Market thinking

COVID-19 Impact: AXA IM’s macroeconomic and investment strategy update – the economic rebound

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 first goal of the lockdown was to re-create some capacity in the healthcare system so that a potential relapse in the pandemic would be more manageable. This is being achieved in most European countries. We expect that by mid-May that most of the euro area will have started to normalise. 

At peak lockdown, the level of economic activity is about a third below normal. For the first quarter (Q1), with the last two weeks of March affected, mechanically Eurozone GDP would be down by about 6% relative to Q4 2019. The re-opening of economies in the second half of Q2 would be consistent with another contraction of at least 12% that quarter - probably more since normalisation will only be gradual.

Beyond the administrative measures, we can draw on the experience of China - which exited lockdown earlier - to expect a subdued pace of recovery. We anticipate that precautionary behaviour will stop the accumulated forced savings from being immediately spent. Investment will take a lasting hit. Capacity utilisation has collapsed, and the level of uncertainty is still high. Corporations will probably hesitate to fully resume their capex programs given the possibility of a pandemic relapse. Singapore, lauded for its efficiency in controlling the epidemic in its early stages, has seen an increase in infections. Last week the infection rate passed the level of one case per 1,000 people, with an average growth rate in cases of 12% over seven days.

Economic policy will need to move from emergency support to a medium-term accompaniment of the recovery. State-guaranteed emergency loans to corporates are providing a vital lifeline, but their maturity is often short. In some cases, for instance the US Federal Reserve’s Main Street Lending Program, they are not particularly cheap - 250/400 basis points above the Secured Overnight Financing Rate. This may create undue pressure on corporate cash flows and impair the speed of the rebound. 

We believe that fiscal policy will have to keep its tap open long after the acute phase of the pandemic is behind us, and central banks will face some thorny decisions. The most important one in our view is how quickly they will offload the public debt they have taken on their balance sheet. Reinvestment over several decades may be needed. This could be a difficult decision for the European Central Bank (ECB) in particular, since it would mean that it would not re-converge towards the capital key – the measure for determining how much of the ECB’s capital each government should provide - for a very long time. Italy, in our opinion, is the main victim of the absence of clarity.

AXA IM Chief Investment Officer, Core Investments, Chris Iggo:

We are likely to be living through the biggest one-off drop in economic activity in our lifetime. Although we hope the recovery follows the expected path, we don’t know for sure what the shape and strength of the eventual economic rebound will be.

Yet looking across the many asset classes that form our core investment universe, it is hard to find any with a negative total return since the S&P 500 hit its 23 March low. A rising tide really has lifted all boats. In fact, data shows that US equities have led the recovery, followed by small caps, emerging market equities and high-yield fixed income.

There have been solid gains in corporate credit markets. Even inflation-linked bonds, treasuries and other government bond markets have managed to hang on to the gains that they made during the bear market phase between the middle of February and the middle of March.

Despite this, there has been dispersion and that has created opportunities for asset managers. Prior to the crisis, investors were in broad terms facing the problem that everything was expensive. Today, some assets seem to have got more expensive - and others seem to have become very cheap.

Most people would argue that government bonds have become more expensive and that yields are unattractive. We would agree, to an extent. However, interest rates will remain extremely low for a long time, and central banks will continue to use their balance sheets to create the flexibility for governments to run large budget deficits. They may not offer much return, but they do offer certainty of cashflow.

We would argue that corporate credit has become cheaper. Credit spreads are higher and large parts of the market can - and will - benefit from central bank credit facilities. That is enough to offset the deterioration in fundamentals marked by rising leverage, and higher downgrade risk.

We particularly like the short end of credit markets. Our view is that curves will steepen again, with short-dated yields falling more as the credit market normalises.

At current levels equities are not cheap, especially relative to the expected level of corporate earnings over the next year. If that really was the bear market – and that is a difficult thing to call – then the credit needs to go to central bankers and finance ministers. Of course, the cost of that will be more debt and concerns over the medium-term outlook.

