COVID-19 Impact: AXA IM’s macroeconomic and investment strategy update – Asia special
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:
Advanced economies are all making progress towards relaxing the lockdown, in line with our expectation that we should see gradual – and incomplete – normalisation in economic activity in the second half of this quarter, even if the disparities across countries will remain wide. This is calling for strong collective policy action in the euro area, but on this front the situation is getting more difficult after the German Constitutional Court (GCC) ruling on the European Central Bank (ECB)’s Public Sector Purchase Programme (PSPP). In a nutshell, the GCC considers that the ECB has not respected the “proportionality principle” and exceeded the powers vested in the European Treaty, giving the central bank three months to justify its position before the Bundesbank is ordered to permanently stop participating to the programme.
The ECB can hardly justify its position without validating the GCC’s assertion that it can exert control over a European institution which is explicitly under the purview of the European Court of Justice. Technically, the short-term consequences of the Bundesbank withdrawing from the PSPP are limited. The GCC ruling does not affect the ECB’s Pandemic Emergency Purchase Programme - which, at €750bn, is now the biggest component of the ECB’s quantitative easing arsenal - and it seems that the other national central banks could continue buying their own national paper. Still, the political message is the wrong one at a time when the solidity of the construct is being tested.
Market reaction has been surprisingly muted, with the Italian spread widening by only about 20 basis points, but we suspect that the ECB has significantly intensified its purchases after the announcement to cushion the blow. This makes progress towards fiscal mutualisation even more necessary, in only to reduce the pressure on the ECB, but this is a politically thorny discussion and so far nothing tangible has emerged on the recovery fund after the failure of the European summit on 23 April.
This is one example of the second-round effects of the economic shock triggered by the pandemic which could slow down the recovery in the second half of the year. Another one is the crisis brewing in many emerging markets, as key players such as Turkey and Brazil are still going through a tough time in the currency market. What’s more, the last thing we need at this point is another round of stress on global trade relations, and from this point of view the re-activation of tension between the US and China these past few days is not good news.
AXA IM’s Senior Emerging Asia Economist, Aidan Yao:
There have been three phases in China’s economic evolution as it weathers the COVID-19 pandemic. The initial plunge reflected the economic paralysis caused by the rapid spread of the virus and Beijing’s draconian measures to contain it. GDP contracted by a record-setting 6.8% year-on-year in the first quarter (Q1) of this year. To put this in context, the near 13 percentage point growth plunge – from Q4 2019’s +6% to Q1 2020’s -6.8% – was almost three times the size of the peak-to-trough decline during the global financial crisis.
But thanks to Beijing’s aggressive actions and precautions taken by the Chinese public, the situation was quickly brought under control by the middle of February. A gradual relaxation of lockdowns then allowed the economy to enter the second phase – “normalisation”. However, this normalisation process was uneven across the different sectors of the economy. The resumption of business for large, state-owned, industrial firms was much quicker than for small, privately-owned, labour-intensive companies.
The third phase reflects the current state of the Chinese economy. While the supply shock has almost completely dissipated, the economy is not yet back to normal (or trend) rate of growth because of demand deficiencies. How the economy performs will depend on global and domestic demand. Neither looks particularly robust at the moment, with the global economy teetering on the edge of a severe recession and China’s own recovery held back by increased consumer caution and a worsening labour market. We think the economy will be, at best, back to flat growth in Q2 and resume only modest expansion in Q3 once the global economy comes back to life and domestic stimulus kicks into higher gear.
For other countries, there could be a number of lessons from China. Fighting COVID-19 requires drastic measures from the government and great sacrifices from the public. The economic costs for containing the virus will likely be substantially more than any economic crises that we have encountered since the Great Depression.
In addition, any premature relaxation of virus controls could expose countries to the risk of a second wave of infections. This will require the authorities to carefully consider the economic and social trade-offs when formulating exit strategies from the current lockdown.
Finally, until a vaccine is developed, the world could potentially face a periodic reoccurrence of mini-outbreaks that keep the public on edge and induce repeated economic shutdowns. Authorities may therefore need to be prepared for a long and drawn-out battle, by carefully deploying their limited policy arsenals. The relatively conservative stimulus implemented so far in China could be an indication that Beijing is hunkering down for a long fight.
AXA IM Chief Investment Officer, Core Investments, Chris Iggo:
A key feature of the crisis is the surge in government borrowing. This will influence global bond yields, which in turn will impact the valuation of other assets. This week the US Treasury Department announced that it will borrow $2.99trn in the three-month period between April and June. This is a huge amount, equivalent to around 14% of the country’s GDP at the end of Q1. In recent years the biggest quarterly borrowing amount was “just” $488bn in Q1 2018. There are going to be a lot of Treasury bonds for sale.
In 2020 so far, the US Federal Reserve has increased its holdings of Treasuries by $1.34trn, taking the total to $3.34trn. It has also been a big buyer of mortgage-backed securities and other assets. Its total balance sheet amounts to $6.7trn, some 31% of GDP – and it is destined to grow. Many economists estimate it will top $9trn this year, a whopping 41% of GDP. And the Fed is not alone. The European Central Bank’s balance sheet is estimated to already be close to 45% of euro area GDP, while the Bank of Japan exceeds 100%. A massive increased central bank balance sheet is the price to pay for keeping bond yields low and for attempting to generate inflation. There is no sign of this trend reversing.
