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asset allocation views

March 2020

After the plunge

A viral epidemic and an oil price war have battered markets. But government responses could offer some respite, however temporary.

Ferocious market reactions to the fast-expanding coronavirus epidemic and the Saudi-triggered oil price war have left equities potentially poised for a sharp, even if short-term, rebound. The shock to the markets is underscored by the jump in the VIX, the equity market volatility index, which saw the biggest three month rate of increase since Black Monday market crash in 1987, bigger even than what was seen during the Lehman Brothers crisis.

A rebound in equities looks all the more likely if policymakers implement co-ordinated stimulus measures, much as the UK did Wednesday with an emergency Bank of England rate cut and huge fiscal package. As a result, we are raising our tactical positioning on equities to neutral from underweight and trimming cash to neutral.

Still, we will tread carefully.  We prefer defensive equity sectors such as health care and remain overweight havens like the Swiss franc, US Treasury bonds and gold.

The prospects for corporate bonds appear less encouraging in the short term, not least because market liquidity is drying up.

Fig. 1 Monthly asset allocation grid
Asset allocation grid

Grid as of 11.03.2020. Source: Pictet Asset Management

Although our business cycle indicators won’t catch up with recent events for a while, early indications are that Chinese output dropped by some 5 per cent on an annualised basis in the first quarter. However, we are encouraged by signs that China is starting to get back to work as the epidemic is brought increasingly under control. Assuming the world’s second biggest economy soon returns to normal, there could be a significant rebound in the second quarter. Other Asian economies have also held up well. Key now will be how events develop in the US and Europe, with Italy setting a worrying precedent for how the virus might disrupt peoples’ lives.

Liquidity conditions are likely to improve with coordinated fiscal and monetary policy response. We estimate the world’s central banks have provided USD350 billion of liquidity so far this year, with the US Federal Reserve and Bank of England implementing emergency rate cuts. This is far from enough – but we believe policymakers will become more aggressive in the coming months, taking this year’s total liquidity provision to USD2 trillion, almost twice as much as the yearly average since 2008.

There are also encouraging signs that policymakers are relaxing banks’ capital requirements and providing funding to vulnerable businesses in a bid to ease strains in the credit market. The BoE’s move could provide a template for other central banks – it has reduced the countercyclical capital buffer rate to zero from 1 per cent and scrapped the plan to raise it to 2 per cent by end-year. It has also launched a GBP100 billion emergency loan package offering term funding for small and medium sized companies.

Having dropped around 20 per cent from their mid-February peak, global equities have gone from being expensive to cheap in absolute terms in less than a month, according to our valuation model. The price-to-earnings ratio on the MSCI World Index dropped to 14.7 on March 10 from 16.9 on February 19, a 13 per cent decline.

Crucially, both equity and bond markets are now braced for a recession – pricing in a 70-75 per cent likelihood in the US. That leaves room for a potential bounce back in response to any government or central bank stimulus. However, although equities are cheap, they are not exceptionally so – on a total return basis we are only one standard deviation below the 20-year trend – so there is scope for new lows if the coronavirus situation deteriorates.

As for market technicals, our sentiment indicator shows that equities are oversold, with a sharp increase in investor fear. However, investor positioning shows that there hasn’t been wholesale flight from the asset class, suggesting that the market has yet to see a capitulation event.

Luca Paolini on the coronavirus

Pictet Asset Management, as of 12/03/2020