A Lombard Odier Investment Strategy Bulletin
Markets are experiencing their second volatility episode of the year, having fallen almost 5% since last Thursday 20 February on renewed fears surrounding the COVID-19. The risk-off stance is translating into sharp price action on gold and government bonds. Our main takeaway remains that the COVID-19 will have a very significant impact on economic data in the coming months, but that most (however not all) the economic activity should recover as the virus risk fades.
Our two key assumptions since the outbreak of coronavirus were that the measures taken by Chinese authorities would succeed in bringing the epidemic under control around the end of Q2, and that international measures such as travel restrictions would manage to keep the outbreak largely contained in China. The first assumption has been supported by data showing a consistent drop in new cases reported since early February in China.
However, recent news regarding new cases in South Korea, Iran, and Italy clearly suggest that global risks have risen significantly since last week. The rapid spread of the virus in Italy, from the first reported case last week to currently over 200 confirmed cases and a rising death toll, is of particular concern.
The scale of the contagion in Italy means that strict measures will likely be necessary to contain it, and the Chinese precedent suggests such measures may last longer than initially expected. Risks to economic activity from such lock-downs can prove significant, especially as the region affected is in Italy’s industrial heartland. The risk is compounded by the relatively limited room for policy easing in the euro area.
Meanwhile, economic activity in China is resuming, albeit slowly. Chinese authorities at both national and
municipal levels have begun to take actions to mitigate the negative impact of travel restrictions and resulting business closings. Xi Jinping’s speech to party cadres on 23 February included a promise to step up fiscal and monetary easing. The central government will initially cut and postpone tax and fee payments, boost special bond issuance, and implement monetary easing. The follow-up will likely be more straightforward stimulus in the form of infrastructure spending (especially healthcare) and research and development (especially biotech and pharma).
We believe that the combined size of all fiscal measures will be equivalent to 1.0-1.5% of GDP. Substantial easing of macro-prudential regulation on the housing sector is also likely. We now expect the home purchase restrictions in tier-1 cities to be lifted in H2 2020.
In addition, Western central banks are monitoring the situation in China and have confirmed their accommodative stance. They are ready to act if necessary. We have pencilled in two cuts by the Fed this year. Our case is clearly being supported by the fact that the current shock is starting to affect business confidence.
Despite the damage caused by the strict measures taken to contain the spread of the outbreak, and given the assumption that these measures will eventually prove successful (on top of the positive impulse from stimulus), we find the risk-reward in this current context to be roughly balanced.
Overall, a laborious recovery was in place before the start of the outbreak, as confirmed by the latest earnings season that posted decent figures – above expectations with earnings growth back in positive territory in both the US and Europe. We see this recovery as being delayed by the current situation in China, but not derailed.
In a low-growth environment, characterised by moderate expected returns and high valuations, we should be prepared for such volatility episodes. Hence our recommendation for several quarters now to maintain a risk profile in line with our strategic asset allocation and a balance between cyclical assets and hedges. Our slight underweight in equities, overweight in carry strategies (emerging market debt in hard currency and high-yield spreads have proved particularly resilient) plus hedges in gold and US Treasuries, will help our portfolios navigate this volatility.