For investors, the outlook is challenging. The common interpretation of the policy response to the COVID-19 crisis has been that central banks will buy significant amounts of government bonds, so governments can spend to combat the economic damage and keep borrowing costs low. Yet the US example shows how difficult that might be. The bonds on offer by the Treasury far exceed the amount by which the Fed will raise the size of its balance sheet in the short term. Instead, the market will have to absorb a lot of the additional borrowing – that means pension funds, banks, insurance companies and foreign investors. The risk is that bond yields do rise – even if temporarily – in order to tempt buyers. A rise in bond yields could make the summer months difficult for credit and equities.
What happens to US Treasury yields is important for emerging markets, where a lot of the debt issued by governments and companies is denominated in US dollars. Asia is ahead of other regions coming out of the pandemic so let’s see how the region’s financial markets are coping with a return to activity and the risks coming from the rest of the world.
AXA IM’s Asia Investment Specialist, Natalia Mu:
We maintain an overall constructive view on Asian equities. Although the COVID-19 pandemic has triggered a significant growth shock to the Asian region, we believe the structural growth drivers remain intact. Over the longer run, Asian economies will continue to see higher growth driven by favourable demographics, industrialisation, urbanisation and the rise of the middle class. In the short term, we expect Asian equity markets will continue to see some volatility, in line with global markets, as the COVID-19 situation evolves while markets digests the impact to the real economy.
In China, it is assuring to see the return to normal has happened relatively smoothly. The strength of continued recovery would hinge on domestic policy and external risks. The upside is China still has large monetary and fiscal policy room to boost growth and companies could receive more direct support if needed.
In terms of demand, the air freight, food and e-commerce industries appear to have recovered to similar levels compared to 2019. However, the airline, hotel and leisure industries remain some way below, and may have to wait until next year to see a full recovery in demand.
In terms of positioning, broadly, we believe quality companies with sustainable business models will not only survive the crisis but also be in a strong position after some consolidation of their fields. We continue to prefer opportunities in healthcare, e-commerce, internet and retail, which align with the longer investment themes we have identified and are more driven by domestic demand. Some of the outperformers we’ve observed include major internet players such as Alibaba, Tencent and Netease, along with condiments maker Foshan Haitian and healthcare names like Hualan Biological. We expect that post-COVID-19, consumers will emerge to be more digitalised than ever and this will have a profound impact across the above-mentioned industries.
Among Asian markets, east Asian countries (China/Hong Kong, Korea, Taiwan) appear to be advanced in terms of virus containment whilst emerging Asia (India, Indonesia and the Philippines) are lagging, with more limited government support. ASEAN and India equity markets have been weaker year-to-date and underperformed the broader MSCI Asia ex. Japan index. Overall, the region is still susceptible to the risks of US/China rivalry on top of the pandemic challenges.
From a valuation standpoint, Asian equities remain relatively attractive, despite the near-term uncertainty and likely cuts in earnings this year. Nonetheless, we believe sentiment will improve as investors assess the scope of recovery next year.
AXA IM’s Head of Fixed Income Asia, Jim Veneau:
Given the extensive central bank intervention and government stimulus now in the global financial system, hard currency Asian credit portfolios can be less defensive. Any re-risking should be done slowly and with an abundance of caution.
The US Federal Reserve’s commitment to extend its bond purchasing to include even high yield corporate bonds has sent a powerful signal to the financial markets. Even though the central bank will not buy US dollar bonds of Asian issuers directly, the Asian credit market has rallied on the improved global investor sentiment, further stabilising what had been disruptive margin calls and outflows during the recent March selloff.
As market volatility reached extreme levels during March, Asian single-B spreads reached +1755 basis points (bps) on a z-spread to worst basis as shown by the JP Morgan Asian Credit Index, the widest level since the global financial crisis in 2008. They have now recovered to +1368 bps by the time of writing (6 May), still close to the widest levels of the 2011 Eurozone-driven selloff. While the market of 2011 was still jittery from the financial crisis and feared a contagion from the still weak euro periphery, the economic uncertainty today appears far worse. Current trends in the market, therefore, may be over-optimistic about both the virus outbreak and the impact of government and central bank intervention.
In comparison, bond markets have been stable and resilient in China, the first country to experience the coronavirus outbreak. Investor sentiment has risen on expectations of government support and an earlier recovery than later-impacted economies. For example, the offshore market has quickly reacted to the improved funding conditions onshore as a result of relaxed bond issuance procedures and increased corporate bond issuance. Chinese property credits appear to be among the investor favourites.
As considerable fiscal and monetary support works its way into the Chinese economy, the onshore rates markets will be well supported with overall funding levels kept low. We see the short end being well-anchored whilst the longer end of the curve faces more pressure from the expected upswing in bond supply to fund spending. Positive perceptions aside, the resumption of China’s economy has been challenging as its lockdown was comprehensive and extensive. Not only may domestic consumers be slower to return to pre-coronavirus patterns of consumption, China’s external demand is also impacted as the virus turned into a pandemic and major economies entered lockdowns. Despite recent stability in the onshore market and outperformance of China’s offshore credit, it’s premature to consider China a safe haven, even on a relative basis.
 Z-spread stands for zero-volatility spread and is constant against the underlying Treasury curve; z-spread to worst further adjusts for the impact mostly of callable of bonds.
 Source: Bloomberg
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