COVID-19 Impact: AXA IM’s macroeconomic and investment strategy update
AXA Group Chief Economist, Gilles Moëc:
The COVID-19 pandemic is forcing a growing number of countries into lockdown. This will have a very significant impact on economic activity since the worst-hit sectors will see their output fall to nearly zero. The rest of the economy will be impaired by disruption to day-to-day life and a deterioration in confidence triggered by heightened uncertainty.
What is key is how long these lockdowns will take to get the epidemic under control. But they appear to be efficient. In Italy – used as a benchmark for the impact on Western economies – the daily growth rate in the number of cases in some of the worst-hit locations in the North, which went into lockdown early, has fallen below 5%. For the country overall, rates have abated but remain close to a two-digit pace. Consequently, we retain as our baseline view that normalisation in the world economy cannot start before the third quarter. Only when all economic regions are past their epidemic peak will global trade be able to continue without demand or supply-side disruptions throughout the value chain.
We would expect both the US and the Eurozone to go through a steep recession in the first half of the year. We see GDP falling by -0.4% this year in the US and by -2.1% in the Eurozone on an annual average. US outperformance would merely reflect a difference in trend growth and a stronger carry-over effect from 2019. The COVID-19 shock is symmetric across the Atlantic, to the tune of about 2% of GDP on an annual average basis in 2020.
A rebound in the second half is dependent on strong policy stimulus to counter second-round effects from business defaults and rising unemployment. The early signs are good. Fiscal packages worth up to 5% or even 10% of GDP are being deployed in the US, UK and Germany. The ensuing rise in deficits will be absorbed thanks to the extraordinary steps taken by central banks.
The Federal Reserve (Fed) has committed to unlimited quantitative easing (QE) and plugged holes in its emergency toolkit by starting to buy corporate bonds (for the first time) and even lending directly to businesses. The European Central Bank (ECB) has removed self-imposed limits for the duration of the crisis while pledging more than €1tn in additional purchases this year. These are truly historic decisions.
Implementation must be closely monitored. It will take some weeks to translate the policy decisions into action, especially since central banks and governments are themselves operating under the same constraints as everyone else. More details on the monetary stimulus actions are needed e.g. what would be the pricing of the Fed’s new intervention tools? Still, we have the building blocks of a very decent protection capacity for the world economy. Now, while implementation is being beefed up, we need to hear some good news on the epidemic front.
AXA IM Chief Investment Officer, Core Investments, Chris Iggo:
It will take some time for markets to return to normal. Volatility remains high and risk indicators still point to significant stresses in parts of the market. Further de-risking and de-leveraging is taking place. Central bank announcements and the provision of huge amounts of liquidity is helping but investors will continue to anticipate bad news on both the economy and corporate sector for some time.
But the large government and central bank stimulus packages will contribute to market stabilisation. Banks were unable to provide this in 2008, so the economic fall-out from the credit crunch was greater. Today banks are stronger, and governments are supporting them. This should help keep credit channels open.
For government bonds the future is one of stable, low yields. Activity will be dominated by large issuance by governments borrowing to finance their fiscal plans, and massive buying by central banks as part of their QE plans. Once the virus is past, I believe there will likely be little value in government bond markets for return-seeking investors. Yield curves may steepen as the economic recovery kicks in. Some sovereigns, like Italy and Spain, will remain under pressure until the Eurogroup finalises details on a broad mutual support package for the most impacted countries in Europe.
On the equity side, much depends on how deep the downturn is and how quick and robust the recovery will be. This will determine the path of earnings. Significantly negative earnings-per-share growth will likely be seen this year. These are unprecedented times but the market rally earlier this week suggests investors do see long-term value in stocks.
What is important is sentiment – and more certainty. In the medium term, the changes likely to be seen in the economy and to business models will provide significant opportunities for equity investors. This I believe, will especially be the case for businesses that have been seen to help the decentralisation of work, increase efficiency of managing supply chains and supported human capital in the broadest sense.
