Tuesday 10th March 2020
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At the time we are writing, major losses are occurring in risk assets, with equity indexes in Europe opening down today by around -6% to -8% and volatility spiking (VIX index above 58, a level not touched since the Great Financial Crisis in 2008).
Demand for safe heaven assets has surged to record levels, with the 10 Y US Treasury yield dropping to a new record level below 0.4% and gold touching a seven-year high above $1,700. The recent reaction reflects fears of increased spreading of the coronavirus at European and global levels and increased uncertainty on the economic outlook, with the news on falling oil prices adding to this uncertainty.
The oil price is crashing by around 20% amid a disagreement on oil production cuts between OPEC and allies. The energy sector is increasingly under pressure due to both demand shock from the coronavirus and supply concerns. We stay cautious on the sector both in the HY and IG credit, as we believe that it will be difficult to see an agreement in the short term.
As of today, we believe that markets have gone from being overly complacent to overly pessimistic, discounting a prolonged period of stagnant growth. Our central case, instead, is the one of a temporary setback, although more prolonged compared to what we were expecting a month ago, followed by a recovery. It is uncertain when economic activity will resume in Europe. Monetary policy support is needed to mitigate the credit crunch risk, while fiscal push is required to support the shock on the supply side.
We could see a further leg down from the current level, if we were to move towards a global recession. But we believe that at the moment, this remains a tail risk. We expect more central bank interventions, after last week’s Fed cut, and more fiscal policy, on top on what has already been announced in various countries (Italy, the US, Australia, just to name a few). These measures could cause the economy to stabilise and avoid a global recession. Encouraging signals are coming from China, where activity is gradually resuming.
Profit-taking, short-term market volatility, and investors’ overreaction were on the cards already in the last couple of week, when the situation started to deteriorate in Europe. This situation supported a tactical move towards a more cautious stance in risk exposure, and an increase in hedging to navigate this phase.
Liquidity is a key priority at the moment and we remain watchful of liquidity conditions in the market. As we have pointed out many times in recent months, market liquidity was one of our main concerns. Managing liquidity risk is an integral part of managing portfolios, alongside that of the risk/return balance. It is carried out via three levels: the first would relate to carrying out fund-by-fund stress tests both in terms of their assets and their liabilities, and adapting the liquidity in the portfolios accordingly.
In the event of massive withdrawals, this would require putting in place measures designed to guarantee equal treatment of unit-holders, such as swing pricing. Finally, there would be the need to have a solid financial structure (equity, permanent resources) to possibly face extreme risks. At this stage, we are at the first level and have increased the liquidity focus across the board.
In conclusion, our main message today is that in these situations of indiscriminate selloff, fear is the enemy to fight. Investors should stay vigilant, but not over-react to current market conditions. In these circumstances, opportunities arise for long-term investors that can add to fundamentally strong investment cases that pay off in the long term.
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