AXA IM’s Head of Sovereign, Inflation and FX, Jonathan Baltora:

In these volatile and uncertain markets, many investors are looking for defensive assets. Among the fixed income strategies that they could consider, we believe inflation-linked bonds are attractive.

Given that central banks’ quantitative easing programmes are being restarted and expanded significantly, we expect inflation-linked bonds to be well supported.

Inflation-linked bonds are mostly issued by sovereigns and more so by highly rated ones. This can give investors a good level of comfort on the issuers’ solvency. On top of that, most inflation-linked bonds find liquidity support as they are included in the QE packages.

The recent increase in real interest rates – since inflation levels are falling - is an opportunity in our view. Historically, one of the main effects of quantitative easing programmes has been to push real yields lower, supporting inflation-linked bond valuations.

We think that real interest rates are too high compared to money market expectations of prolonged easy monetary policy.

Inflation expectations are depressed as a result of the drop in oil prices and expectations of much slower economic growth going forward.

While it is reasonable to expect inflation to be close to 0% in 2020, the combined impact of the biggest globally coordinated monetary easing and monetary-financed budget stimulus on inflation remains to be seen.

The economic recovery that will eventually follow may see some significant inflationary pressures, as was the case during the recession after the 2008 financial crisis and Japan’s Fukushima nuclear disaster.

In any case, the market might have to price in higher inflation to a certain extent, and current market levels look too depressed in our opinion from this perspective.

The impact of the coronavirus pandemic on oil demand, which has sent prices plummeting and in the case of the US, turning negative for the first time ever, will also make the inflation picture look worse in the near term.

However, it is worth remembering that food and energy prices, while the largest contributors to inflation volatility, only contribute marginally to the actual level of inflation. In short, the oil price move, however dramatic, is ‘noise’ and a large share of the move lower in oil prices is already priced-in.

We expect to continue to see real interest rates decreasing and believe that in an environment where central banks are printing money to finance budget spending, sovereign bonds linked to inflation are becoming attractive again.

AXA IM Head of Active Emerging Markets, Sailesh Lad:

Emerging markets have been caught in the eye of the storm on two fronts. Firstly, the health crisis resulting from the outbreak of coronavirus - and secondly the collapse in oil and other commodity prices. This has resulted in a sharp downgrade in expectations for not only global growth but also asset prices generally.

Currently the number of coronavirus cases does not seem as severe as mainland Europe or the US but this might simply be down to testing levels. However, health care systems are weaker in many developing countries and population density is far greater in cities, making lockdowns harder to be effective. This could have ramifications on weaker domestic demand and consumption, coupled with the overall weaker global growth trajectory.

Unlike previous market crises, emerging markets have opted to cut interest rates and allow their currencies to depreciate, rather than tighten policy and deplete reserves in a bid to avoid capital flight. The International Monetary Fund has promised $1trn to help developing markets but this will come with certain conditionality and no funding will be provided if it is deemed to make a countries debt unsustainable going forward. Last week the G20 agreed the suspension of debt for poorer countries until the end of 2020. All these measures should relieve a lot of the pressure that emerging market countries are currently facing.

Emerging market bond spreads have doubled since the start of the year and there are clearly winners and losers - so differentiation remains key in picking individual countries to invest in. For example, we are avoiding those countries whose economies are heavily reliant on remittances and/or tourism – for example Costa Rica and the Dominican Republic - which we expect to fare much worse than those that don’t.

We are also differentiating between oil importers and exporters as well as reducing holdings in high cost oil exporting countries such as Nigeria and Angola.

Many emerging market curves have flattened and so currently we have a preference to be investing mainly in the front end, i.e. up to five years, as we perceive there isn’t enough yield compensation for taking duration risk.

As much as risk appetite may be returning the market, it is still in “safe haven” mode. Emerging markets are perceived as a riskier asset class and so will be a secondary beneficiary of this risk-taking, but the landscape could look very different if funding pressures mount and default rates rise.

Fundamentals will be the main driving force of any out performance for our asset class - and this is why we believe that differentiation remains central to stock selection.

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