What's moving the investment landscape?
This week we launch a new monthly review that aims to make sense of the factors driving financial markets. Sharpe Thinking will include timely, active insights from our portfolio managers, analysts and economists, delivered to you by the Investment Office – our independent oversight body that ensures our strategies perform in the best interest of clients.
The coronavirus plays its hand
For weeks, the coronavirus was a wild card that threatened global markets. But in late February, a spike in observed cases outside of China meant that it was played (see figure 1). The result was a sharp multi-day market correction, led by a rout in energy prices and double-digit price declines in the price of oil and natural gas – an echo of the 2015-2016 commodity crisis.
Our base case is still that the shock will be a temporary one. While global economic activity is likely to be significantly disrupted in the first half of the year, a sharp recovery should follow in the second half and result in a relatively limited drag on growth overall.
The underlying assumption is that the epidemic will be successfully contained over the next couple of months. But this is dependent on a number of factors: developments in China, other affected countries rapidly adopting containment measures and whether or not the virus eases as the weather improves in the northern-hemisphere spring.
However, we still know little about the virus’s likely evolution. The market reaction provides more evidence of how fragile and the vulnerable the current macroeconomic environment is: one characterised by sluggish growth rates and an overreliance on policy action.
Figure 1. Beyond borders: the coronavirus spreads outside of China
Source: Johns Hopkins CSSE, as at February 2020.
We expect Chinese GDP to contract in Q1, while other Asian economies should also be badly affected. Our Global Emerging Markets (GEMs) team previously thought that the profit margins of emerging markets were poised to turn a corner, supported by a strong structural growth story of urbanisation, an aspiring middle class and digitisation (read more about this in the team’s 2020 country allocation review). The latest market ructions are likely to delay any improvements.
Fixed income: navigating the storm
Members of our Credit team expect their asset class to be less affected by the coronavirus than equities, largely because it is not as sensitive to changes in growth expectations. But in the near-term the recent turbulence has resulted in one of the weakest periods in four years for both credit and equities, meaning that talk of a US rate cut has resurfaced.
The team is positioning itself to deal with any fallout from the virus. Our exposure to energy companies is focused on low-cost producers which already have hedges in place to mitigate lower prices. And while the auto sector should be affected – production halts will have a significant effect on output – we already had a negative view on the industry, owing to declining sales in China and the US due to trade tensions and the unsustainable use of sales incentives, respectively.
Industrial metals are currently under severe pressure, as the virus has reduced demand for copper and iron ore. While we maintain our positive view on the sector’s long-term fundamentals, we have a number of defensive trades in place through our flexible strategies. To understand our Credit team’s approach to defensive investing, read our recent piece on downside protection.
Looking beyond the coronavirus, we have still found areas of opportunity over the past few weeks. Within the luxury goods industry, we benefited after our holding L Brands announced its CEO’s departure and its intention to sell its majority stake in Victoria’s Secrets (which would be a creditor-friendly move).
We believe that a dynamic and flexible allocation to a broad spectrum of liquid credit instruments – including bonds, credit-default swaps and floating-rate notes – is the best defence in the event of a market shock. While record-low interest rates have resulted in an unprecedented expansion of BBB-rated credit (see figure 2) we think that an increase in the number of fallen angels should provide an opportunity to invest in attractive but mispriced instruments.
Figure 2. The size of the BBB-rated universe has soared
Source: Federated Hermes, ICE Bond Indices, as at February 2020.
We have also used options to reduce the impact of shocks on the Hermes Unconstrained Credit portfolio. Recently, we profited from our most in-the-money options on the Markit CDX High Yield and Crossover indices and have rolled them into longer dated, bigger notional and further out-of-the-money positions. The result has been an options exposure with more convexity and less contribution from delta and duration-times spread. Our new positioning means we should be protected if the market continues to sell off.
European equities: digging deep for hidden gems
The outlook for European growth was muted even before the coronavirus epidemic erupted – despite the uptick in inflation at the end of 2019. Nonetheless, our European Equities team continues to unearth firms it describes as ‘diamonds in the rough’.
Our Impact Opportunities team also sees potential in its holding Ecolab, which provides products that improve food cleanliness and sanitation. By aiding the prevention of foodborne illnesses, it is well placed to help solve food security issues and deliver Sustainable Development Goals 2, 3 and 6, which target zero hunger, good health and wellbeing, and clean water and sanitation.