Drop in economic activity as exceptional as extent of monetary support

3 minute read

The global economy is in the midst of a major contraction. The pandemic has resulted in varying levels of worldwide shutdowns. This has caused a sharp deceleration of economic activity in the manufacturing and services sectors, offset by an unprecedented magnitude of monetary easing, financial stimulus and multilateral support. Parts of the economy are now cautiously being reopened and it is likely that economic activity picks up gradually as more lockdowns are to be eased. Still, economic activity remains at suppressed levels.

Macroeconomic backdrop

In the US, the measures have caused a complete stop of many segments of the economy. The newest jobless claims readings are illustrative of this as more than 30 million US employees have lost their jobs in a matter of weeks. Given the massive scope of the contraction, the fiscal and monetary authorities have stepped in. The US government has announced a $2 trillion fiscal package to aid the industries and workers most affected. At the same time, the Fed eased monetary policy and functions as the liquidity provider of last resort by implementing programs targeting various lending markets. Although these programs can help address the symptoms of the problem, they cannot solve the problem itself. These programs can rather help to maintain affordable lending rates and liquidity until the restrictions are lifted.

Figure 1: Our asset class overweights/underweights in our model portfolio as of May 1, 2020 on a 3-month horizon. Each percentage reflects the relative weighting of the different asset classes within our model portfolio.

The European situation is similar to the US. Many countries have been in lockdown for the past weeks and economic activity has slowed significantly. Leading indicators point towards a major contraction with readings poorer that during the heights of the global financial crisis. National governments and the ECB have implemented large scale support programs that should provide support and liquidity to citizens, governments, banks, companies and financial markets.

The situation in Japan and the UK is similar, with major economic slowdowns and fiscal- and monetary support packages announced.

The EM growth forecasts have been lowered as the widespread lockdowns negatively impact economic activity. Several smaller emerging markets (especially commodity exporters) are facing rising fiscal deficits and US dollar funding shortages. The resulting weakness in emerging market currencies does not seem to be having much, if any, pass through effect in producing higher consumer price inflation and expectations. Covid-19 appeared in China first, and China's economy which was the first to collapse is now the first to reopen and recover. There is, however, substantial uncertainty over the magnitude of the growth slowdown in the first quarter and the subsequent rebound. US-China relations are getting further attention as the US considers punitive measures on China's handling of the global pandemic, furthering the decoupling between the two largest economies. This will likely be countered with sanctions by China and probably result in failure to implement the "phase one" trade agreement signed on 15 January. The IMF has secured $1 trillion in lending capacity to help emerging markets struggling with the economic impact of Covid-19.

The outlook for the global economy is strongly linked to the duration of lockdowns. In case lockdowns can be eased relatively quickly, economic activity can pick up again, supported by the large stimulus measures. If economies cannot restart soon, second-order adverse effects will be more pronounced and the potential for a strong recovery diminishes.

Asset Allocation

On a tactical horizon, we have an underweight position in equities and an overweight in fixed income. We are neutral on alternatives.

Within fixed income: Within sovereign bonds, we are underweight in developed world government bonds. Following the recent market crisis, those bonds have generally rallied, with US bonds hitting record-low yields. On the other side of that position we are overweight in investment grade bonds where we see a very good return-to-risk trade-off. We neutralize our EM bonds position as our previous short position is no longer justified given valuation and price technicals of EM bonds. We are neutral in high yield and we open a small overweight in securitized.

Within equities: Within equities we have a fully neutral positioning. The uncertainty around the coronavirus crisis and the economic fallout from it make it difficult to make relative regional bets.


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