional and defining time for the global economy, but policymakers and central banks are taking decisive action to steady markets and the macroeconomic backdrop. Our investment experts outline their current views on the situation, explain what they expect could happen from here and highlight where there could be opportunity…
AXA Group Chief Economist, Gilles Moëc:
The flattening of the epidemic curve is well underway across most of continental Europe, and a growing number of countries are openly discussing the conditions of relaxing their lockdowns. However, in the absence of vaccines or an efficient anti-viral treatment, the speed of normalisation will be decided by the capacity for testing, to avoid a relapse as we go in to the third quarter (Q3). This suggests the level of activity will remain sub-par well after containment measures begin to be relaxed.
We continue to be more circumspect about the US. The growth rate of the disease has slowed, but remains significantly above the levels seen in Italy. The later a lockdown starts, the longer it must last, since beyond a critical mass of acute cases the healthcare system gets swamped and takes time to recharge. Our baseline expectation is that the US would not be in position to normalise before the end of Q2, with an associated contractionary impact on world growth.
While newsflow is definitely improving as far as controlling the epidemic is concerned, at least in Europe, estimates of the cost to GDP continue to rise. France’s central bank confirmed the INSEE statistics bureau’s assessment that activity falls by 30-35% in lockdowns, prompting it to disclose its estimate for Q1 GDP in France to show a 6% contraction on a quarter-on-quarter basis. This order of magnitude can probably be used for most advanced economies. With lockdowns lasting six to eight weeks rather than four weeks as previously hoped, annual GDP for 2020 may well fall by around 4% in Europe and the US. The depth of the recession in the first half of 2020 is second order though – especially since fiscal policy supports income. We think markets have already priced a bad outcome for Q1 and Q2 and are focusing on the chances of a rebound into Q3.
When it comes to the shape of the recovery we predict a “swoosh” shape (similar to the Nike logo). This would see a fairly slow re-acceleration coming after a protracted slump – especially since we think a higher preference for saving may be a legacy of the pandemic – but positive GDP growth from Q3 onwards is our central scenario. In the meantime, we think there is still a need for some fine-tuning of the policy response, especially when it comes to supporting corporations. The implementation of the credit guarantee schemes in the US and the UK is still problematic, and we are concerned by the sensitivity of central bank support to agency ratings.
AXA IM Chief Investment Officer, Core Investments, Chris Iggo:
Despite central banks cutting interest rates – leading to a sharp decline in government bond yields – we feel that investors should not totally discount government bonds going forwards. The highest-quality government bonds did act as a hedge against risky assets during February and March, and portfolios that had some exposure to duration would have in general performed better than pure equity or pure credit funds. Bond yields are lower, but this means the duration of a bond portfolio is longer. A small allocation to government bonds can potentially protect portfolios going forward.
On the credit side, March was one of the worst months ever for total returns. In my opinion, investors are unlikely to suffer a repeat of this performance any time soon, given how far credit spreads have moved and how much central bank credit support has been put into the system. After negative monthly returns in the past, credit indices have delivered positive returns over the subsequent 12 months 90% of the time for investment grade and 80% of the time for high yield.
Short-duration strategies are particularly attractive for investors who may have cash. Short-dated fixed income was badly hit by the need to raise liquidity in March. This has left the short end of the curve relatively cheaper. For example, the one- to five-year part of the UK corporate bond market has a yield to worst (the lowest possible yield without the bond defaulting) of 2.74%. The 10-15 year sector has a yield-to-worst of 2.72%. Investors can get similar yields on short-dated bonds with less duration than on longer-term bonds with more duration. In high yield, the yields are even more attractive and credit yield curves are inverted.
We expect three phases to the market recovery. The first is the peak of the virus, with reduced numbers of new cases and mortalities, and decreased pressure on public health services. The second is more clarity on the removal of lockdowns. Then we would move into the third which is the medium-term economic recovery. Equity investors will anticipate moving through these phases and should then be able to stabilise 2020 and 2010 earnings expectations. However, delays to either phase one or two and less confidence in the robustness of phase three would leave equity and credit markets vulnerable to another leg of the bear market.
