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March 2020

Barometer: Bulls laid low as virus spreads

The economic and financial effects of the coronavirus outbreak remain unclear. Which means we continue to take precautions.


Asset allocation: taking precautions

The coronavirus has spread well beyond China and its neighbours, threatening to morph into a global pandemic. Stocks have fallen sharply in response, with the S&P 500 Index this month suffering its steepest weekly fall since the 2008 financial crisis. 

In this uncertain climate, we have been shifting to a more defensive footing in recent weeks, taking our equity allocation to underweight while increasing our holdings of cash. Still, that's not to say we expect to remain cautious for an extended period; experience tells us that attractive investment opportunities emerge whenever markets succumb to prolonged indiscriminate selling.  

Fig. 1 Monthly asset allocation grid
March 2020

Source: Pictet Asset Management

For now, our base case scenario is that the virus outbreak will shave around 0.3 percentage points (ppts) from China’s GDP growth for the whole of this year, taking it down to 5.6 per cent. The impact on the world as a whole will be around half as much, with the global economy now likely to grow by around 2.5 to 2.6 per cent in 2020. 

However, the situation could become much more serious if the coronavirus turns into a full-blown pandemic. Academic research suggests that a mild pandemic, like the Hong Kong flu of 1968-9, would trim global economic growth by 0.7 ppts, while a severe one, modelled on the Spanish flu half a century earlier, would slash it by 4.8 ppts – tipping the world into recession (see chart).

Crucially, the impact will be widespread. Japan, potentially, will be more affected than China; Europe and UK could also suffer a heavy blow. 

Fig. 2 Counting the cost
Economic impact of  modelled flu pandemic by region, % change in GDP, first year*
economic impact of pandemics chart

*Mild scenario is modelled on the Hong Kong flu of 1968-9, moderate is modelled on the 1957 Asian flu and sever on the 198-9 Spanish flu. Sources: "Evaluating the economic consequences of avian influenza", World Bank, 2006 and "Global macroeconomic consequences of pandemic influenza", McKibbin & Sidorenko, 2006

So far, the impact has yet to emerge in our business cycle models. And, arguably, from an economic point of view there is a saving grace in the fact that the world has been looking relatively healthy before the virus hit.

What's encouraging is that central banks and governments around the world are already stepping in to try and limit the economic damage. China is in a particularly strong position thanks to the big role of the state in the economy, which gives it the power, for example, to cut energy prices and to order large banks to support small and medium-sized enterprises in affected regions through extended or subsidised loans.

Our models show that the total liquidity flow1 in China is currently running at around 18.9 per cent of GDP, well below the long-term average of 31.1 per cent of GDP, which leaves plenty of room for more stimulus. The US can also provide more liquidity injections – based on past easing cycles, if the situation demands it we see potential for as much as 150 basis points worth of rate cuts from the US Federal Reserve.

Japan and Europe both have more limited room for manoeuvre in terms of monetary policy, yet are both already feeling the impact of the coronavirus.

Looking through the prism of valuations, the outbreak came at a bad time – equities in particular were expensive, with both US and global indices setting fresh all-time highs at the start of 2020. The subsequent sell-off has reduced some of the exuberance:  the MSCI All-Country World Index now looks fairly valued according to our models, with a price-to-book ratio, at 2.2 times, in line with the 20-year average. 

Technical indicators suggest the sell-off could continue. Investor surveys still show a degree of complacency. Surveys show investors remain overweight stocks, and there are few signs that equities are 'oversold'  However, positive seasonal factors – stocks tend to do well from March to May – could help limit losses.


Equities regions and sectors: case for the defence

The coronavirus may be indiscriminate in who it infects, but not all regions and equity sectors are likely to suffer equally.

So we reduce our allocation to the euro zone and Japanese shares by one notch – to neutral and underweight respectively – because we don’t think the risk of supply chain disruption is fully recognised.

Given the lack of clarity over how the Covid-19 outbreak might unfold and the speed at which infections seem to be spreading, caution is the order of the day. Both the euro zone and Japan seem to be relatively more exposed to the virus outbreak outside of China and Iran. Their economies are struggling to grow and their central banks are running out of firepower – the European Central Bank’s (ECB) key rate is zero and Bank of Japan’s is -0.1 per cent, while the Federal Reserve’s is 1.75 per cent.

We remain positive on the UK, which is showing signs of shaking off its Brexit-related problems. Indeed, companies’ preparations for Brexit could well help them weather supply-chain disruptions caused by the virus.

Fig. 3 Call for a medic
MSCI ACWI Health Care 12m forward P/E relative to MSCI ACWI P/E
MSCI ACWI Health Care 12m forward P/E relative

Source: Refinitiv, MSCI. Data covering period 01.012002-01.02.2020.

And we also remain overweight emerging markets and China. Policymakers in the emerging world have led the response to the virus by cutting rates faster than their developed market counterparts. 

