COVID-19 Impact: AXA IM’s macroeconomic and investment strategy update - the implementation phase
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 expect most of continental Europe will have started exiting from lockdowns by mid-May, but we are circumspect about the US. While some improvement in the rate of coronavirus cases is visible in the hard-hit US coastal regions, we need to brace ourselves for a potential acceleration in central areas. This means we may need to wait until the end of the quarter for a broader return to normalisation in the US.
In the meantime, we will carefully monitor the effectiveness of the extraordinary policy stimulus in protecting the economy. Jobless claims suggest that more than 10% of the US workforce is unemployed, but with a level of income very close to their in-work earnings. A strong take-up of the Paycheck Protection Programme is consistent with another 10 to 15% of the workforce being kept on payroll using federal loans – which may ultimately turn into grants if successful in saving the jobs.
Beyond protecting income, survival of businesses is key. The Federal Reserve (Fed) intends to keep BBB- rated names (as of 22 March) eligible for its purchase programme providing their new rating is at BB- or above. It also announced it will extend its liquidity schemes incentivising banks to maintain flows of loans to the corporate sector.
Turning to Europe, we expect pressure to build on the European Central Bank (ECB) to also relax the rating thresholds in its corporate sector purchase programmes. Meanwhile, we are concerned about Italian public debt, which could exceed 150% of GDP this year. Given its low nominal GDP trend, the country will likely face a daunting task to stabilise its debt even after the pandemic is under control.
The support package negotiated by the Eurogroup last week is welcome but leaves us circumspect. Indeed, the most potentially powerful component – the Recovery Fund – is very vaguely defined at the finance ministers’ level. We believe a solution could lie in the ECB taking emergency loans originated to businesses directly on its balance sheet, allowing for a very long amortisation and protecting corporate cash flows.
Central banks are arguably walking a tightrope between the supporters of Modern Monetary Theory – who would favour debt monetisation (the financing of government operations by the central bank) in almost any circumstances – and disciplinarians who want a return to traditional monetary policy. We argue that some forms of slow monetisation are acceptable if they apply only to the portion of central banks’ balance sheets which can be clearly identified as relating to the pandemic. It is a delicate balance however, and we can see a similar debate arising on how to deal with the looming financial difficulties in emerging markets.
AXA IM Chief Investment Officer, Core Investments, Chris Iggo:
We are now in the implementation phase of central bank and fiscal authority policy support. Huge amounts of money have been pledged but there will inevitably be delays before the cash starts flowing through the economy. However, markets continue to gain support from the policy backdrop and the slowing down of the global COVID-19 infection rate. Even so, there are reminders of how large the economic shock is likely to be, with the International Monetary Fund (IMF) saying it expects global GDP to decline by 3% in 2020, the worst since the Great Depression.
Government bonds are supported by the quantitative easing programmes announced by major central banks, while corporate credit is also bolstered by credit facilities. For example, the Fed’s primary and secondary market corporate credit facilities promise a combined $750bn worth of firepower to buy bonds, loans and credit exchange traded funds. Last week the term sheets were amended to allow purchases of bonds recently downgraded into high yield.
The next few weeks will be interesting as we start to see corporate earnings reports. The early reports from large US banks have shown a large increase in loan-loss provisions – prudent given the expected hit to GDP in the second quarter. The headlines are likely to get worse, but markets continue to be forward-looking.
Emerging markets remain troubling. Economies have been hit by the decline in oil prices, the impact of the US/China dispute and now COVID-19. Many countries are also in lockdown, resulting in a collapse in domestic economic activity. The Institute of International Finance estimates that emerging economies will need to finance $730bn in external debt through the end of this year. Some countries will struggle, given their high current account deficits and already-high levels of external debt.
Capital inflows have collapsed, and reserve levels are falling sharply in some countries. Most at risk, in my opinion, are economies like South Africa, Ukraine and Turkey.
On the plus side, valuations are attractive, and the recent stabilisation of oil prices is also positive. However, domestic policy options are limited, reserves are falling and currencies have weakened. There is less room for big fiscal policy stimulus in emerging markets in general. External deficits will fall, but financing debt will be a problem. Support from the IMF for the most troubled borrowers, together with a continued improvement in risk appetite in developed markets, are essential for a sustained recovery in emerging market assets and economic growth.