AXA IM Head of European High Yield, James Gledhill:
As we came into this crisis, issuers of high yield debt were in reasonable shape. In particular, high yield (HY) companies have used the last few years to term-out debt – moving shorter term facilities to longer-term – and typically have a degree of flexibility in the form of revolving credit facilities (RCF). Relatively few companies need to refinance debt in 2020 and 2021. There is no maturity wall.
That said, the hard stop in parts of the economy is extreme. In HY, the energy sector has been particularly impacted (notably US oil), alongside transport, leisure and retail. Even with no debt to refinance, might some of these companies have cash needs in excess of their RCFs?
Balance sheet liquidity has always been a key part of our credit analysis but it is particularly relevant now to determine which companies may have trouble bridging to the other side of this crisis in both a base case and a more stressed case where lockdowns persist longer. Unsurprisingly we are reviewing holdings for short-term liquidity needs in both scenarios.
At the time of writing (8 April) spreads in Europe are 733 basis points (bps), US 886 bps and globally 905 bps. This is around 200 bps tighter than the peak in March and perhaps 500 wider than the start of the year.
These spreads are equivalent to the peak of the tech crash in 2002. The only period with wider spreads was the financial crash of 2009 where spreads hit 2000 bps briefly. Our base case is that the swift action and scale of monetary and fiscal policy will avoid this outcome when combined with the better capitalisation and functioning of the banking system as a whole.
Defaults will rise, possibly in two phases – imminently and then additionally in 2021. However, we believe this will be concentrated in particular sectors (particularly oil) and is currently sufficiently discounted by the market.
We came into this period with risk positions that had been reduced over the last couple of years and a notably cautious position on oil in the US. We believe that there will continue to be volatility in the months ahead but it is our intention to increase the duration and risk positioning in the portfolio, where appropriate, over the coming weeks and months while controlling risk for more stressed situations that may arise. History suggests that entry into the HY market at these sorts of spreads has a good probability of a very strong return over a one-year view.
AXA IM Global Technology and Digital Economy strategies fund manager, Jeremy Gleeson:
Equity markets have been both volatile and challenging over the past few weeks to say the least, as investors attempt to assess the impact and duration of the coronavirus outbreak.
However, the technology sector has demonstrated itself to be more resilient than the broader equity market – and we believe a number of factors are driving this.
For example, the requirement to work from home during the present time will likely demonstrate to many that remote access technology can be effective and might even become part of many workers long-term routine. We expect that some software company providers and cloud-based security companies will likely benefit as a result of this backdrop – with the recent market performance of some names indicating as such.
In addition, while it is still too early to fully comprehend what impact there might be on all forms of retail, it does appear that companies with a strong online strategy will likely prove to be more capable at dealing with the current situation.
During this unprecedented period where governments are asking populations to stay at home for an extended period, companies within the communication services sector, such as Netflix, or video game companies might see more demand for their services. Likewise, we expect the time spent on social media and video platforms such as YouTube to increase.
Many of our long-term investments are now trading at very attractive valuations, but we are aware that forecasted revenues and earnings will almost certainly have to be reduced across all businesses. We are mindful that volatility in equity markets might continue for some time - however, we are adding to existing holdings where we see opportunities arise.
Ultimately the current situation has truly been a black swan event, and even now it, is hard to predict the duration or the magnitude of the effects. Within our investment philosophy, is the preference to only invest in companies who address a strong long-term opportunity. And we firmly believe that the potential of the long-term themes within our strategies remain intact - and could potentially be even more robust - once the current turmoil is over.
 Source: Barclays Bloomberg US Corporate Bond and US High Yield total return indices, as of 8 April 2020
 Source: Bloomberg as of 8 April 2020
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