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Insight 27.02.2020

The viral demand shock goes global

The viral demand shock goes global

Spotlight - With the failure of authorities to contain the coronavirus contagion to within China or even Asia, the prospect of a more sustained demand shock for global economies has emerged. This poses the potential for elevated risks for investors looking ahead.


Key points

  • As a result, we expect we may have to lean heavily on the ‘risk-off’ and asymmetric exposure in the weeks ahead just as we did in the January market decline and when facing the periodic volatility seen since late-2018.
  • In particular, US dollar duration should continue to prove valuable in this uncertain environment. Indeed, the yield declines seen in recent weeks only bring US risk-free yields to the mid-point of our estimated 0.8-1.8% fair value range.
  • In FX, Swiss franc positions against the EUR and to a lesser extent against the USD should continue to be valuable within broader risk-off allocations. While we continue to believe that gold retains longterm value as risk-off protection, the one-sided positioning in particular combined with underlying, leverage suggest that at a minimum, near-term volatility may lie ahead before more significant asymmetry and potential upside can be realised.
  • Risk oriented investors may find opportunities in the recent spike in volatility via asymmetric structured solutions to cushion downside risks while allowing for upside participation. Similarly, a further widening in US high yield spreads may once again trigger the implicit Federal Reserve ‘backstop’ in the asset class creating opportunities for investors ahead.

The coronavirus demand shock may go global

Despite extreme containment measures in China since late- January, the meaningful clusters in Korea, Singapore, Iran, and Italy that have emerged in recent weeks suggest that China’s efforts and the actions of global governments have not been enough to restrict the infection to Greater China.

While the human tragedy of the viral outbreak is immeasurable, the widening number of geographic clusters as well as the prolonged disruption to air travel key pose a meaningful economic threat to global supply chains and activity that is as yet unpriced in global financial markets.

So, although we had anticipated that US and global policymakers had sufficient tools at their disposal to mitigate the impact of a temporary, localized outbreak in China, a more prolonged, global outbreak has the potential to test the policy toolkit and the political will of governments around the world.

Indeed, the US Federal Reserve while arguably retaining the most policy flexibility of Western central banks, may remain on the sidelines until the demand shock emanating from China finds its way on to American shores. This would echo the way the US central bank waited until 1998 for the 1997 Asian Financial Crisis to impact directly on US financial stability. Indeed, even though the Fed was more proactive in the face of the eurozone financial crisis, Fed action still came only once systemic threats emerged to the US economy.

Currently, despite market declines since mid-February, US and Euro area financial conditions still remain short of the tightening backdrop that spurred rate cuts and balance sheet expansion in late-2019. Similarly, while US credit spreads have widened following their late-2019 tightening, they sit short of the spreads that helped spur the July and October 2019 rate cuts.

Some may indeed question whether Fed policy action will be effective, as the current bout of volatility has come against a backdrop of the Fed seeking to pause its balance sheet expansion. This approach followed on from the late-2019 surge and aims to ensure stability in American money markets as well as a broader deceleration in global liquidity growth. We suspect, however, that renewed liquidity momentum would go a long way towards rekindling ‘animal spirits’ at least temporarily looking ahead.

Lean on ‘risk off’ exposure in periods of uncertainty…

In light of the continuing period of global macro uncertainty, we have spent the better part of the past 18 months building a substantial, actively managed ‘risk-off’ portfolio to cushion returns during unnerving declines like we have now.

Across our risk-off allocation, we continue to see longer-dated US Treasury securities as valuable. With the prospect of a virus-driven demand shock and/or the potential for rising taxes under a Bernie Sanders administration following the 2020 US Presidential elections, we see the risk of a further decline to <1% on the 10-year US Treasury as a beneficiary in the face of such demand shocks.

As highlighted in our 2020 Investment Outlook, safe haven currencies should also be a core part of risk-off allocations. In particular, we see positions in Swiss francs against the EUR and to a lesser extent against the USD continuing as being valuable within broader risk-off allocations.

Though we continue to believe that gold retains long-term value as a safe haven, the one-sided positioning in particular combined with underlying, leveraged positions suggest that at a minimum, near-term volatility may lie ahead before more significant upside can be realised. As a result, directional gold exposure may not provide the same risk-off cushion in the near term. Instead, exploring gold option strategies may offer more adequate asymmetric exposure in the weeks ahead.

…paired with asymmetric, risky asset exposure

It is reasonable to have concerns about policy error on the part of either the US Federal Reserve or other central banks around the world. This is especially true given the risk of multiple demand shocks (including US money market instability and/ or the prospect of the election of US Senator Bernie Sanders as the next US President). To counterbalance these issues, we aim to pair our ‘risk-off’ portfolio with our broader risky asset exposure. These potentially cushion returns during unnerving declines as seen recently. They also allow investors to maintain positions in risky assets such as equities that provide return drivers in more normal periods as seen since late-2018.

Indeed, the more than 5% decline in markets since the February peak is just below the average correction seen in 2019 where the Fed had proactively leaned against a tightening in financial conditions (which we expect them to continue to do in 2020). Making an even more cautious comparison of the current decline to that of 2018 when the Fed was raising rates and seemed more reactive to stress in the financial system, suggests we are approximately 50% of the way through a comparable decline.

Indeed, with the spike in volatility in recent days, asymmetric structured equity solutions are once again presenting themselves and should continue to serve portfolios well in cushioning downside risks. They also allow for participation in even temporary recoveries as seen in early-February.

Moreover, with US high yield spreads remaining short of the levels seen when the Fed was cutting rates and restarting its balance sheet expansion in late-2019, a modest further widening in spreads may offer renewed opportunities in the asset class as seen in late-January in anticipation of the Fed restarting policy easing.

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Michaël Lok
Group Chief Investment Officer 
and Co-CEO Asset Management

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Norman Villamin
Chief Investment Officer Private Banking
and Head of Asset Allocation

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Patrice Gautry
Chief Economist

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Yves Cortellini
Deputy Head of Asset Allocation

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