Odds of second-half recovery delayed

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Market volatility across the globe has spiked to unprecedented levels in the wake of heightened fears of the spread of the coronavirus (Covid-19) which has led to many countries resorting to lockdowns to contain the contagion.

Given such fear-driven and incoherent dislocations, greater caution is warranted. Our previous assumption predicated on the scenario that the ground situation in the US and Europe would not be worse than the original outbreak in Hubei, China is now looking increasingly less likely, and hence the lower probability of our base case scenario of a second half recovery.

Volatility has spiked to levels that make markets unreliable

The S&P500 had a minus 9% day followed by a 9% gain on back-to-back days last week (6 March to 13 March) which saw virtually all asset classes being pummelled. Bond yields for US 10-year Treasuries rose from 0.76% to 0.96%; credit spreads widened with the Barclays Global Aggregate Average up 130bp to 184bp. Gold was down by 8.6% and equities by 12.4%. Such levels of volatility make it impossible to know where portfolios will be heading in the near-term and thus necessitate greater caution in our risk positioning.

Path of virus outbreak makes the economic outlook increasingly uncertain

We had previously taken a view of a 2H20 recovery on the assumption the outbreak in Europe and the US would not be as severe as in China. If they follow the preventive paths of China and South Korea where new cases have flattened and even dipped to single or double digits, the negative economic impact would possibly only persist for two months once the number of cases retreats. Under such a scenario, risk assets will start on the paths to recovery. Instead, it appears that policymakers in Europe and the US – who unlike China – had a lead time of two to three months to prepare, are ill-equipped to handle the Covid-19 spread.

This increases the potential odds of the worst case scenario. The current extent of outbreaks in the West threatens to add several more months to the efforts to arrest the contagion. It also increases the risks of second-wave infections.

The positives are that more fiscal measures are in the offing from governments all over the world in their efforts to mitigate the fallout from the disruptive economic impact of Covid-19 on workers and industries reeling from lockdowns and travel restrictions. These multi-pronged measures have come on the heels of concerted co-ordination by leading central banks to head off any credit crunch for short-term borrowing for global banks.

The policy response to support economies has been large and swift with more to come. Unlike the Global Financial Crisis, the problems are not structural. The admixture of supportive policies and strenuous efforts to combat the virus has the potential for a strong recovery when the threat of the virus diminishes. But in the near term, Europe and the US will likely see the number of cases continuing to rise before it is brought under control.

Our medium-term outlook

While we had previously been expecting a 3Q20 recovery, it seems that the likelihood have been pushed back to the fourth quarter of 2020. We have thus lowered our monthly risk allocations to equities and high yield fixed income while maintaining a neutral outlook on a medium-term basis. For the near term, we are looking at overweighting cash positions and investment grade (IG) bonds while underweighting high yield credits and equities.