AXA IM Robotech strategy portfolio manager, Tom Riley:
While 2020 has so far been a challenging period for investors, the Robotech strategy has healthily outperformed the broader market.
Amid the current volatility we believe the strategy’s resilience has been aided by the balance sheet strength of the companies in which we invest. Broadly speaking the companies held in the strategy have substantially less debt – or indeed no debt – compared to broader equity indices, which insulates them to some extent from some of the market turbulence.
We have seen strong performance from companies that are seen to be benefitting from the new working-from-home environment. These include companies providing remote working applications such as German software company TeamViewer, or leading automated online retailers such as Ocado or Amazon. We have also seen good performance from companies making semiconductors that are used for high performance computing and artificial intelligence in data centres, such as AMD and Nvidia. These data centres are supporting the increased volumes in cloud computing as people work from home and seek online entertainment.
We believe that one of the legacies of COVID-19 is the disruption of global supply chains, which as well as the previous impact of the US/China trade war, will force companies to rethink their manufacturing footprints and how they source components. It will take a long time to reconfigure global supply chains, but we believe marginal investments could well return to the US and Europe. That trend would be supported by a steady decline in the cost advantage of outsourcing to developing nations as rising wage inflation continues in countries like China. Incremental investments in nearshoring manufacturing could come with a greater role for robotics and automation technology, which we believe should provide long-term support to this theme.
Additionally, we foresee increased pressure on governments to increase healthcare spending. Although there is clearly a finite budget for this, we believe that technologies that will benefit are those which can help reduce costs, improve patient outcomes and get patients through hospitals quicker. Robotic surgery ticks all three of those boxes and we anticipate a healthy growth rate for the industry going forward.
Some healthcare names have seen their share prices hit as elective procedures like robotic surgery for spinal issues get deferred and COVID-19 related issues are prioritised. Importantly, these deferrals are not cancellations (the patients will still need surgery in due course) so the recovery will likely be substantial when conditions normalise again in the coming months. With our longer-term investment horizon, over the last few weeks we have been increasing some positions in companies that we feel are starting to trade at substantial discounts to what we believe their earnings potential would be in normal economic conditions.
AXA IM Euro Credit Short Duration strategy senior portfolio manager, Boutaïna Deixonne:
We have seen a great deal of volatility recently in credit markets, specifically in short duration bonds, with low liquidity and significant dislocation.
We have been navigating this environment by reducing beta across the strategy since mid-December, after a market rally pushed spreads tighter. We took this opportunity to take profits on some high-beta names and reduced some off-benchmark positions.
As the rally continued in January, we thought that valuations were extremely tight, as a result we bought protection through credit default swap (CDS) indices. With COVID-19 spreading outside of China and affecting both the real economy and financial markets, we increased the CDS exposure (a buyer of protection) in early March.
These three actions have mitigated somewhat the impact of the wider spreads we have seen since the last week of February.
There have been large outflows from exchange traded funds and also some active funds in short duration, which has affected market liquidity – some bid/ask spreads have widened massively. However, there has recently been some large primary issuance, which saw good demand and over-subscribed books. This has started with largely defensive and well-rated names, but at the end of March and early April, others – even in cyclical sectors – have taken the opportunity for issuance. We expect issuance to be quiet in the coming weeks as corporate earnings season starts.
We are not overly concerned at present about issuers being downgraded to high yield. There will likely be some that make that move, but we think the number will be quite limited, especially in the Eurozone, though we expect more ‘fallen angels’ in the US.
Technicals are strong: there is an equilibrium between supply and demand; central banks’ quantitative easing measures will likely be supportive; and we are expecting some stabilisation in terms of outflows. The weak spot is fundamentals, which are not so good – as the real economy has been hit significantly by the impact of coronavirus. We expect to see some disappointing results as companies start to report first quarter earnings, though much of this is likely to already be priced in.
The significant widening of spreads we have seen since late February has made us slightly more positive on risk assets and as such we have cut part of our hedging. We continue to participate selectively in the primary market that offers a good concession (the difference between the spread when the bond is issued and when it trades in the secondary market) and better liquidity compared to the secondary market.