And just as the Chinese government could be more aggressive in containment measures than, for example, the US and Europe, it is also likely to be more aggressive and, thus, successful in imposing measures that support its economy – through fiscal and monetary stimulus and direct support of its banking sector. This may well account for the Chinese market’s resilience during the crisis – the MSCI China equities index is down under 2 per cent since the start of the year, while the global index dropped more than three times as much.

In line with our more cautious stance, we also trim our allocation to industrials to underweight from neutral and reduce exposure to financial stocks.

Industrial stocks look particularly vulnerable. The sector is exposed to macroeconomic risks, while supply chain disruptions are already having an impact on individual companies. 

Health care stocks, on the other hand, looks set to benefit. There’s the most immediate issue: demand for medical and pharmaceutical resources is bound to remain high as the contagion spreads globally. Earnings have already been rising at a stable rate over the past decade and more. Meanwhile, the sector’s valuation based on forward price-to-earnings ratios is below where it’s tended to trade relatively to the market as a whole (see chart). For now, these factors help to mitigate any risks that might arise from the upcoming US presidential election – Bernie Sanders, who is leading the pack for the Democratic nomination, is a supporter of socialised medicine.


Fixed income and currencies: expensive havens

Gold and US Treasuries might be expensive but that shouldn’t deter anyone seeking protection from the financial and economic effects of the coronavirus. We remain overweight both.

True, benchmark yields on US government bonds hover around record lows while 30-year debt yields have fallen below 2 per cent for the first time ever. Yet, as the Fed itself has recently indicated, the threat of a global pandemic materially increases the odds for further monetary easing. The minutes from the central bank’s last rate-setting meeting warned that the “possible spillovers from the effects of the coronavirus in China have presented a new risk to the [economic] outlook.” 

US policymakers have room for manoeuvre. Based on an analysis of monetary easing cycles from 1970 to the present, we estimate that, in the unlikely event of a rapid deterioration of economic conditions, the Fed has scope to cut rates by an additional 150 basis points and buy up to a further USD3 trillion in assets.

Fig. 4 Underpricing risk
Euro and US dollar high yield bond spreads, basis points
High yield bond spreads chart

Source: Refinitiv. Data covering period 26.02.2015-26.02.2020.

An overweight position in gold also makes sense. The price of the precious metal has recently hit a 7-year high but we believe that demand should firm up as coronavirus cases increase outside China. The Royal Mint has reported a near 500 per cent rise in demand for gold bars and coins in recent days; net inflows into gold topped USD3 billion last month. 

By contrast, corporate bonds look especially risky investments as the economic skies darken. Spreads offered by both investment and speculative grade company bonds do not compensate investors for the risk of a deterioration in either earnings or a rise in default rates in our view. Making matters worse is that the average credit quality of the corporate bond market continues to deteriorate. As the OECD noted in report released earlier this month, triple-B rated bonds, the lowest investment grade ranking, accounted for more than half of all the corporate bonds issued since 2018. This suggests that a future economic downturn could result in higher default rates than past credit busts.


Global markets overview: running for cover

Equities took a beating in February as growing fears over the economic impact of the coronavirus outbreak triggered panic selling. The MSCI’s gauge of global stocks suffered a weekly loss of over 10 per cent, its largest weekly drop since the 2008 global financial crisis.

Global stocks have lost USD5 trillion in market capitalisation in the final week of February, equivalent to Japan’s annual economic output. The Volatility Index, Wall Street’s fear gauge, spiked to an intraday peak of 49 on February 27, ending the day at its highest level in five years.

Fig. 5 Fear Index
VIX Index peaks associated with market shocks
VIX Index peaks associated with market shocks

Source: Refinitiv, Pictet Asset Management. Data used is the closing level of the CBOE Volatility Index; observations taken from the covering period 28.02.1990-28.02.2020. 

Japan, UK and emerging Europe led the global sell-off in equities, while emerging markets, including Asia, managed to limit their losses to around 5 per cent.

Global stocks have fallen by some 9 per cent this year in local currency terms, having rallied nearly 27 per cent in 2019. 

Energy was the worst performing sector as oil fell more than 10 per cent. Disruptions to international travel and supply chains raised concerns over falling demand from China and other major economic powers.

Government bonds rallied across the board, with US Treasuries finishing the month up nearly 3 per cent as investors priced in the chance of an interest rate cut by the Fed in March.

The benchmark 10-year note hit a record low of around 1 per cent. Safe-haven gold ended the month flat, but it’s the best performing asset class since January with gains of over 4 per cent.

Emerging market local currency bonds finished the month in red as the US dollar rose by more than 1 per cent. Investors shied away from riskier credit, with European and US high yield debt falling by over 1 per cent.


In brief

barometer march 2020

Asset allocation

We trim equities to underweight and raise cash to overweight.

Equities regions and sectors

We maintain defensive positioning by reducing euro zone to neutral and Japan to underweight, trim industrials to underweight, reduce our overweight in financials and raise health care to full overweight.

Fixed income and currencies

We maintain our overweight in US Treasuries and gold and underweight in US and European credit.