Credit spreads are reaching levels approaching those seen in 2008. The lesson we can learn from then is that subsequent returns to credit investors were very strong. Right now, investor hesitancy stems from not knowing how official support will work and how bad cash-flow interruptions to many businesses will be. Overall, I believe a broad, diversified and actively-managed investing approach to credit could generate decent returns from these levels over the medium term.
AXA IM Head of Active Fixed Income Europe & Asia, Marion Le Morhedec:
Fixed Income markets endured significant tensions during March, witnessing extreme deleveraging amid some major dysfunctionality. At present, almost all asset classes are delivering negative returns year-to-date, the exception being government bonds. In addition to the coronavirus crisis, the world’s emerging markets took an additional hit from the oil price war which began between Saudi Arabia and Russia.
But valuations are extreme, and outflows are not over yet. While outflows have been driven by ETFs in emerging markets and credit, and risk-parity funds in futures, we are seeing a large difference in our daily operations between corporate – where forced sellers are still impacting valuations – and government bonds, which are trading almost normally.
The extreme volatility has also forced investors into deleveraging. Following the central banks’ announcements, we are waiting for the concrete implementation of the plans, as tensions have been particularly high for commercial paper and short-dated corporate bonds. Liquidity is not back to normal and we believe it is too early to turn risk on.
However, dislocation in fixed income markets means investment opportunity. We see value in real yields, as inflation-linked bonds benefit from good liquidity and are part of the central banks’ purchase programmes and we believe inflation strategies are likely to perform well in the coming months. In emerging markets, while there is extreme dislocation, illiquidity remains an issue and we feel we are not yet at the end of the turmoil. We believe investment grade credit will recover, but we are monitoring the downgrade risks, and therefore need to be selective. Presently we favour US credit in our global strategies as the asset class has suffered twice as much as in Europe and we expect it to benefit from the new measures. And as a responsible investor, we are committed to supporting the global economic rebound.
AXA IM Global Head of Multi-Asset, Serge Pizem:
The market response to the COVID-19 pandemic has been like nothing we have seen since the 2008 financial crisis. We expect sharp volatility to continue in the immediate future and have reduced our exposure to risky assets while short-term risk remains high. We remain especially vigilant of the rate of new infections in Europe and the US, where acceleration or deceleration will be the metronome for our short-term allocation views.
Strict containment measures have become more widespread, particularly in Europe. They will not put an immediate end to the epidemic, but they will slow down its progress and relieve the burden on health systems. These measures will have a significant negative economic impact and are expected to result in a deep recession in developed economies, with a sharp contraction expected in the first half of the year. However, growth is expected to rebound moderately in the third quarter and more sharply in the fourth – equivalent to a U-shaped recovery. This scenario is conditional on the absence of a significant dislocation in credit markets, which could trigger higher defaults and translate into a longer and deeper recession.
Significant liquidity pressures have begun to emerge as the prospect of recession in developed economies sparks fears of a clear deterioration in the quality of corporate credit, resulting in more defaults. These concerns have affected credit spreads and the interbank market, tightening financial conditions and worsening the short-term economic outlook.
Therefore, we significantly reduced the overall risk within our total return strategies and strengthened our risk mitigation strategies to deal with the turbulence. We have also lowered our equity exposure through derivatives. Similarly, we also reduced equity exposure in our benchmarked funds.
However, over the medium/long term, we remain constructive and maintain our view of a modest recovery in the manufacturing sector by the end of the year. Indeed, faced with the looming risk of recession and liquidity pressures, central banks have started to deploy a monetary arsenal to help mitigate the pressure. The Fed surprised positively by reducing its rates to zero and reinstating its asset purchase programme, through the purchase of $700 billion in bonds and the reinstatement of its Commercial Paper Funding Facility to allow companies to access short-term financing.
Simultaneously, the fiscal portion of the response to the crisis is gradually being prepared, with various governments announcing major support measures. Germany has pledged to provide €500bn in loan facilities to support companies in difficulty. Similarly, the US is preparing a gigantic $2tn plan to support household income and prevent business failures and thus cushion the economic shock. Fundamentally, we recognise that short-term risk has increased significantly and have reduced our exposure to risky assets to preserve capital accordingly.