Cross Asset Investment Strategy

CIO Views

Contagion speed is key for markets to reach turning point

Markets (financial cycle) are leading the economic cycle and will bottom out before the end of the coronavirus pandemic. However, they would stabilise once reassured on three points:

• The cyclical pattern of the pandemic, or when there is some sign of an improvement on the speed of the contagion. This depends on the ‘time’ variable (extension of the crisis period) and on the mobilisation efforts (containment measures introduced in different countries). There is still a lot of uncertainty at this point.
• The ‘whatever is necessary’ tactics of the fiscal and monetary authorities, and whether these policies are considered credible when it comes to easing financial conditions for the corporate sector or providing adequate resources to households so the latter can endure a period of higher unemployment resulting from an economic shutdown. Markets seem to have finally understood how big and unprecedented these efforts are.
• The short end of the credit curve, after recent dislocations, and core bond yields, which rose since the fiscal measures were announced, discounting higher future debt. Bond yields now appear to be under control, while on the credit side there is still room for improvement.

However, the policy bazookas won’t be effective unless there is a corresponding fall in the speed of Covid-19 contagion. The combination of the two will drive the timing of the recovery and, as long as the pandemic does not seem to be under control, volatility will persist. What matters most to investors, in our view, is the speed of the pandemic’s direction that is still pointing towards a rise in the number of cases, with an acceleration in recent weeks. When containment measures start to produce results, the speed of contagion should decelerate. This happened in China first, and we now see some signs of it in Italy. Most countries are still some way from their peak. The UK and the US are still in an acceleration phase, as are many EU countries, while some EM countries are at an early stage.

If the global lockdown proves successful, the pandemic should accelerate toward its peak in the next month, after which the speed of the increase in new cases should start to decline. We are moving in this direction, but we are not there yet. In the short term, we can only expect temporary relief from the extreme market dislocation rather than a full and stable recovery.

In this transitionary phase, as the crisis unfolds, it will become clear to investors that the day after the pandemic ends they will find themselves with lower core bond yields and thus a need to find yield elsewhere. Credit markets and EM debt will be the natural candidates in the public markets, though pressure on these assets remains high at present and it’s not yet time to call aggressive entry points. In credit, we remain cautious and highly selective in high yield, while we prefer the IG space which should benefit from central banks’ umbrellas, as will peripheral bonds. A continuation of the downward loop in the market could only be justified by a permanent shock to potential growth, but this is not the most likely scenario right now.

Equity markets will remain under pressure until signs of stabilisation in the curve of the epidemic’s evolution materialise. We see opportunities arising in quality cyclical sectors that could bounce back strongly once the appeal of cyclicals is restored, as we approach the peak of the pandemic. Some bottoming out could begin earlier at regional level and China is a good candidate for that. In terms of portfolio management, this backdrop calls for a continued-cautious approach, as we recognise that global risk aversion will persist in the short term, and will legitimately drive a flight to safety into a combination of high-quality, defensive and liquid assets. Active management and selection will be key to managing this ‘in-between phase’ and, in particular, the trade-off between performance and liquidity. Now, more than ever, robust liquidity management will make a difference.

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