COVID-19 Impact: AXA IM’s macroeconomic and investment strategy update
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:
We consider Italy as a benchmark for how the epidemic can be handled in a democratic, developed western economy. The country is on the right path – with daily growth in new cases now below 5% - but there is still a trickle of new cases. This suggests that a month of lockdown may not be enough to properly stop the epidemic. We expect output to fall by 30-35% in any developed nation at the peak of their containment measures. One month of lockdown would thus depress annual GDP by 2.5-3%. As long as policy stimulus can control the second-round effects – that is, protect income and avoid business defaults – the relationship is probably linear - a six-week lockdown would “cost” 3.75-4.5% of GDP on an annual basis.
What is crucial is whether the contraction in GDP can be contained to the first two quarters of 2020 with a rebound afterwards. This would be positive for asset prices, irrespective of the output loss in the first half of the year.
The data flow from China is cautiously positive. The Purchasing Managers’ Index confirms the message from real-time indicators – the Chinese economy is no longer contracting. However, the rebound looks subdued, for instance when compared with the end of 2008, and some of the containment measures have been tightened again – such as cinemas re-closing – after an initial relaxation. In any case, all the key regions need to be past the epidemic peak for the world economy to start normalising, otherwise global trade will continue to act as a drag.
From this point of view the US is crucial, for two reasons. First, while lockdown measures have now been enacted almost everywhere in the US, the decision came late – and the later the lockdown, the longer the containment measures will have to be maintained. Also, while differences in testing patterns may be a factor, the propagation of the virus in the US is occurring at a faster pace than in Italy.
Second, the automatic stabilisers – aspects of fiscal policy that are triggered automatically – are less powerful in the US than in Europe. Income support measures have to be powered up from scratch, so implementation can take longer and be patchier. In Europe the combination of regulation and in-work unemployment benefits keeps workers attached to firms. In the US, layoffs are often the only option. This means that when the situation stabilises, US employers will have to make a clear choice on whether to re-hire or not. This may prolong the slump in income in the US.
We think the immediate policy response is appropriate and provides decent protection. However, we probably need to think about ways to deal with the medium-term issues, in particular the significant but unavoidable jump in corporate and public debt. Debt mutualisation, or de facto debt cancellations via the central banks should be on the menu – but for now, the political willingness appears to be missing.
AXA IM Chief Investment Officer, Core Investments, Chris Iggo:
Markets moved into a new phase during the last week of March. Volatility measures reduced, credit spreads narrowed and some of the funding issues that had threatened disorderly moves in markets were less evident. There was even some evidence of credit markets opening up to corporate borrowers, with a number of new issues including from names such as Goldman Sachs, Nike, McDonalds and Toyota in the US dollar markets and Airbus and Nestlé in the euro credit markets. These came with a hefty new issue premium – meaning the coupon and the spread against government bonds was significantly higher than would have been the case before the crisis.
However, it has been a healthy sign that markets are re-opening and that investors are confident in the credit backstops put in place by central banks. This is welcome, but the recovery in the health of the market is entirely due to the public policy response and not to any meaningful improvement in the short-term fundamental outlook.
Credit spreads have come down a little, although borrowers will have to pay higher interest rates for some time to come, given the increased level of ratings downgrades and concerns about defaults in the high yield market. A number of companies across Europe and the UK have already suspended their 2020 dividend payments – either because they want to retain cash or because they are under pressure from regulators to do so. This is likely to be seen as negative for equity investors, but helps shore up confidence in credit regarding the continuation of coupon payments.
Volatility in government bond markets has fallen as well. Yields are settling at some 40-60 basis points below their pre-crisis levels in the UK and US government bond markets, and close to the pre-crisis levels of yield in the European core government bond market. Our view remains that longer yields can fall a little further as quantitative easing programmes kick in and curves flatten further. However, the level of official interest rates sets a floor to the longer end of the curve. Over the coming months there will be a huge increase in government borrowing around the world, and it is uncertain whether this will lead to higher bond yields. For now, central banks are absorbing all the new issuance – and that is supporting bond markets.
Equity markets staged a recovery in the last week of March but are still down 20-30% year-to-date. The progress of the global infection rate of COVID-19 remains key to market expectations, but investors will also need to see more clarity on the containment exit strategy. A view on how quickly lockdowns can be lifted is necessary before we factor in a return to more normal levels of economic activity. Only then can forward earnings start to converge on a consensus that does not exist at the moment. For example, a 25% decline in US earnings per share in 2020 and a convergence on the 2008 price/earnings multiple would be consistent with a S&P 500 index level of as low as 1,500.
