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Caution and patience needed in the short term


MONTHLY INVESTMENT BRIEF

FEBRUARY 2020

 

Laurent Denize

Laurent Denize,
GLOBAL CO-CIO &
GLOBAL HEAD OF FIXED INCOME


For long-term investors, risk premiums still favour equities

Could the coronavirus epidemic severely dampen the sentiment that at the beginning of the year was decidedly more optimistic as regards to a stabilization of the world economy? Most certainly. The SARS episode of 2003 suggests that the panic surrounding the coronavirus will only abate once the number of new cases has peaked. Many commentators have drawn comparisons between today's epidemic and the SARS epidemic in 2003. The economic impact was short-lived. While China's GDP growth fell to 3.4% in the second quarter of 2003, it rebounded to 15.7% in the third quarter, a decline of about 1% for the year. Not so bad then, except that ... the Chinese economy now accounts for nearly 20% of world GDP and 40% of growth, compared to 20% in 2003. Production chains are also much more interconnected in a world that remains highly globalized despite Mr. Trump's attempts to limit trade. In short, the cost in basis points for world growth is likely to be more severe than expected and may rekindle fears of defla-tion or even a recession at the end of 2018, especially as central banks have less room for manoeuvre and valuations do not offer too many exit opportunities. So, is everything negative?

In the medium term and provided the epidemic is contained in the coming weeks, equity markets should resume their up-ward trend. This is partly due to the fact that global growth should benefit from the lagged effect of falling bond yields and an improvement in the global manufacturing sector through significant restocking. We should also bear in mind that uncertainty, an important factor in investors' risk aversion, has receded sharply with the truce in the trade war and the implementation of an orderly Brexit. Furthermore, we believe that fiscal/credit stimulus will continue in developed countries and particularly in Europe, with perhaps a change of heart on the part of the German government in response to recent exogenous events. China should also provide further support. The share of healthcare spending remains well below that seen in developed countries, which will encourage the gov-ernment to increase social spending and continue to add liquidity to support its economy.

In short, there is no cause for panic for the moment. But let's face it, the market was expecting stronger corporate earnings, more capex and more risk-averse investors. That's not really the scenario that was anticipated. At the very least, we need to hedge against the risk of a pandemic that looks to be lasting longer and affecting the economy for longer than the few months originally anticipated. How do we do that? In three ways:In short, there is no cause for panic for the moment. But let's face it, the market was expecting stronger corporate earnings, more capex and more risk-averse investors. That's not really the scenario that was anticipated. At the very least, we need to hedge against the risk of a pandemic that looks to be lasting longer and affecting the economy for longer than the few months originally anticipated. How do we do that? In three ways:

- Increasing duration in developed countries. 

- Buying volatility as downside protection.

- Favour quality and stocks that are less exposed to the macroeconomic impact of the virus (telecommunications, retail consumer goods and real estate). 

Despite some bumpy trading sessions, market turmoil has not pushed option prices to excessive levels. Far from it.

It is time to be cautious, the end of the year is still a long way off and the asymmetry of risk/return trade-offs does not lend itself to excessive risk-taking. For long-term investors, risk premiums still favour equities. It may therefore be opportune to start switching from bonds to equities as long as the current headwinds persist. But here too, there is no rush ...

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