From shock to shock
COVID-19 – and the economic shock that soon followed – had undermined global markets by the end of Q1. And like the virus itself, the strength of government response will ultimately determine the reach of contagion in markets.
The market response to the developing economic crisis initially evolved along fairly traditional lines. Bond yields, equity indices and commodity prices all began to fall on global growth fears. Market commentators were then quick to draw parallels with the global financial crisis (GFC) some 12 years earlier.
This traditional playbook soon unravelled. By early March, the volatility shock had turned into a VaR shock, with the liquidation of assets to raise cash and significant changes in historical correlations. This affected all asset classes, with even safe havens showing vulnerability.
The initial policy response by central banks (and the Fed in particular) focused on halting the pace of the liquidation of assets. This made sense as a critical first step and helped drive a return to a more traditional volatility shock.
More supportive measures are expected in Q2; however, there is market scepticism over how much interest rate cuts alone can offset the demand destruction we are seeing – especially with many central banks already operating at near-zero interest rate levels. In our opinion, a key factor going forward will be not just how much the likes of the Fed ease policy rates, but their ability to keep the back end of yield curves under control. We will also closely watch the impact of the Fed’s repo announcement at the end of March, which aims to give foreign central banks the ability to quickly raise USD liquidity.
The big question among investors now is whether the market has ‘bottomed out’. We believe the market has shown some important signs of stability, but we also believe it has yet to price in the full extent of economic weakness.
We expect further downward pressure on corporate earnings, and on investor sentiment. Regardless, some asset classes remain well supported, and we are advising our clients to focus on these for now. There are assets that still represent good value, in our view. One example is the fixed-income market in China, which is behaving more like its developed-market counterparts in terms of stability. Indeed, we are watching the performance of China’s broader financial markets carefully as they continue to show stability in the face of global uncertainty.
In FX, investors retreated to the traditional safe haven of the USD in Q1. Many market commentators expect this safe-haven status to be maintained. However, we believe structural long holdings of the currency could be undermined in this rate-cutting environment as the USD loses its interest rate premium. We see opportunities in other currencies – including the CNY, which is showing signs of resilience.
Over to commodities, where we expect a protracted period of weakness for oil prices. We don’t expect sentiment around the OPEC+ talks to improve much after their collapse in March – and predict that the fallout will be the most significant event for the oil market since the 1986 price crisis. We also remain constructive on gold prices. With DM bond yields trading near zero and central banks expanding their balance sheets aggressively, the fundamental case for owning gold remains compelling, in our view.
Amid the turmoil, all eyes will be on the broader policy response in Q2, following the initial ‘whatever-it-takes’ response to stabilising market sentiment. Some countries may resist the use of more draconian virus containment measures for social and economic reasons – limiting the chances of a growth recovery. A slow response may postpone the hit to growth, but also postpone the recovery. We think governments need to act quickly to ensure that the health crisis doesn’t evolve into an economic crisis. The actions of the Fed – and the subsequent recovery of the US economy – will ultimately determine the narrative for markets in H2.