AXA IM Global Head of Framlington Equities, Matt Lovatt:
Global equity markets have experienced a peak to trough decline of 30-40% in local currency terms. Many records have been broken, with the US experiencing the fastest drop in equity prices since the 1930s – and comparisons to the 2008 global financial crisis suggest the coronavirus-related decline has been twice as quick.
The earnings outlook for equities has dramatically changed, from around 10% growth for global equities to an earnings decline of 25-50%. The evidence is that Asia is getting back to work, while the US is in the first stages of lockdown, but it is clear that all countries will be anxious of recurrence risk for some considerable time. For companies everywhere the world has changed and in the short-term the outlook has polarised.
For some companies the short-term focus has been to reinforce liquidity positions as much as possible, while dealing with the impact of the virus for both their business and staff. Consumer-facing businesses such as travel, leisure and restaurants are facing a fundamental fight for survival, with many seeing sales virtually vanish in the short term. Many of them will likely need government support, or to raise capital and cut dividends.
Other companies, however, are in the midst of a significant opportunity. The obvious beneficiaries are in food and health, but not across whole sectors. For example, in healthcare there is a race to develop vaccines, testing and equipment, but other areas are struggling, such as the health businesses supporting elective procedures.
Looking more broadly, the growth in digital consumer activity is accelerating for many established online companies. Many businesses have stopped accepting physical cash to avoid transmitting the virus on coins and notes, which is supporting the ongoing switch to digital payments. Similarly, the large-scale shift of employees working from home has placed huge demands on broadband infrastructure and datacentres, resulting in additional opportunities. Remote working applications and associated security software upgrades have also seen demand grow. We believe our digital economy strategy is strongly placed to benefit from all these trends.
Our strategies have been impacted by the market correction, but broadly, relative performance has been resilient. This reflects the fact that we tend to focus on businesses that have strong balance sheets – often net cash, high margins and strong cashflow generative capabilities.
AXA IM Head of Active Fixed Income UK and manager of the AXA IM Global Strategic Bond Fund, Nick Hayes:
To construct an investment thesis in the current environment it is important for investors to understand how they were positioned before the coronavirus crisis, and what has changed. In the run-up to March 2020, as managers of an unconstrained global fixed income strategy, with a wide investment universe, we have been focused on three key themes. Clearly, this crisis could not have been predicted, but we believe these themes remain very relevant in the current conditions. So far, they have stood up reasonably well in the period of heightened volatility.
Duration: We came into 2020 bullish on duration, holding somewhere in the range of three to five years of duration. The economic cycle was mature, risk assets were not cheap, and we had seen a turn in the developed market central bank interest rate cycle. Whether government bonds are used as a hedge to risk assets, for liquidity provision or a pure alpha generator, it’s as important as ever to be holding high-quality, liquid fixed income. Such assets are not cheap, and in the medium term an explosion of issuance should be negative for prices, but in a crisis, holding pure interest rate-sensitive assets is a powerful investment tool.
Selectively long credit: To generate performance, investors need credit to generate income, carry and diversification. In the year to date, returns have been disappointing, and as ever spreads have correlated with equities. From a more cautious stance we are turning more bullish on credit as valuations have become more attractive. Over the medium to long term, there is potential for strong returns given the current spreads, which price in very elevated default risks. We have started to add US dollar high yield as a first port of call.
Insurance policies: Be it owning elevated cash, or cash proxies such as zero-to-five-year government bonds, cash has never been more important – even though it yields nothing. We have also successfully hedged part of our credit cash bonds through credit default swap indices. In the run-up to the crisis it appeared a cheap insurance policy, and during the crisis it has generated returns far in excess of our expectation. While less cheap, we think the rationale for holding remains valid.
The outlook is uncertain, but opportunities are presenting themselves in many fixed income markets. Despite all-time low yields in government bonds we now live in a high-yield world, thanks to the risk asset dislocation. The carry that is on offer from high yield, emerging markets and the new issue market in certain areas of high-quality credit are very attractive. They might well become cheaper, but in that environment, we envisage reducing the portfolio hedges and further deploying cash to go hunting for yield. Once we get through this current period of uncertainty, fixed income portfolios can once again generate attractive risk-adjusted returns. This will allow investors to move from a focus on capital protection to capital growth.
 Source: Bloomberg, data as of 1 April 2020
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