The Covid-19 global outbreak that started in early January represents an exogenous shock to the global growth cycle, at a time when the world economy was on the cusp of a new synchronized cyclical recovery. Driven by this shock, our macro framework moved into a global contraction regime in February (i.e. global growth expected to be below trend and decelerate). This regime remains in place today and is broad-based across regions (Exhibit 1). Furthermore, given the increased severity of the lockdown and quarantine measures undertaken by governments around the world, it is highly likely that most, if not all, countries and regions will experience a significant recession in the first half of 2020. Therefore, we expect the economic data to deteriorate meaningfully over the next few months. At this stage it is difficult to determine how long this macro environment will persist. Historically, contraction regimes in our framework have lasted on average 6 months with wide dispersions, ranging between 2 and 15 months across all episodes since the 1970s. We will continue to follow the data and the framework as it runs its course, but it is nonetheless valuable to compare the current downturn to recent episodes of financial turmoil, despite meaningful differences in the source of the shock and market imbalances.
Figure 1: All regions are in a contraction regime, and are likely to deteriorate further
One thing, in particular, stands out in today’s downturn. Policymakers have learned valuable lessons from the Great Financial Crisis (GFC) and the European debt crisis (EDC), and they have reacted promptly to the challenge in just a couple of weeks, compared to the multi-month process during the GFC and EDC. This time the fiscal and monetary policy response around the world has been meaningful in size and scope, and in some instances extraordinary. In many cases the fiscal response is even larger than in the GFC, with the US fiscal package equaling about 9.2% of GDP (nearly double the size of the GFC response), and Europe’s response equaling 2.6% of GDP (compared to 2.3% of GDP in the GFC) with additional transient and contingent debt guarantee schemes that could amount to between 10%-25% of GDP across individual European countries, if utilized. 1 Finally, given the typical gradual approach to stimulus removal, the fiscal impulse will likely be substantial for years to come.
Similarly, major central banks have promptly enacted measures to ease financial conditions and ensure liquidity in the financial system, resulting in interest rate cuts and open-ended quantitative easting. The Federal Reserve (Fed) has gone even further, becoming the effective lender of last resort and providing financial support to corporates both in the primary and the secondary markets. 2 Despite the enormous uncertainty and challenge of the current situation, it is reasonable to assume these steps should help stabilize markets, partially mitigate the economic damage of the enforced quarantines, and support the speed of the subsequent recovery.
While it is difficult to anticipate the timing of the cyclical trough, we expect such a turnaround to first occur in market-implied growth expectations, as asset prices should discount the positive impulse from fiscal and monetary policy ahead of the economic data (Figure 2). As in most recessions, we expect credit markets to lead the way, signaling a stabilization in the cost of capital and an inflection point for risky assets, ahead of earnings or earnings expectations.
Figure 2: Market-implied growth expectations not signaling a bottom in the cycle yet
From a strategic asset allocation standpoint, for investors with a multi-year time horizon (longer than 5 years), we believe the current global sell-off represents a unique opportunity to rebalance exposures from risk assets (i.e. equities, credit) to strategic targets at much cheaper valuations.
From a tactical asset allocation standpoint (with a somewhat less than 2-year horizon), we believe it is appropriate to take a more selective approach to risk assets and remain somewhat defensive. Our global 60/40 portfolio total risk is marginally below the benchmark’s risk. 3 Relative to the benchmark, we remain moderately underweight equities, primarily in emerging markets, and overweight government fixed income, with a bias towards a steeper yield curve. Within equities, we favor defensive factor exposures with tilts towards low volatility, quality and momentum, while we reduced exposure to (small) size and value. However, over the past two weeks we have moved to an overweight exposure in credit via US investment grade and emerging markets sovereign debt, as a first step towards harvesting attractive risk premia.
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1. Shares of GDP are our calculations, based on 2019 GDP figures and stated notional spending amounts in official press releases.
2. The Fed announced a program that will provide new financing to investment grade companies through two facilities, the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF).
3. 60% MSCI ACWI & 40% The Bloomberg Barclays Global Aggregate Bond Index (USD Hedged)
Duration measures interest rate sensitivity. The longer the duration, the greater the expected volatility as rates change.
The MSCI ACWI Index is an unmanaged index considered representative of large- and mid-cap stocks across developed and emerging markets. The index is computed using the net return, which withholds applicable taxes for non-resident investors.
The Bloomberg Barclays Global Aggregate Bond Index is an unmanaged index considered representative of global investment-grade, fixed-income markets.
The opinions expressed are those of Alessio de Longis as of April 1, 2020, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
Diversification does not guarantee a profit or eliminate the risk of loss.
MSCI Inc. Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent.
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The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.
An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high-quality bonds and can decline significantly over short time periods.
Because the Subsidiary is not registered under the Investment Company Act of 1940, as amended (1940 Act), the Fund, as the sole investor in the Subsidiary, will not have the protections offered to investors in U.S. registered investment companies.
The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified investments.
The Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risks associated with an investment in the Fund.
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